The World Economic Outlook report from the International Monetary Fund warns of significant risks in a eurozone meltdown, and reflects the schizophrenic attitudes of policy makers in general as they search for a solution to a problem that has no solution.
Government 10-year bond yields (interest rates), 2007-2012
The above graph from the report illustrates what’s happened as well as anything. What it shows is the interest rates that investors are demanding to loan money to various countries. What’s happened quite dramatically since the credit crisis began in 2007 is that investors are demanding more and more interest on loans to Spain and Italy, and less and less interest on loans to Germany and the U.S.
This reflects the prevailing view that Spain and Italy are likely to need bailouts, and investors know that in the most recent bailout of Greece, investors were forced to take 74% “haircuts.” On the other hand, everyone seems confident that Germany and the U.S. will pay off its bondholders in full, an assumption that Generational Dynamics predicts will turn out to be wrong.
World financial officials and pundits have been predicting every month that the housing crisis has bottomed out and that the economy is starting to grow again. What we’re seeing in real time is what I learned about when I was in school in the 1950s, when my teachers ridiculed the officials and pundits of the 1930s who kept predicting that “prosperity was just around the corner.” Last week, I quoted Wharton School’s Jeremy Siegel as predicting a stock market rise to Dow 17,000 within a couple of years, which puts him into the tin foil hat category. (See “14-Apr-12 World View — Wharton School’s Jeremy Siegel is lying about stock valuations”)
This is how generational theory works. The generations of survivors of the 1929 crash and the 1930s Great Depression are gone now, and nothing like it has happened since then, leading the politicians and pundits to conclude that it can never happen again because economists have figured out how to prevent it, by going more and more massively into debt.
As Alan Greenspan recently pointed out, every economy model has been dead wrong for the last few years. And as I’ve pointed out many times, economists cannot explain why there was a tech bubble at all, why it occurred in 1995 (as opposed to 1985 or 2005), why there was a real estate bubble, why there was a credit bubble, why the bubbles burst in 2007, or anything else that came after. They’ve been wrong time after time.
I’m always amused by the airhead financial experts and economists who say that the real estate bubble occurred because Alan Greenspan’s Fed lowered interest rates in the 2002-2004 time frame. First off, the real estate bubble began in 1995, the same time as the tech bubble. And second, interest rates have been at zero for the last four years, and yet there’s been no new real estate bubble; in fact, the last real estate bubble has continued to burst.
Turning now to Tuesday’s IMF report, we can see the consequences of the continuing bursting of the real estate and credit bubbles:
One must wonder why, with nominal interest rates expected to remain close to zero for some time, demand is not stronger in advanced economies. The reason is that they face, in varying combinations, two main brakes on growth: fiscal consolidation and bank deleveraging. Both reflect needed adjustments, but both decrease growth in the short term.
Fiscal consolidation is in effect in most advanced economies. With an average decrease in the cyclically adjusted primary deficit slightly under one percentage point of GDP this year, and a multiplier of one, fiscal consolidation will be subtracting roughly one percentage point from advanced economy growth this year.
Bank deleveraging is affecting primarily Europe. While such deleveraging does not necessarily imply lower credit to the private sector, the evidence suggests that it is contributing to a tighter credit supply. Our best estimates are that it may subtract another one percentage point from euro area growth this year.
What’s being described here is the collapse of the credit bubble. While the credit bubble was being created, roughly from 1995 to 2007, governments, businesses and individuals went into tens of trillions of dollars of debt. That debt was used to purchase homes and stocks, creating bubbles in those sectors. Once the bubble started bursting, governments, businesses and individuals began paying down debt. So that means tens of trillions of dollars is leaving the world economy. It took 12 years (1995-2007) to build up the credit bubble, so it’s reasonable to expect it to take 12 years to collapse it (2007-2019).
The IMF report depicts a kind of uneasy calm in the world, as a lot of people are claiming/hoping/wishing that the crisis has ended, but the report makes it clear how dangerous things are.
Accordingly, downside risks continue to loom large, a recurrent feature in recent issues of the World Economic Outlook. Unfortunately, some risks identified previously have come to pass, and the projections here are only modestly more favorable than those identified in a previous downside scenario.
The most immediate concern is still that further escalation of the euro area crisis will trigger a much more generalized flight from risk. This scenario, discussed in depth in this issue, suggests that global and euro area output could decline, respectively, by 2 percent and 3½ percent over a two-year horizon relative to WEO projections. Alternatively, geopolitical uncertainty could trigger a sharp increase in oil prices: an increase in these prices by about 50 percent would lower global output by 1¼ percent. The effects on output could be much larger if the tensions were accompanied by significant financial volatility and losses in confidence.
The above paragraphs describe a very interesting concept: “a much more generalized flight from risk.” This phrase captures the issue that generational theory focuses on. The fear being stated is that people will be less and less likely to want to borrow money or to lend money. Since debt was the main engine that kept the economy growing before 2007, a “flight from risk” means that the economy will not grow again.
This is exactly the generational point. The Boomers and Gen-Xers who were so abusive of credit and debt prior to 2007 have now been very badly burned, and they’re going be exhibiting a “flight from risk” for most of the rest of their lives. They will never be willing to go into debt again to the extent that they did prior to 2007. That’s why there won’t be any real growth again until the 2020s, when today’s generation of young children become demanding teenagers.
As I’ve said, there’s no solution to this problem. There’s no way to reflate the credit and housing bubbles, though the Fed and the European Central Bank (ECB) are certainly trying. The new IMF report recommends more of that:
Furthermore, excessively tight macroeconomic policies could push another of the major economies into sustained deflation or a prolonged period of very weak activity. Additionally, latent risks include disruption in global bond and currency markets as a result of high budget deficits and debt in Japan and the United States and rapidly slowing activity in some emerging economies. However, growth could also be better than projected if policies improve further, financial conditions continue to ease, and geopolitical tensions recede.
Policies must be strengthened to solidify the weak recovery and contain the many downside risks. In the short term, this will require more efforts to address the euro area crisis, a temperate approach to fiscal restraint in response to weaker activity, a continuation of very accommodative monetary policies, and ample liquidity to the financial sector.
This is where the schizophrenia sets in. The IMF itself has been a world leader in demanding austerity from countries that it bails out. But here, the IMF report is recommending that austerity be abandoned, replaced with an unending, infinite supply of liquidity.
The report says this even more strongly later:
Austerity alone cannot treat the economic malaise in the major advanced economies. Policies must also ease the adjustments and better target the fundamental problems–weak households in the United States and weak sovereigns in the euro area–by drawing on resources from stronger peers.
Policymakers must guard against overplaying the risks related to unconventional monetary support and thereby limiting central banks’ room for policy maneuvering. While unconventional policies cannot substitute for fundamental reform, they can limit the risk of another major economy falling into a debt-deflation trap, which could seriously hurt prospects for better policies and higher global growth.”
The phrase “unconventional monetary support” of course means print an infinite amount of money and pour it into the banking system, trying to stave off a deflationary spiral. That’s what’s been tried in ever-increasing doses since 2007, and it’s failed to work, because generational attitudes and behaviors have changed.
Europe is now right on the verge of a major new crisis. There will be enormous pressure on the ECB to flood the banks with free liquidity, but there will also be enormous pressure from the Germans not to let that happen. Meanwhile, the U.S. government goes exponentially deeper and deeper into debt, waiting for some crisis to cause everything to unravel. Generational Dynamics predicts that crisis is coming with 100% certainty.