September 3, 2012
This week, the world’s most powerful central bankers, led by Ben Bernanke, will hook up in Jackson Hole in Wyoming for their annual chinwag. This year, Mario Draghi will not be going, as he has some urgent business to attend to in Europe. However, like no other year, the chitchat of these individuals will determine the path of a global economy which is increasingly dependent on infusions of cheap credit from central bankers.
A few months ago in this column I wrote that this would be the “year of the central bank”, and it has pretty much turned out this way.
This week we are going to take two different angles – one American and one Spanish – to try to answer the main question perplexing financial markets these days, which is: can central banks save the day, or is each round of monetary easing simply pushing the day of reckoning out further?
We will try to answer this before the expected announcement this week from the ECB about what it intends to do about buying government bonds in the months ahead and – probably more crucially – before the German constitutional court ruling on September 12, on the legality of using German money to bolster the eurozone’s stability funds.
But first let’s examine what is going on the US and what Ben Bernanke is expected to announce, or at least hint at, in his Jackson Hole speech.
The economic news in the US is at best patchy. Second quarter GDP growth was upwards, but it is nowhere near as robust as it has been in previous recoveries. Unemployment is still far too high, and America is deleveraging at a ferocious rate, paying back debt which was built up in the Noughties boom.
While the private sector is deleveraging, the public sector is taking on more and more debt. This is quite normal because, after all, if we are all saving, who is going to do the spending? However, the figures for US debt build-up are quite startling and are worth having a look at.
Last week, US federal debt rose to over $16 trillion. Last year the figure was $15 trillion. It took 200 years to accumulate federal debt of $15 trillion, it took less than nine months to add another $1 trillion.
As Bill Bonner of the Daily Reckoning blog points out: “The average interest rate paid on this debt is only 2.13 per cent. At that low rate, the cost is only about $340 billion in interest payments. Were the interest rate to double to a more normal 4.26 per cent, the total interest cost alone would be closing in on the Pentagon budget.
“Without putting too fine a point on it, debt – much of it in foreign hands – is growing at about an 8 per cent annual rate. GDP is growing at a 1.7 per cent annual rate. For every dollar of extra output, debt increases more than $4. Official debt is growing more than four times faster than the economy that is meant to sustain it”.”
This is the problem for the US because, the more the economy struggles, the more quantitative easing (QE) is likely to be brought forward and, on present trends, it is taking more and more debt to generate less and less output. If this continues, the US will continue to get indebted faster.
It looks scary, but does it actually matter? The US current account deficit is narrowing. Therefore the US private sector is financing this budget deficit and many argue that, as long as this is the case, the government is simply recycling savings and there is no problem. In fact, much of mainstream economic thought would suggest that this is the right thing to do in a balance-sheet recession where people and companies are deleveraging.
But Paul Ryan, the Republican vice-presidential candidate, doesn’t believe this. He sees the build-up of debt as the beginning of the end for the American economy, and if his running-mate, Mitt Romney, wins the election, we are likely to see a massive reduction in the US budget deficit and a massive reduction in central bank monetary easing. From where I am sitting, this looks guaranteed to tip the US into recession in 2013.
Therefore, the central bankers at Jackson Hole this weekend are bound to have one eye on monetary developments, the other on politics and a third on Europe.
Europe’s problems are mounting by the week. The best indicator of this is data from Spain. In terms of deposits fleeing, Spain is turning into a big Greece. â‚¬74 billion of deposits left Spanish banks in July. This is twice the previous monthly record. Spanish banks have now lost 11 per cent of their total deposit base this year. This is what happened in Ireland, but the pattern is more like Greece.
Banks that lose deposits have to replenish these with a direct infusion of capital. This can only come from someone buying equity in the bank, someone lending fresh capital via bond purchases or selling some of their assets to raise money.
How likely is it that someone would take an equity stake in a Spanish bank now? Not very likely. How likely is it that someone would like to buy the assets on the books of the Spanish banks, the most liquid of which are Spanish government bonds? Not likely either. And how likely is it that someone in the private sector would buy Spanish bank bonds now with the economy cratering and bad debt rising? Again, not likely.
The Spanish problems explain why Draghi is not at Jackson Hole this weekend. He knows he is the last line of defence for the Spanish banking system, which is the precursor for similar developments in Italy. The ECB will simply either have to buy up Spanish government bonds directly or orchestrate another massive LTRO (long-term refinancing operation – ie, cheap loans for banks) initiative to keep the Spanish banks from going under.
As a result we should expect more aggressive monetary financing from the ECB this week. Otherwise the Spanish banking system sinks. In the US, we should also expect Bernanke to announce more QE if necessary. This will up the ante for both the Republican Party and the German constitutional court in the weeks ahead. As to whether printing money can save the world, the evidence thus far suggests, not on its own.