PIMCO CEO Mohamed El-Erian Source: Google Images
An excellent Economist Special Report on the World Economy last week led with a quote from Pimco CEO, Mohamed El-Erian, that the economy has reached a “new normal,” or recovery on a reduced (less prosperous) path. The Special Report rightly focused on US imbalances with China, the fiscal mess we’re in worldwide (especially in the United States), and worries of persistent unemployment and banking system weakness. The only point I would stress more emphatically than either El-Erian or the Economist did is the dire need for medium-term fiscal consolidation to avoid a worsening of sovereign creditworthiness (and therefore higher interest rates and lower economic growth).
The El-Erian/Economist argument is that: 1) the weak banking sector will limit the mediation of savings to investment in the economy for some time, dampening growth; 2) households, buffeted by falling housing prices and lost jobs and income, will increase their savings and reduce consumption, also restraining growth; and 3) China, with its huge trade surpluses and low levels of domestic consumption, will not bail out such deficit countries as the U.S. Therefore, a premature withdrawal of the fiscal stimulus any time soon could derail the incipient recovery before the private sector is back on its feet. A fair point, but timing is everything. If we wait too long to tighten fiscal policy, the goverment debt burden could skyrocket, interest rates will rise, the economy will tank, and the dollar will plummet. Better to keep monetary policy loose instead — notwithstanding a call by some hawkish regional Fed presidents for rate hikes sooner rather than later.
Before he was CEO of Pimco (the largest bond manager in the world), El-Erian managed the firm’s emerging markets book. It was in this capacity that I met him a number of times as an emerging markets analyst. He sports a quiet, brainy manner, holding his cards close and peering over onto yours — an image he cultivates, which convinces people to seek out his reluctant pearls of wisdom, like the “new normal.” El-Erian was what we call a “country risk” analyst before taking the helm of Pimco. Country risk analysts have seen this type of crisis many times before — in Mexico, Brazil, Thailand and Korea, among other places. True, it is today more serious for the planet, given that the U.S., a $14 trillion economy, is at ground zero. Nevertheless, the issues are much the same.
Country risk analysts talk about a concept known as “debt dynamics.” It is an equation in which you consider the variables that could drive government debt higher. Interest rates, the non-interest budget balance (known as the “primary” balance), and GDP growth. In order for government debt to be on a downward path, the government’s primary budget surplus (non-interest revenues minus non-interest spending) and GDP growth must be large enough to offset interest payments on the debt. In the U.S. case, the primary balance has gone into deficit of nearly 10% of GDP this year, the real interest rate on the government debt is nearly 3%, the debt-to-GDP ratio is expected to rise to nearly 90% next year, and GDP growth is expected to languish at 1-2% per year. Without a sharp reduction of the primary budget deficit, America’s debt-to-GDP ratio will explode. What’s more, this will mean that America’s “country risk premium” will rise, moving the interest rate the government pays even higher, which in turn will further dampen economic growth.
This is why health care reform with its $900 billion price tag, however warranted over the longer time, is simply fiscally irresponsible right now. Yet the Democrats insist on using their Congressional majorities, which won’t last forever, to expand entitlements in the middle of the most serious fiscal crisis this government has ever seen. Americans, spoiled by prosperity, have not experienced the chill of a sovereign credit crisis like we have seen time and time again in emerging markets. It can happen here.
In business school, they teach us that the U.S. government bond rate is the “risk-free” rate, and that “country risk premiums” on less-creditworthy governments represent the spread above America’s cost of capital that such governments must pay to borrow. Will America’s government bond rate remain the risk-free rate after all is said and done in this crisis? Or will America pay a spread above another government’s “risk-free” rate. Washington will write that ending.
In emerging markets over the last 20 years, financial crises often began with a credit boom, which led to a bubble in equity and home prices, imbalances with the rest of the world (e.g. trade deficits), and a government bailout of the private sector, launching government debt to the stars. In America, it is clearly deja vu all over again. This is why country risk analysts almost unanimously supported the bank bailout last year, because by shoring up sick banks, you avoid even greater losses of output. Yet many Americans (including leaders in both the Republican and Democratic parties) resented the government bailout of Wall Street.
Great powers and great economies throughout history have declined under the weight of deteriorating finances. I hope the “new normal” is for humankind to learn from history.
