Contagion from Europe

Daniel Cloud

Should we be starting to worry about an economic contagion from Europe? Why are we still in this sort of trouble, four years after the crisis of 2008? How can we begin to get out of trouble? Since I don’t represent any particular political faction, I’m not going to tell you that the problem in Europe is too much vacation time, or not enough “stimulus.” We blame everything for our economic and budget problems, except the way we actually manage our economies and plan our budgets, and everyone, except the people who actually do these things. But what got us, and keeps us, in trouble is the way we plan, the notion that we can forecast our revenue and spending years or decades in advance, that we can make promises about exactly what will happen in twenty years, that we can abolish the business cycle, or tell central banks, in advance, exactly what they will need to worry about. The desire for certainty, the political demand for a crystal ball, is the real source of our present problems on both sides of the Atlantic. Since this longing to be deceived is unlikely to disappear soon, we should hope for the best in Europe, but prepare for the worst—while hoping America gets off lightly, but preparing for the possibility that it won’t.

Why is long-range forecasting to blame? Some European governments are having diffculty selling their bonds at good prices, trouble borrowing at normal interest rates. Where did all the unwanted bonds come from? Of course, governments borrow money by selling bonds to savers, so they’re a consequence of government spending, all through the developed world— exceeding tax revenue by trillions and trillions of dollars. And what caused that? Is it the result of long European vacations, or the Bush tax cuts, or a strong yen?

People in Japan don’t get much vacation and neither do Americans, yet both governments are very heavily indebted. The Europeans didn’t enact the Bush tax cuts, but they’re still in trouble. The dollar has been weak, but that didn’t save us. What we all actually have in common is that our expenditures, in America, things like Social Security, Medicare, and Medicaid, were mostly planned long ago, on the basis of a forecast that the 3 or 3.5 % trend growth we enjoyed in the 80’s and ‘90’s would continue forever, without interruption. On the other hand, our revenues are just whatever we actually happen to get in the real world, where that didn’t happen.

As soon as we encountered something that made that long-range forecast inaccurate (the bursting of the dot-com bubble in 2000 was what actually did it, but something else would have come along eventually) we were all in deep trouble, because revenues weren’t going to grow as planned, though expenditures still would. So we had to do everything we could to make the interruption in trend growth as short and shallow as possible, even at the cost of creating another, even bigger bubble in housing markets. That desperate move predictably backfired, and after ’08 we started really falling behind. Our only recourse then was to issue more debt, to cover the already-planned spending, and, in America, pay for a stimulus plan in the hope that somehow we would get lucky and zoom back up to the trend- line (because the thing that must be avoided at all costs is actually explaining to the voters that we’ve promised what no one can promise, and asking them to accept what is available in reality, instead).

But that even more desperate expedient failed to rescue the situation and, in addition to the hangover from the housing bubble, we (especially in Europe) now began to experience a drag on economic performance from all the debt we incurred trying to meet planned expenditures. Empirically, evidence shows that a debt-to- GDP ratio much over 80 % is a problem because it begins to slow down growth. This leaves tax revenues falling farther and farther behind earlier projections, requiring you to borrow even more to meet your obligations, which makes you fall even further behind.

At this point, most of the developed world is already at or over that fatal level, so the prospect of ever getting back to the planned revenue trend is increasingly dim, but we go right on spending as planned. The problem isn’t confined to the public sector. In America, our pension fund managers decided long ago to plan for an indefinite continuation of an 8 % return – the ten year bond is now yielding less than 1.5% – so none of them have the money to meet their obligations either. All of this is simply the result of supposing we could know what economic growth, or returns on investments, would be in future decades, when it’s perfectly clear that we can’t predict either thing even a few quarters out.

Let me give you another example of this mania for planning. Consider the widespread assumption among policy-makers and market participants that the developed world can’t really have a debt crisis, because in the end we can just “inflate our way out of the debt.” The assumptions behind this claim are that we can control the inflation rate without causing any harmful side effects, and that we can stop inflating any time we choose, without incurring much pain.

The first assumption may be a bit optimistic. The Fed, in the US, has been pursuing a thinly- veiled attempt to push the “core” inflation rate up for some time. That is what the policy of “quantitative easing ” was originally supposed to be for – it’s something you do when you’re worried about deflation, to try to get inflation back up to a safer level. Despite printing quite a lot of money, they only really managed to push up the prices of commodities like crude oil, corn, gasoline, and for a while, house prices—facilitating an enormous increase in the indebtedness of governments. Self-sustaining wage inflation is still nowhere to be found in the developed world.

Why should it be so difficult to get wage inflation going? There are two obvious reasons – a bottomless supply of labor, courtesy of globalization, and an endless stream of labor- saving inventions, driven by Moore’s Law. Faced with an apparent increase in demand as a result of money printing, employers don’t need to bid up the wages of workers in their own country. They can either create the new jobs in China or India, where labor is inexpensive, or else automate them out of existence with technology that gets better, faster, and cheaper every year. (Think of how many retailing jobs Amazon replaces.) These exogenous circumstances, which gave us a couple of decades of rapid growth with falling inflation when that was what we wanted, are still dragging the inflation rate down even now that we’ve changed our minds.

Though all the money the Fed created couldn’t overcome these technological conditions and push up the wages of workers, it had to go somewhere. If the price of labor doesn’t move up, excess money can only end up in asset markets, where it bids up prices and produces bubbles— creating an appearance of economic health in the short term. But in blowing up a bubble, you’re really just borrowing from the future and encouraging the building of vacation homes with the resources you should have been investing in productive activity. So when the bubble bursts, you find that the misallocation of resources has actually left you poorer.

But what is it that makes the Fed, as an institution, so peculiarly insensitive to the harmful effects of its policies? How can it be so strangely unaware of, or unconcerned by, the bubbles it has been creating in asset markets, when the harmful effects of, say the global bubble in house prices, are so painfully obvious to everyone else? Why, it’s the result of another ambitious attempt to plan the future, based again in the simplicity of theory and not the complexity of reality. Because we thought, at some point, that we knew exactly which problems a central bank might encounter, and exactly what should be done about them, we decreed, for all time, that the Fed only ever needed to worry about inflation and employment, nothing else. Driven by this very specific definition of success, they cheerfully fueled the crazy exuberance of the 90’s.

Yes, it seems foolish now, but there was little measured inflation, unemployment was low, and most importantly, they were following the instructions contained in the plan, so how could there possibly have been any problem? The creation of the dot-com bubble was inadvertent, no doubt many people at the Fed were alarmed by it on some level, but there was simply no plan for worrying about that sort of thing, so what could they do, except point out that the exuberance they were fuelling was “irrational”?

Surprisingly, that didn’t save us, so they then tried to deal with the consequences ( 9/11, which, they thought they could predict, would exert a permanent chilling effect on the economy, as consumers hid at home for several years) by blowing another bubble, in global housing markets. Now that the bubbles in housing markets around the world have burst, they’ve been busy blowing up the final bubble in the market for government bonds. Europe’s current troubles are just that last bubble starting to burst as well. Each one is more damaging to the real economy than the last.

What about Europe’s current plans, what about their plan to rescue Spain? Will it work? Since this request for help is not the first that has been made by a European country, we should be able to predict its outcome by looking at how the other requests worked out. Will the promises of their partners save them from Greece’s fate? But rates, along with the associated evaporation of confidence, drove sharp economic contractions.

Italy, an even bigger economy, is close behind Spain on the same path. Their GDP will shrink by about 2 % this year, and their debt-to-GDP ratio is already well over 120%. Their ten-year bonds are now yielding over 6%. If they get over 7% and stay there, which is likely if Spain follows the same path as Portugal, Greece, and Ireland, they too will be forced to ask for assistance, meaning that they will eventually experience soaring interest rates and a collapsing economy.

The pace of events is difficult to predict because policy-makers will delay the crisis as long as possible, but, at some point, there will begin to be the kind of feed-back effects that caused the 2008 crisis to accelerate after the bankruptcy of Lehman Brothers. Once Italy goes, sooner or later, (if they stay on their planned spending path) it will be France’s turn. They don’t seem to be in trouble now, but a level of debt and spending that might seem sustainable before the southern half of Europe enters a depression is likely to look much more alarming to investors once the depression starts.

The idea that Germany, Austria, the Netherlands, and Finland, between them can somehow stop this whole process by handing out money they don’t have is a politician’s fantasy. If they try, they’re likely to end up borrowing so much money they get in the same sort of trouble themselves. Even if they don’t, it’s not certain that they can avoid it. The big American banks will come out unscathed, having prudently or luckily done the right thing this time, but even their employees can’t actually know for sure, now, whether that will happen. If they do get into serious trouble, we may have no choice but to recapitalize them, again, unless we want to do without a banking system, though from a political point of view it seems likely that the terms imposed will be less generous this time.

The interesting question is, will we get off that lightly, with just a decline of a few percentage points in GDP, a second TARP program, and unemployment moving back over ten percent? Or will we, too, eventually lose our ability to borrow at low interest rates, and, like Europe, move towards a depression?

American policy-makers, confronted with this question, tend to say two things.

The first is that so far, the yield on our bonds has only gone down, as money seeks safety. Why shouldn’t we expect that effect to continue? But that is exactly like saying, in 1999, that the stock market must be safe, because it was still going up. Bubbles keep inflating until they pop. If that event is your trigger for worrying about the problem, by the time you start worrying it is guaranteed to be too late.

The second response seems more plausible. “Surely nobody will ever worry about the ability of the United States government to pay its debts, because they’re denominated in dollars, and the government can always print more dollars to pay them off.” Well, it’s true, we always can endlessly print more dollars – just as the Weimar Republic could endlessly print more marks. When a central bank begins actually monetizing the debt of its associated state, the amount of money that must be created goes up exponentially over time. Surprisingly quickly, trillions turn into quadrillions, and quadrillions turn into quintillions then pretty soon we are all walking around with wheelbarrows full of cash. The experiment has been tried many times – recently in Zimbabwe – and it always turns out the same way.
Most people assume nothing like that could ever happen in America, and I’m inclined to agree with them. The Fed would realize what it was doing, and balk. Somehow they would be institutionally unable to do what every economist knows in his bones is the worst thing you can do. If they didn’t, at some point the electorate would stop them.
The quantitative easing they’ve already done doesn’t commit them to going all the way to monetization – QE is a policy that can be defended on theoretical grounds, even if it hasn’t worked, but genuine debt monetization would be insanity. That means the Fed won’t just print whatever money is needed to pay whatever debt we issue, which implies that it will be rational for lenders to begin charging the US government a risk premium at some point, because they’d be stupid to count on the Fed doing something it’s too rational to do. In turn that means we, with a government debt that already exceeds our GDP and an annual budget deficit that dwarfs that of most European countries, actually could be vulnerable to contagion. Perhaps the Fed will be willing to issue enough money to postpone the reckoning, but that’s hardly good news – it simply means we have time to slide further down the slippery slope. There still isn’t any story about how catastrophe can be avoided when they eventually have to stop.

The problem with all the arguments for American invulnerability is that they assume we can plan the disaster, that we’ll never lose control and nothing unexpected (like the price of oil going to three hundred dollars a barrel, as a result of some effort to plan Iran’s future) will ever get in the way. In fact, history shows that if you’ve left yourself vulnerable by becoming overextended, trying to avoid contagion by adroitly managing your way through the bursting of a bubble is a very risky game. What would make us much safer is a realistic plan for living within our immediate means. We could start by implementing Bowles- Simpson, if we were actually serious about saving ourselves. But the events in Europe mean that time is running out, and the longer we do nothing, refuse to adjust our old plans to the new reality, the greater the risk of contagion becomes.

Daniel Cloud teaches philosophy at Princeton University. Before becoming a philosopher, he was a founding partner at Firebird Fund Management, where he helped create one of the first successful Russia funds. His recent book, The Lily: Evolution, Play, and the Power of a Free Society, is available on Amazon.