Willem Buiter, Chief Economist at Citigroup and a former member of the Bank of England’s Monetary Policy Committee, spoke to Bloomberg yesterday about critical events now happening in the euro zone. Buiter sees downside risk to European growth estimates and believes a soft restructuring will eventually be followed by a hard restructuring.
I agree that Greece will eventually restructure. When commenting on the Greek situation on CNBC last month, I indicated that this is a foregone conclusion. In the write-up after that appearance I also wrote that principal reduction aka a ‘hard’ restructuring is inevitable:
It is unclear whether the move to principal reduction will be messy. An involuntary default would clearly be messy. I don’t see this scenario as likely, and it certainly won’t happen in 2011. Instead, I anticipate a soft restructuring followed by a certain amount of political dithering, which will create contagion that forces a hard restructuring (aka ‘soft default’) down the line. This will be “somewhat messy”.
Contagion risk is the critical concern. Just this morning, Spanish daily El Pais wrote how “España vive su peor semana en los mercados de deuda desde la debacle de Irlanda – Spain is experiencing its worst week in the debt markets since the Irish debacle”. This article details how spreads are rising through the euro zone periphery including in Spain where the spread to German Bunds is now 250 basis points, 30 more than last Friday.
The macro backdrop is challenging because, as I indicated on Wednesday, “Political pressures to remove fiscal and monetary stimulus are too much to bear.” This is not only true in the US but also across Europe. Flattening in China, an inverted yield curve in India and Brazil, and policy tightening in South Korea despite all-time low money growth are all indications of headwinds in emerging markets as well.
But, more importantly for US investors, there will be no Bernanke Put to counteract this. US interest rates are already at zero percent. QE2 is over and there is immense pressure on the Fed from within as well as politically to refrain from more unconventional policy. My sense is that the economy will weaken significantly before the Fed moves against it – and only then because of vocal outcries for more policy stimulus. At the same time, we should remember, the new fiscal year for states in 2011 and the debt ceiling debates will loom large as fiscal contractions at the same time.
In sum, you have a weakening recovery, uneven job growth, less accommodative monetary policy, tightening fiscal policy at the federal and local levels, austerity in Europe and tightening in emerging markets coupled with secularly high profit margins and above long-term trend price-earnings ratios. In my view, all of this will come to bear in a negative way this summer on risk assets: commodities, equities, and high yield bonds. Treasuries are the mystery. Economic weakness should support them but the debt ceiling debate is an overhang that makes Treasuries unattractive. High quality, high dividend, lower risk equities and high grade corporates outperform in such an environment.
From a global perspective, the only way to counteract these headwinds is through business capital investment or household consumption. From a US domestic perspective:
What are potential ways out of this?
- A reduction in the capital account surpluses. Obviously, a Chinese revaluation might help here because what would really end the capital account surpluses is a major devaluation in the dollar vis-a-vis its trading partners. Now, this is a de facto decrease in American per capita income but it will bring down capital account surpluses. Obviously, if central banks stopped accumulating dollars and switched to euros or yuan or yen, that would also help.
- A reduction in private sector surpluses. This could happen via the household or business sector. If we had a capital spending binge, then business savings would go down. If households starting seeing job growth and started to reduce savings levels due to the psychological effect’s from increased economic security, then this could reduce the private sector surplus. But given high household debt levels, this would be a bad thing.
My analysis here says that the Clinton years’ achievement was due largely to a booming economy fuelled by a capital spending binge in the telecom sector and by business generally, mixed with an unsustainable decrease in household savings. Barring a repeat of this – something I would argue is a bad thing – the only way to get around the government deficit is to depreciate the dollar.
Global trade balances must sum to zero of course. For every trade surplus there is an equivalent deficit counterbalancing it somewhere in the global economy. That means the risk is to the downside, especially given optimistic second half growth forecasts. In Germany, for example, the Bundesbank’s forecast is still for Germany’s economy to maintain its tempo (link in German). My general sense, therefore, is that Buiter is right: on a global basis business capital spending and consumption growth, particularly from emerging markets are the areas which will limit negative scenarios.
Video below