While it might seem like somewhat stating the obvious, it is nonetheless worth driving home to the politicians and public policy wonks who see rates at record lows and perceive a Keynesian borrow-and-spend-fest as once again the solution to borrowing-and-spending too much. As Morgan Stanley puts it, fiscal policy is sailing between the Scylla of chase-your-tail austerity and the Charybdis of sovereign insolvency. In short, it is impossible for developed market (DM) governments to grow their way back to solvency. Doing nothing would sail governments towards the whirlpool of national insolvency – at some stage. But avoiding insolvency would risk being monstered by recession. If ‘expansionary austerity’ worked, then Europe would now be booming. The outlook for fiscal policy and public sector finances is a major uncertainty for investors and, critically, is part of the reason why risky assets are being de-rated and ‘safe’ assets are at unprecedented valuations.
Morgan Stanley:The Strait of Mess
Fiscal policy is sailing between the Scylla of chase-your-tail austerity and the Charybdis of sovereign insolvency. It may be possible – with perfect foresight, untrammeled authority, tolerant markets, accommodating central banks and a disregard for political pressure – to navigate between these two threats. History suggests otherwise. Either way, this adds what is likely to be a long-running element of political and financial risk to the investment outlook. Markets are reacting by increasing the rating on ‘safe’ assets, and de-rating riskier assets, including equities.
Most DM governments are essentially broke. Of course, governments are not businesses, so the usual rules do not apply. But it seems that the net present value of governments’ liabilities – including the commitments embodied in current social security policies – exceed the net present value of their assets (including yet-to-be collected tax receipts). Exhibit 1 shows estimates of the (negative) net worth of some G-10 governments, relative to current-day GDP.
Three factors have contributed to this structural problem.
First, the great recession and its aftermath reduced governments’ expected receipts. As is typical after major crises, GDP does not return to its pre-crisis trajectory and trend growth is lower. Exhibit 2, from my colleague Arnaud Mares, shows a stylized version of this pattern, overlaid with the actual OECD GDP through the current cycle, with Morgan Stanley forecasts. The gap between the pre- and post-crisis trend for GDP accounts for a permanent loss of public sector income.
Second, the great recession led to great swap of debt from the private to the public sector. For example, the IMF estimates that government support to financial institutions has been over US$1.7tr, increasing public sector debt by almost 7% of GDP for the countries offering support. As an aside, because debt has been swapped, rather than reduced, aggregate debt in many economies is now higher (relative to GDP) than in 2008.
The third factor is largely unconnected to the current cycle: the escalating cost of ageing and health care. This crystallizes the contingent liabilities embodied in current welfare policies.
In short, it is impossible for governments to grow their way back to solvency. Doing nothing would sail governments towards the whirlpool of national insolvency – at some stage. That may be some time away, although for Europe, the near-term risks are greater, because of its peculiar institutional structure. Exhibit 3 shows the IMF’s estimate of the fiscal tightening required by 2020 to stabilize debt. The figures are changes in public sector primary budget balances (the budget excluding interest charges) as a percent of GDP, with and without the cost of ageing and health care.
But avoiding insolvency would risk being monstered by recession. If ‘expansionary austerity’ worked, then Europe would now be booming. Instead, austerity reduces growth, weakens the private sector (including banks), and ultimately damages the fiscal position it was intended to correct. Taken to extreme, this chase-your-tail tightening leads not to recession, but depression. When there is spare capacity – like now – fiscal changes pack a powerful punch. The IMF estimates that spending changes have multiplier of around 1¼ (Exhibit 4).
A few points:
First, this is largely a developed-economy problem. IMF estimates suggest only modest tightening is required by major emerging economies to stabilize public debt to GDP.
Second, as Arnaud Mares puts it, there is no question that negative-net-worth governments will impose a cost on the private sector. The only questions are when and how. The options are asset confiscation, explicit default, surreptitious default (financial oppression), or conventional fiscal tightening.
Third, how that cost is allocated has significant investment implications, but is inherently a political decision. Investors may hope for an outcome that minimizes financial pain, but history suggests that decision-makers minimize political pain.
Fourth, Europe is struggling to balance medium-term solvency and short-term cycle strength; the looming fiscal cliff in the US will test whether US policy-makers are more adept.
Finally, the outlook for fiscal policy and public sector finances is a major uncertainty for investors. It is part of the reason why risky assets are being de-rated and ‘safe’ assets are at unprecedented valuations. Exhibit 5 shows an index of policy uncertainty and the average US Treasury and German bund 10-year yield (inverted in the chart, so the line goes up as the yield falls). Yields have fallen as uncertainty has risen. To the extent that uncertainty about fiscal persists – and this seems set to be a structural risk – it reinforces our view that in future the valuation on risk assets will be structurally lower than the average of the past 20-30 years.
Source: Morgan Stanley