The end of an era for Cloud Cuckoo land economics

 
Allister Heath
IT came as a shock but not as a surprise. America’s downgrade is another psychologically important moment in the decline of the West: the US and much of Europe, once uncontested superpowers, are now the world’s weakest economic link. The post-Bretton Woods era is coming to an end. Asia and the emerging nations are on the rise – and the world’s increasingly vocal creditors. As economic power shifts, so will geopolitical and cultural influence. The US, which for decades enjoyed massive inflows of cheap financing, and huge benefits from owning the world’s reserve currency, needs to start to live within its means. The same is true of Europe, which faces two additional challenges: the Eurozone, which cannot survive in its present form and which has become the most urgent threat to global prosperity; and (even more than America) bloated welfare states and a generalised failure to grasp that weak education systems, high taxes and crippling regulations are a no-no in a globalised world.

Western governments as well as Japan have tested to destruction the belief that governments can ensure perpetual growth by borrowing ever more, keeping interest rates low or printing money. This sort of thing can sometimes work in the short-term. But it cannot go one forever. We have now reached the end of that road: “stimulus” packages of the fiscal or monetary variety have become counter-productive, with every extra pound in economic output created coming at a much greater cost. Ultimately, one needs real, sustainable growth – and that must mean deferring consumption to allow the savings required to finance productive investment; a sound, non-manipulated currency; interest rates that reflect reality; and lots of hard work, creativity, skill and innovation, suitably incentivised. The pseudo-Keynesian micro-management that dominates policy-making is not only intellectually bankrupt but has been proved to fail in practice. Politics and wishful thinking has been defeated by economic reality. In a world of scarce resources, we need to produce before we can consume – all the borrowing and money-printing in the world cannot refute this simple truth.

So much for the long run. The downgrade will obviously have a substantial effect in the very short-term – municipal and local government bonds in the US will also be downgraded – but the overall, immediate changes won’t be as far-reaching as some fear. There will be intense volatility, of course; it is impossible to predict just how violent today’s reactions will be, the extent of the sell-off of “risk assets” such as equities and the flight to safe havens (such as the Swiss franc and gold). There will be other knock-on effects. Will clearinghouses require more collateral to be posted, hiking the cost to cover trades? Will the repo markets hit turbulence? What will happen to clearinghouses’ own credit ratings? Will America’s money market funds be all right? Will reality-denying governments obsessed with shooting messengers respond with knee-jerk “crackdowns” on the hated “speculators”? We will soon find out.

The fallout may be contained because the two other major credit rating agencies have not yet shifted their position; because the Chinese and other cash-rich nations with hundreds of billions to invest don’t have much choice of where to put their money (the euro and yen are far riskier than the greenback, so yields on Treasury bonds are likely to remain pretty low, continuing to fuel that bubble); and because the US authorities were quick to maintain the regulatory status of US debt so banks, insurers and others’ capital reserves won’t be affected. But while the US’s decline could run for decades, and will involve further downgrades, the Eurozone’s crisis is urgent. The only question is how much debt the authorities will want or be able to federalise – how many toxic government bonds will the European Central Bank and the European Financial Stability Facility buy, in exchange for creating money or issuing Eurobonds backed by all Eurozone countries. Prudent taxpayers in Germany and elsewhere will pick up the bill left by profligate nations; but given its huge, multi-trillion euro size, this could destroy yet more credit ratings. France could be next for a downgrade. Even more importantly, a sovereign bailout will destroy any remaining popular support for the euro project, especially in Germany, understandably so given that the population was lied to when it was told that countries would retain their fiscal independence despite giving up monetary sovereignty. Short-termist investors may cheer the Eurozone’s transformation into a fiscal union – but this will only delay the day of reckoning. The era of cloud cuckoo land economics is ending: the sooner everybody wakes up to this the better.

allister.heath@cityam.com
Follow me on Twitter: @allisterheath