Poisonous' economic combinations

The US Fed's quantitative easing and its low-interest rate regime has encouraged
the corporate sector to take on more debt to build up cash buffers, lift divide
nds and buy back stocks
By Nick Beams
SINCE the global finan-cial crisis in 2008 and the ensuing Great Recession, innu
merable reports on the world economy have appeared from offi-cial bodies such as
the International Monetary Fund. the World Bank and the OECD, as well as academ
ic insti-tutions, seeking to ascertain when a 'recovery' might begin. Released t
his week, the 16th annu-al Geneva Report. commissioned by the International Cent
re for Monetary and Banking Studies, and written by prominent economists, differ
s in one major respect. Earlier studies, while pointing to the ongoing problems
of the world econo-my, have tried to find at least one 'bright spot . This repor
t finds none. In fact, its basic theme is that any num-ber of economic scenarios
in one or other region could set off another financial disaster. The report's m
ain focus is what the
authors call 'debt dynamics.' Contrary to the widely-held belief that debt has c
ome down since the global financial crisis, they point out that the overall worl
d debt (public and private) ratio to GDP has reached new highs. Excluding financ
ial sector debt. it has risen by 38 percentage points since 2008 and now stands
at 212pc of GDP. The authors point to a 'poisonous combination' of lower world g
rowth and lower inflation. When inflation is relatively high, debt burdens are e
asi-er to pay off because the real value of money is lower. In today's world of
lower inflation and even outright defla-tion, however deleveraging becomes much
more difficult. At the same time, debt reduction lowers growth, setting in motio
n a 'vicious loop.' The report also notes that potential output growth in the de
veloped econ-omies had been on the decline already since the 1980s. The financia
l crisis "has caused a further. perma-
nent, decline in both the level and growth rate of output." The report casts a c
ritical eye over the US economy. "[Cjontrary to the widespread perception and se
lf-con-gratulations of public officials." it remains heavily indebted as a conse
-quence of the near 38 percentage point increase in federal debt relative to GDP
. Much of the increase in public debt resulted from financial bailouts. The most
striking result of state intervention to prop up the US finan-cial system is th
e expansion of the balance sheet of the Federal Reserve. Its holdings of financi
al assets have gone from less than 6pc of GDP in 2007 to 25pc today. The Fed's i
ncrease in asset pur-chases. known as quantitative easing, coupled with its low-
interest rate regime, has encouraged the non-financial corporate sector to take
on more debt. This borrowing has not been used for real investment and
increased production but to build up cash buffers, lift dividends and buy back s
tock to boost share values. Keeping interest rates low made investors 'stretch f
or yield,' the report states. "In effect. the Fed has been 'recruiting' investor
s to purchase risky assets. The problem is that not all investors may appreciate
the extent of the risk they acquire in the bargain." Surveying the European eco
nomy, the report says that on the "current projection for inflation and potentia
l output growth. the eurozone finds itself in a situation of great fragility." C
hina is "one of the candidates for the next episode of the debt crises that have
plagued the world since the early 1990s." The path for 'successful' debt reduct
ion 'looks quite narrow. and "there is a high likelihood of either a prolonged p
olicy of very low growth or even another global crisis." m Courtesy: WSWS