Introducing the ‘submerging markets’ of the UK, US | FT Alphaville

Introducing the ‘submerging markets’ of the UK, US

Mavercon blogger and former Bank of England MPC member Willem Buiter is back with an interesting view of the UK and US positions in the current financial crisis. In fact, he coins a whole new economic classification for them – behold the submerging markets.

He explains:

On a number of occasions I have cautioned against deficit-financed fiscal stimuli in countries whose governments have weak fiscal credibility, that is, countries where current tax cuts or public spending increases cannot be credibly matched by commitments to future public spending cuts and tax increases of equal present discounted value. I believe that both the US and the UK fall into this category.

Ouch. This is going to be good. Indeed, Buiter adds:

Increasingly, I find it helpful to analyse the crises afflicting the US and the UK as emerging market crises – perhaps they could be called submerging markets crises.

What do both countries have in common with emerging markets? Well, as Buiter explains, both saw government budget discipline dissipate with fiscal policy becoming pro-cyclical. Strong domestic investment in both cases outstripped domestic saving. Financial regulation and supervision was weak to non-existent, encouraging credit and asset price booms and bubbles. Corporate governance, meanwhile, especially but not only in the banking sector, became increasingly subservient to the interests of the CEOs and the other top managers.

Indeed, the degeneration was such that Buiter believes it may have lastingly affected both the UK’s and America’s ability to cope using traditional economic stimuli. As he explains:

This morality tale has important consequences for a government’s ability to conduct effective countercyclical policy. For a fiscal stimulus (current tax cut or public spending increase) to boost demand, it is necessary that the markets and the public at large believe that sooner or later, measures will be taken to reverse the tax cut or spending increase in present value terms. If markets and the public at large no longer believe that the authorities will assure fiscal sustainability by raising future taxes or cutting future public expenditure by the necessary amounts, they will conclude that the government plans either to permanently monetise the increased amounts of public debt resulting from the fiscal stimulus, or that it will default on its debt obligations. Permanent monetisation of the kind of government deficits anticipated for the next few years in the US and the UK would, sooner or later be highly inflationary. This would raise long-term nominal interest rates and probably give risk to inflation risk premia on public and private debt instruments as well. Default would build default risk premia into sovereign interest rates, and act as a break on demand.

Accordingly, because Buiter doesn’t believe the US or the UK authorities have the political credibility to commit themselves to future tax increases and public spending cuts to compensate for the spending increases they are contemplating, he doesn’t believe they should be engaging in any significant discretionary stimuli. Whether that be through higher public spending (consumption or investment) or through tax cuts or increased transfer payments.

In short, fiscal stimulus would be a waste of time according to Buiter and the focus should be on bank rescue and quantitative easing. As he explains:

The US and UK fiscal authorities should aggressively use their fiscal resources to support quantitative easing and credit easing by the Fed and by the Bank of England (through indemnities offered by the respective Treasuries to the Fed and the Bank of England to cover the credit risk on the private securities these central banks have purchased and are about to purchase). The £50 bn indemnity granted the Bank of England for its Asset Purchase Facility, by HM Treasury should be viewed as just the first installment on a much larger indemnity that could easily reacy £300 bn or £500 bn.

The rest of their “scarce” resources, meanwhile, should be directed to recapitalising the banking system with a view of supporting new lending in particular. When it come to shareholders, his view pretty much echoes that of Niall Ferguson’s:

Existing private shareholders of the banks, and existing creditors and holders of unsecured debt (junior or senior) should be left to sink or swim without any further fiscal support, as soon as new lending, investment and borrowing has been concentrated in new, state-owned ‘good banks’.

As for the recent mega Treasury flood, Buiter cautions:

In a world where all securities, private and public, are mistrusted, the US sovereign debt is, for the moment, mistrusted less than almost all other financial instruments (Bunds are a possible exception). But as the recession deepens, and as discretionary fiscal measures in the US produce 12% to 14% of GDP general government financial deficits – figures associated historically not even with most emerging markets, but just with the basket cases among them, and with banana republics – I expect that US sovereign bond yields will begin to reflect expeted inflation premia (if the markets believe that the Fed will be forced to inflate the sovereign’s way out of an unsustainable debt burden) or default risk premia.

Which leads Buiter to have the following and ultlimately extremely bearish view on the dollar:

The US is helped by the absence of ‘original sin’ – its ability to borrow abroad in securities denominated in its own currency – and the closely related status of the US dollar as the world’s leading reserve currency. But this elastic cannot be stretched indefinitely. While it is hard to be scientifically precise about this, I believe that the anticipated future US Federal deficits and the growing contingent exposure of the US sovereign to its financial system (and to a growing list of other more or less deserving domestic industries and other good causes) will cause the dollar in a couple of years to look more like an emerging market currency than like the US dollar of old. The UK is already closer to that position than the US, because of the minor-league legacy reserve currency status of sterling.

All of which concludes the birth of the submerging market economies.

Related links:
We don’t want no stimulus plan (or, the case against Keynes) – FT Alphaville
Atlantis, a submerged economy of old – Wikipedia