Madagascar, a country we first blogged about in June and then again in August, may be down to its last few days as regards AGOA, the US preference program that underpins about 50 percent of the country’s $500 million textile industry.  Because of the change of government that took place in Madagascar in March, the US has been steadily threatening to suspend its AGOA eligibility unless the country returns pronto to constitutional government.  A committee consisting of representatives from State, Commerce, Labor, Treasury, USAID, the NSC and the USTR has been deliberating for several days on whether Madagascar’s transgressions merit suspension from AGOA.

With little likelihood that egregious democracy and human rights violators like Gabon and Angola will be suspended from AGOA, it’s hard not to be cynical about why Madagascar has come under such scrutiny for a regime change in which a highly experienced kleptocrat was replaced by a less experienced one.  Or why, suddenly, there is such concern about a return to constitutional government when it’s not at all clear that Madagascar’s leaders over the last 40 years have ever placed the interests of their people above their own.  We can be fairly sure that if Madagascar were pumping oil instead of just looking for it the country’s AGOA status would not even be under consideration. Still, we’re going to try not to be cynical.

We don’t know WHAT the AGOA eligibility committee on Madagascar is talking about. (The committee doesn’t actually make the final decision on AGOA.  They make a recommendation to the president who typically announces who’s in and who’s out around Christmas time.)  But we imagine the discussion breaks down in two ways.  On one side, there are the idealists who believe that the AGOA goals of promoting democracy and good governance will never be achieved unless the US gets serious about sanctioning individuals who overthrow democratically elected governments.  After seeing Madagascar’s political leaders backslide, prevaricate and just plain lie about their intentions in on-going negotiations brokered by the AU, SADC and the UN, the idealists are skeptical about whether these leaders – none of whom is a poster child for good governance – are serious about resolving their long standing differences.  The idealists are probably right.  These political adversaries, who have overthrown one another like kids playing leapfrog, despise each other.  We can expect that, AGOA or no AGOA, political friction, back-stabbing and jockeying for position will continue in Madagascar for years to come – just like in most countries.

On the other side of the committee table, there are the realists who recognize that cutting off AGOA is unlikely to have any effect on those behind the overthrow of the previous government but will vaporize millions upon millions of dollars of foreign investment in Madagascar, some of it by US companies, and dump tens of thousands of young female workers trying to feed their kids into the streets.

So what to do?  Cancel AGOA in support of a principle that will do nothing to advance good governance in Africa, or continue it and support workers and investors who had nothing to do with the whole business?  Forgive us for our presumption that this is a fairly obvious call.

This is an interesting test of whether independent observers who actually care about Madagascar have any effect on US government decisions in our democracy, or whether the departments concerned simply act with impunity to pursue their own interests and agendas. The rest is up to you, most esteemed AGOA committee.

Opinions and comments on RGE EconoMonitors do not necessarily reflect the views of Roubini Global Economics, LLC, which encourages a free-ranging debate among its own analysts and our EconoMonitor community. RGE takes no responsibility for verifying the accuracy of any opinions expressed by outside contributors. We encourage cross-linking but must insist that no forwarding, reprinting, republication or any other redistribution of RGE content is permissible without expressed consent of RGE.   

But fiscal deficits cannot be lowered in the immediate future. For the time being, fiscal (and monetary) policies must continue to support economic activity. The economic recovery is uneven and could be threatened by any premature withdrawal of policy support. Private demand is still unable to stand on its own two feet.

 This gives rise to a policy conundrum. How can we reconcile the competing requirements of  short-term support for the economy and longer term fiscal solvency?

Fiscal solvency strategies

The challenge for policymakers is to formulate strategies for fiscal solvency—what we often call “exit strategies”—and communicate these strategies to the general public. The G-20 countries recognized this requirement in their recent communiqué. This will be important, but words may not be sufficient. Are there actions that governments can undertake today to enhance their credibility without negatively affecting aggregate demand?  Yes, there are. 

First, governments can reform their institutional fiscal framework to make it more likely that fiscal adjustment takes place when the time for action arrives. The precise framework will depend on country-specific circumstances. Possible reform options include fiscal responsibility laws, numerical fiscal rules (to take effect only when conditions normalize), fiscal councils tasked with monitoring fiscal developments, improvements in budgetary procedures, and increased fiscal transparency.

The example of Germany is worth noting. In June, the German parliament adopted a new constitutional fiscal rule that limits the structural deficit of the federation to 0.35 percent of GDP from 2016 onward and requires structurally balanced budgets in the states from 2020.

Health, pension reforms

Second, various reforms in health and pension entitlements, though politically not easy, can be undertaken without jeopardizing economic recovery.

These reforms will not have a large impact on the today’s deficit, but can dramatically improve long-term fiscal trends and signal commitment to fiscal sustainability. They will not undermine demand if well structured—with a focus, say, on increasing the retirement age—or if they are passed now but implemented gradually.

These reforms can have powerful effects. For example, it is estimated that increasing the retirement age in European Union countries by two years can save the equivalent of some 40 percent of GDP (in net present value terms).

In sum, postponing fiscal tightening does not mean postponing fiscal action.

Opinions and comments on RGE EconoMonitors do not necessarily reflect the views of Roubini Global Economics, LLC, which encourages a free-ranging debate among its own analysts and our EconoMonitor community. RGE takes no responsibility for verifying the accuracy of any opinions expressed by outside contributors. We encourage cross-linking but must insist that no forwarding, reprinting, republication or any other redistribution of RGE content is permissible without expressed consent of RGE.   

In Washington I had the chance to meet someone I admire a great deal, Nick Lardy at the Peterson Institute, and although I shouldn’t put words in his mouth so as not to misrepresent him, I am glad to say that he seems to agree with the analysis of Chinese high savings as a consequence of policy-related constraints on household income growth, although he thinks currency undervaluation may have a greater impact on high savings than low interest rates, whereas I think it is the other way around.  In fact more generally I think this argument has become increasingly influential, and more and more analysts seem to be taking it up, both inside and outside China.

In that light I read earlier this week a fascinating and perhaps important article by Hung Ho-Fung in the current issue of the New Left Review, in which he argues that China’s development model has left it dangerously vulnerable to changes in US demand, and that these polices include repression especially of rural income.  According to Hung:

The PRC’s urban-biased development model, then, is the source of China’s prolonged ‘limitless’ supply of labour, and thus of the wage stagnation that has characterized its economic miracle. This pattern also accounts for China’s rising trade surplus, the source of its growing global financial power. However, the low wages and rural living standards that have resulted from this development strategy have constrained China’s domestic consumer market and deepened its dependence on the global North’s consumption demand, which increasingly relies on massive borrowing from China and other Asian exporters. As those other exporters have been integrated with China’s export engine through the regionalization of industrial production networks, the vulnerabilities of the Chinese economy have turned into weaknesses of the East Asian region as a whole.

Hung goes on to make a point that I wish many more would make.  When people like me warn about continuing domestic imbalances within China and the difficulty that China will face in its transition, we are often attacked for “blaming” and criticizing China.  Monday I was at a conference consisting of many prominent European and Chinese (and a few American) analysts who were discussing global imbalances.  At the end of one panel a member of the audience, who turned out to be from the Ministry of Commerce, demanded the right to make a rebuttal and set off on a fairly strange harangue in which she lambasted, to everyone’s bemusement, any attempt to assign China responsibility for any aspect of the crisis as well as any suggestion that its fiscal stimulus was worsening the underlying imbalances.  China has not, apparently, made even minor policy mistakes at all in the past decade and especially in the past year.

The nationalist argument

China and the American Jobs Machine, by Robert Reich, Commentary, WSJ: President Barack Obama says he wants to "rebalance" the economic relationship between China and the U.S. as part of his plan to restart the American jobs machine. "We cannot go back," he said in September, "to an era where the Chinese . . . just are selling everything to us, we're taking out a bunch of credit-card debt or home equity loans, but we're not selling anything to them." He hopes that hundreds of millions of Chinese consumers will make up for the inability of American consumers to return to debt-binge spending.

This is wishful thinking. True, the Chinese market is huge and growing fast. ... But in fact China is heading in the opposite direction of "rebalancing." Its productive capacity keeps soaring, but Chinese consumers are taking home a shrinking proportion of the total economy. Last year, personal consumption in China amounted to only 35% of the Chinese economy; 10 years ago consumption was almost 50%. Capital investment, by contrast, rose to 44% from 35% over the decade. ...

Chinese companies are plowing their rising profits back into more productive capacity—additional factories, more equipment, new technologies. China's massive $600 billion stimulus package has been directed at further enlarging China's productive capacity... So where will this productive capacity go if not to Chinese consumers? Net exports to other nations, especially the U.S. and Europe. ...

The Chinese government also wants to create more jobs in China, and it will continue to rely on exports. Each year, tens of millions of poor Chinese pour into large cities from the countryside in pursuit of better-paying work. If they don't find it, China risks riots and other upheaval. Massive disorder is one of the greatest risks facing China's governing elite. That elite would much rather create export jobs, even at the cost of subsidizing foreign buyers, than allow the yuan to rise and thereby risk job shortages at home.

To this extent, China's export policy is really a social policy, designed to maintain order. Despite the Obama administration's entreaties, China will continue to peg the yuan to the dollar... This is costly to China, of course, but for the purposes of industrial and social policy, China figures the cost is worth it. ...

While China's currency policy is certainly a worthy topic for discussion, lately we are spending a lot of time pointing our fingers at others and blaming them for our problems rather than engaging in the more difficult task of getting our own house in order. I'm not saying that we should ignore things that unfairly disadvantage us, whatever those might be, just that a continued focus on external factors provides a convenient excuse to avoid going through the difficult changes needed to reform our own economy, an excuse that can be exploited by powerful interest groups opposed to needed change (though Reich at least touches on the US side of the equation in a part I left out).

Yes, China needs to change its currency policy, and the fact that it won't or can't change will probably lead to further economic imbalances, perhaps to dangerous levels, and cause increased political tension in the future. But I hope we don't allow the financial industry and others wishing to deflect blame for the crisis and avoid stricter regulation to use the controversy over China's currency policy to divert our attention elsewhere and alter the narrative about how we got into this mess.

Some might think that this comes from an “exotic” form of fiscal policy whereby governments opened their coffers to prop up financial institutions. But only a small part of this debt spike is matched by a rise in financial assets. It really boils down to “plain vanilla” deficits—revenue losses from the recession, fiscal stimulus, and some underlying spending increases that would have occurred even without a recession.

A first step

Pretty much everybody agrees that something has to be done about this, and that fiscal policy needs to be tightened once the economic recovery has firmly established. The first step is to stabilize the debt-to-GDP ratio.

Even this will not be easy, given trend increases in pension and health spending, often reflecting population aging. But is stabilizing debt ratios at their post-crisis level enough?

The temptation will be strong. Just look at the numbers.

Let’s assume that advanced countries want to reduce gross debt to 60 percent of GDP (the median pre-crisis level) by 2030. To do this, they will need to improve their structural primary balance by 8 percentage points of GDP over the next decade, and keep it there for another decade. Obviously, this is a tall order. Simply stabilizing debt at its post-crisis level means half the work—an adjustment of 4½ percent. This is still ambitious, but much more manageable.

Easy path not the best

Still, taking the easy path is not the best idea. Governments need to do whatever they can to lower debt ratios, for at least three reasons. 

• First, they need space for fiscal responses to possible future crises. If you start with high debt, it’s really hard to let fiscal policy cushion the shock—just look at Italy. 
• Second, high debt pushes up real interest rates, with pressure on a limited pool of private savings. We have computed that raising government debt ratios by 40 percentage points (exactly what is projected to happen on current trends) would increase real interest rates by a sizable 2 percentage points. This may even be an underestimation as it is based on backward-looking estimates from a world where only a few countries were running high debt ratios, which could partly be financed abroad. With so many large economies borrowing at the same time, the effect on interest rates may be larger.    
• Third, high-debt countries tend to grow more slowly—just look at Japan and Italy. While other factors were certainly at play, the experience of several emerging market countries confirms the existence of debt overhang effects.

Altogether, I believe that living with 100 percent government debt ratios is not a good idea. Fiscal exit strategies in advanced countries should target a reduction of government debt to prudent levels.

If a debt ratio not exceeding 60 percent—as noted, the pre-crisis median level—was regarded by many countries as an appropriate norm before the crisis, it should continue to appear so after the crisis. And while it is too early to tighten fiscal policy today, the plans should certainly be put in motion.

Opinions and comments on RGE EconoMonitors do not necessarily reflect the views of Roubini Global Economics, LLC, which encourages a free-ranging debate among its own analysts and our EconoMonitor community. RGE takes no responsibility for verifying the accuracy of any opinions expressed by outside contributors. We encourage cross-linking but must insist that no forwarding, reprinting, republication or any other redistribution of RGE content is permissible without expressed consent of RGE.   

But one difference this time is now the dollar, rather than the yen, looks like the best funding currency, and the dollar is a deeper market, so the scale of potential damage is much greater. Second is that a lot of countries are running loose money policies, but they are at least making some credible noises re tightening (whether they follow through is another matter, of course). The US, by contrast, has made clear that it is keeping things easy-peasey for the foreseeable future. And the US (starting with the Greenspan era) has signaled any hawkish moves well in advance, so the odds that the Fed will have a sudden change of heart are just about zero.

Now, to play devil’s advocate, one could argue that the loose money policy is warranted. There is tons of slack in the economy, unemployment is high and rising, capacity utilization stinks. Surely raising rates now would be the worst move possible, right?

The authorities are completely responsible for the messes on two different fronts that intersect to create monetary policy dilemma. Going below 2% for Fed funds was a huge error (well maybe you could justify 1% as a very short term expedient), but the Fed is now painted in a corner. But second, and the much bigger issue, is that (as everyone can see) all this cheap money is not going into the real economy. A few very high quality borrowers are getting good rates; everyone else finds credit scarce and costly. So spreads are higher than before, and even absolute rates are often higher expect in markets like mortgages where the Fed has intervened.

Now some readers will correctly say that overly loose lending is what created the problem, and we need to undo that, but they are conflating two issues. Tightening up on WHO gets credit and HOW MUCH they get is separate from pricing. If this was mere improved standards, you’d expect to see more discrimination within various types of borrowers. But instead, across entire swathes of borrowers, particularly consumers and small businesses, banks have simply turned off the spigot. This has little to do with a return to prudent practices. In fact, it illustrates a real cancer: that across consumers and many small business owners, old-fashioned multi-variable decision-making (which included some verification of income) has been replaced by heavily or entirely FICO based systems. Those systems failed utterly. But they were cheap to operate, banks have no intention of reverting to earlier, more costly approaches. So we have a credit assessment process that is broken, but no one wants to admit it.

So if all this loose money isn’t getting to the real economy, there should be no reason not to raise rates, right? Wrong. This little procedure is again, entirely about the banks, screw the real economy and everyone in it. First, low rates (and now a steep yield curve) are an ideal setting for banks to make money. Greenspan pulled the same trick in the wake of the S&L crisis, and it enabled banks to rebuild their very wobbly balance sheets comparatively quickly (I’m amazed at the revisionist history about the early 1990s banking woes, which also involved pretty serious damage from dud LBO loans, and left the US banking system seriously undercapitalized). This plus high spreads makes ofr a very attractive environment for any new business.

But the second reason for keeping rates low is explicitly to keep asset prices aloft. The bubble is an explicit goal of policy. Remember, early in the crisis, they was talk of the markets being irrationally depressed. Funny how it is only prices that are seen as inconveniently low, and not ones that are insanely high, that are criticized.

But to cite Richard Nixon parodists: Let us make one thing perfectly clear. These monetary shenanigans are in no small measure the result of the utter failure of nerve late last year and early this year, to take sick institutions and resolve them. In many cases might not have entailed the bogeyman of nationalization (as in protracted government ownership), but throwing out the old top management and board, and forced debt to equity conversions. Cleaning up the banks was never treated seriously as an option, when the track record clearly shows that that is the fastest, least-cost way to deal with a financial crisis.

Notwithstanding the rebound of the world markets, the current structural global crisis is far from being over. Furthermore, it seems that new distortions and “asset bubbles” are being recreated. Commodities and oil prices are dangerously inflated. While governments and public institutions continue in their struggle to support the financial system and to avoid an economic catastrophe, there is a huge gap and an opportunity for investors with integrity and high ethical standards to take the lead. These are Pension Funds, Endowments and Foundations, Sovereign Wealth Funds, Supranationals, Central Banks, cash rich councils, and institutional investors.

Two fundamental factors emerge clear and assume critical relevance.

The first one is the “cash constipation” of such institutional investors with free capital. Their problem is how to protect their declining assets and to identify new sources of yield and diversification to preserve their goals. Their risk is failing in their fundamental scope.

The second is the “capital starvation” of the real economy. i.e. the persistence of a deteriorating environment for “sound” enterprises and infrastructure projects, because of declining demand, fall in the level of confidence and trust, withdrawal of the banks’ support, etc... These companies and infrastructure projects now need resources, a strategic support to embrace new business models, to produce new sustainable offerings, and to insure long-term operations. Their risk of failure would further delay any form of possible recovery and deepen the current economic depression.

The legacy intermediaries, that traditionally favored the exchange and flow between those who had free capital and those who needed it, are frozen, technically in default and not in condition of providing such vital function. Furthermore, their business model is in tatters.

Hence, the strong players with long-term views and objectives find themselves not only in a highly superior and privileged position for the extreme widespread scarcity of capital and absence of willingness to invest it. These institutions face now a heavy responsibility and an opportunity: to take on the task of “financing” directly those meritable enterprises and projects with sound credit worthiness in their endeavors to respond to the challenges of a more balanced and sustainable development.

“Direct Investing”: a New Asset Class

I am proposing what is effectively a new investment category, which does not exploit the owner in terms of fees, governance, control and transparency.

This new asset class is necessary and made possible because of the dire unprecedented circumstances, and it is facilitated by technological and informational advancement.

“Operation Direct Growth”, is a strategic plan that focuses on the “direct reallocation of capital use” between long-term investment institutions with surpluses and real economy firms in sound conditions and prospects that yet need further resources and support.

There will be no intermediaries in the exchange. The main actors of this scheme will be a consortium of institutional investors, among Pension Funds, Central Banks, Endowments, Sovereign Wealth Funds, and Supranationals. The savings and efficiencies of this new “Direct Investments” will be considerable. This will regenerate a new wave of real economic growth and at the same time produce better guarantees of returns for the investors. It will ignite a virtuous circle, a return to hire people, reestablishing a circuit of confidence and trust, and the opportunity to stimulate a sustainable balanced and ethical growth. 

Liu, using language reminiscent of warnings by NYU economist Nouriel Roubini and speaking at a financial forum in China’s capital Beijing, said:

This situation has already encouraged a huge dollar carry trade and had a massive impact on global asset prices… It is boosting speculative investment in stock and property markets and will pose new, insurmountable risks to the global recovery and, particularly, to the recovery in emerging markets.

In my view, this is pure political posturing by the Chinese in order to defuse any U.S. criticisms of Beijing’s currency peg. Call it a pre-emptive strike. The U.S. has seen the unemployment rate rise to 10.2% and the trade deficit rise quite dramatically as well. Many are blaming the Chinese and their currency peg to the U.S. dollar.

The Chinese expect Barack Obama to deliver a message that his administration will find it increasingly difficult to hold protectionist pressures at bay given the Yuan’s firm peg to the U.S. dollar even while the dollar has plummeted.  To prevent the U.S. from successfully painting the Chinese peg as the sole major risk to the global economic recovery, the Chinese must therefore point to the destabilizing measures taken by the U.S. to reflate its domestic economy.

All indications suggest that we are now returning to the same unbalanced pre-crisis growth model – but with the global economy in a considerably more fragile state. In this climate, the issues of the Yuan currency peg and low interest rates in the U.S. will continue to be front and center going forward.

Opinions and comments on RGE EconoMonitors do not necessarily reflect the views of Roubini Global Economics, LLC, which encourages a free-ranging debate among its own analysts and our EconoMonitor community. RGE takes no responsibility for verifying the accuracy of any opinions expressed by outside contributors. We encourage cross-linking but must insist that no forwarding, reprinting, republication or any other redistribution of RGE content is permissible without expressed consent of RGE. 

Demographic trends, GDP trends and deleveraging trends are all similar. But, Marshall goes further by pointing to the misallocation of fiscal resources, the emergence of crony capitalism and the likelihood of zombie banking which he saw in Japan and is seeing now in the U.S.

Another similarity is low interest rates. One issue Marshall didn’t take on when asked about low interest rates by Brian is how this policy not only reduces the cost of capital, but also decreases investment returns, encouraging the carry trade and excessive risk.

When looking at how we are avoiding the mistakes of Japan, I didn’t find the arguments as convincing because it’s early days yet. But, there is hope.

The segment runs just over 5 minutes.

Click for Video

Opinions and comments on RGE EconoMonitors do not necessarily reflect the views of Roubini Global Economics, LLC, which encourages a free-ranging debate among its own analysts and our EconoMonitor community. RGE takes no responsibility for verifying the accuracy of any opinions expressed by outside contributors. We encourage cross-linking but must insist that no forwarding, reprinting, republication or any other redistribution of RGE content is permissible without expressed consent of RGE.