Month: August 2020

How to build the confidence needed to borrow and lend

An economic recovery programme for South Africa demands the kind of business and political leadership that now appears to be lacking.

These are truly unprecedented economic times. Never before have large sectors of our own and most other economies been told to stop working. Large numbers of potential participants in the economy are being forced to stay at home. The impact on the supply of goods and services, the demand for them and the incomes normally earned producing and distributing them, has been devastating. Perhaps up to 20% of potential output, or GDP in a normal year, will have been sacrificed globally to the cause. We will know how much has been sacrificed only when we look back and are able to do the calculations.

In South Africa’s case this one fifth of GDP would amount to about R1 trillion of income permanently lost. These are extraordinary declines in output and income. Ordinary recessions, when GDP declines by 2% or 3% in a quarter or a year, are much less severe than this.

Compensation however can be paid to the households and business owners who, through no fault of their own, have lost income and wealth. It is being provided on different scales of generosity across the globe. The richer countries are noticeably more generous than their poorer cousins. South Africa, alas, is among the more parsimonious, at least to date in practice.

There is however no way to recover what has been lost in production. All that can be hoped for is a speedy recovery of the economy when businesses and their employees are allowed to get back to normal. But getting back to producing as much as before the lockdowns means not only more output and jobs becoming available. Any recovery in output will have to be accompanied by more demand for the goods and services that the surviving business enterprises can supply. Without additional spending during the recovery process, there will not be additional supplies of goods, services, jobs and incomes.

Providing unemployment benefits and other benefits paid in cash to the victims of the lockdowns will help to stimulate spending. In the US, every household received a cheque in the post of over $1000 and temporary unemployment benefits of $600 per week were more than many would have earned. The average US household will come out of the crisis with more cash than they had before. And more may be on the way. Spending the cash will help the pace of recovery.

The US and many other countries will be doing what it takes to get back to normal. They will also be learning along the way just how much spending by governments it will take before they can take their feet off the accelerators. They are not being constrained by the monetary cost of such spending programmes. The cheapest way for a government to fund spending is by printing money and redeeming the money issued with more money.

The central banks of developed economies are supplying large extra amounts of cash to their economies in a process of money creation also known as quantitative easing or bond purchasing programmes. The supply of central bank cash in the largest economies has grown 30% this year. Central banks have been buying financial securities, mostly issued by their governments in exchange for their cash that is so willingly accepted in exchange. By so doing, they have helped force down the interest rates their governments pay lenders to very low levels – sometimes even below zero for all government debt, short and long dated. This is an outcome that has made issuing government debt even for 10 years or more even cheaper than issuing money.

These governments have also arranged on an even larger scale (relative to GDP) loan guarantee schemes for their banks to encourage bank lending that will enable businesses that have bled cash during the lockdowns to recapitalise, on favourable terms. Central banks, secured by funds committed by their governments, are covering up to 95% of any losses the banks might suffer if the loans are not repaid. The take-up of such loans by businesses in the US has been very brisk.

South Africa, as mentioned, has not adopted any do-what-it-takes approach to our crisis of perhaps larger relative dimensions. I have argued that we should practise the same logic as the developed economies and rely in the same way on our central bank to create money to hold down the interest cost of funding higher government spending and the accompanying debt. This would be a similarly temporary exercise in economic relief – one well-explained and understood as such – for only as long as it takes.

South Africa has moreover introduced a potentially significant loan guarantee scheme for our banks, with a potential value of up to R200bn. Sadly, little use of the credit lines has so far been made: only R14bn appears as taken up. Every effort should be made to encourage businesses to demand more credit and for the banks to lend more, since they are exposed potentially to only 6% of the loans they make. Working capital, which is necessary to restart SA businesses, is therefore available. The confidence to re-tool seems to be lacking, as is the determination of the banks to find customers willing to invest in the future, from which they will benefit permanently, should they succeed.

The recovery programme demands a business and political leadership that now appears to be lacking. Leadership should want large and small businesses to believe in their prospects after the lockdown and to act accordingly. Economic recovery – getting back to normal as quickly as possible – demands no less.

The Reserve Bank can put its reputation for inflation fighting to good use – reviving our economy after lock-down.

How much income will be sacrificed for the lock downs will depend upon how quickly production (supply) and spending (demand) can be resumed. As always supply and demand will depend on each other and respond together. The more an economy is stimulated by way of government spending on relief and by monetary policy – lower interest rates and more money and credit supplied – the more demand will be exercised and be expected from the customers of businesses. And the greater will be their willingness to tool up and hire workers and managers to satisfy demands.

So much is almost common cause globally. Learning about how well the recovery is going and when the foot can best be taken off the accelerator will be necessary. But surely not until it becomes very clear that an economy is back to normal. That is producing as much output and income as it is capable of- without inflation. When and if inflation comes back, stimulus should and can be reversed.
And the steeper the path back to normal the less the lockdown will have cost in real terms- in income sacrificed. And the cheaper the government can borrow to fund its growing deficits, the less will the future interest bill on much increased issues of government debt.
Hence massive reliance has been placed on central banks in the developed world to print more money. Cash created by central banks in the form of the note issue and bank deposits with the central bank is government debt that does not ordinarily bear interest. Hence extra money issued by central banks has been used on a vast scale to buy government and corporate debt in the market-place in order to hold down all interest rates and to fund government spending directly. Now called politely quantitative easing – but money creation by another name. And to supply their banks with additional cash reserves so that they might provide additional credit on favourable terms to the private and government sectors.
Extra central bank purchases of government debt in the developed have even exceeded this year the vastly increased issues of government debt by the major economies. Hence we observe low even negative interest rates across the entire term structure of interest rates. Making issuing debt for some governments even cheaper than money. The future tax-payer in the developed world has not been made not hostage to a spending and borrowing surge of unprecedented proportions, outside of war time.

The self-same approach is called for in SA and for any economy with its own currency and central bank and for the same very good reasons. And with the same recognition that stimulus can be reversed when the time is right. Unfortunately, the SA Reserve Bank does not agree. It has consistently argued against the case for buying government bonds on an aggressive scale to hold down interest rates. Most recently it has suggested that QE is not only undesirable but impractical, until interest rates are at zero and deflation beckons.
The argument made is that bond purchases (or for that matter increases in Foreign Assets held by the Reserve Bank or declines in their government deposits liabilities) adds to the supply of cash in the system and would have to be fully sterilized by equivalent sales of securities by the Reserve Bank.

However there is never any compulsion to sterilize all such purchases nor any logic in doing so. The object of any bond buying would be to add to the money base by some well-designed amount to encourage the private banks to lend more. The banks might prefer to hold more cash supplied to them in reserve and if so would not have to borrow from the Reserve Bank making the repo rate possibly irrelevant. But this might call for still more cash to be injected and for interest rates to go to zero -helpfully in the circumstances of depressed demand.
Ideally the extra cash supplied to the banks would better be used to fund additional lending to the private and public sectors to encourage spending. The much fuller adoption of the loan guarantee scheme (potentially R200bn of extra bank lending) would reduce any potential demand from our banks for excess cash reserves. The scheme should provide the extra capital and as important the confidence to reboot the SA economy. It urgently needs a champion in the Reserve Bank.
Should the economy recover enough to threaten inflation targets the Governor could be providing good reasons why the monetary taps can be tightened as easily as they were loosened. Given his hard-won inflation fighting credentials these could be used to save the economy from avoidable distress – without prejudicing long term stability.

War and peace – Making sense of the biggest spending splurge in peacetime

Only the arrival of inflation is likely to put an end to the biggest round of government spending seen in in times of peace.

The extent of the surge in government spending and borrowing and money creation currently under way, especially in the richer nations, has no precedent in peacetime. Perhaps that’s because we are not really at peace. We are at war with a virus and, as in most wars, this is accompanied by warlike amounts of impenetrable fog, multiple chaotic situations and much wealth destruction.

Yet there is no sign of any taxpayer revolt to the spending propensities of governments. The current spat between Republicans and Democrats over additional spending is by no means asymptomatic. As I write these words, Congress and the President have already approved extra spending of US$3.2 trillion. The Democrats have now proposed an extra US$3.4 trillion of relief divided up their way. The Republican offer is of an extra US$1.1 trillion spent very differently. For a US$20 trillion economy, either set of spending proposals is formidable.

The global outlook for government debt is truly astonishing. The US fiscal deficit is predicted to approach 25% of GDP shortly, much larger than it has ever been, but for World War 2. In the UK, the debt/GDP ratio was below 60% in 2015 and forecast by the Office for Responsible Budget to fall marginally by 2050. The latest forecast is for a debt/GDP ratio, currently at 100%, to double by 2030. Managing government debt with the aid of central banks and their power to create money, usually the cheapest non-interest bearing form of government debt, is characteristic of all funding arrangements in and after wartime. But if this is war, then it is one without more inflation, either now or expected in the future. 90% of all developed market debt now yields less than 1% a year, of which 10% offers negative returns. It is therefore an inexpensive war for taxpayers to fund.

The recent growth in the size of developed market central banks is equally and consistently awesome. Or is it awful? It could not have happened without them. And there is every prospect of further growth in their assets to come. The balance sheets of four of the largest economies (US, Japan, the European Union and the UK) have increased by the equivalent of US$5.7 trillion (16% of GDP) since February, in other words, by about 30% in five months. Further purchases of securities, mostly issued by their governments, combined with support for extra private bank lending, can be expected to take their balance sheets to about US$27 trillion by 2021, the equivalent of 67% of GDP.

They have similarly increased their liabilities, in the form of extra deposits held by private sector banks at the central bank. These and other central banks have been exchanging their cash for government and other debt on a scale that has made them completely dominant in the market for government debt. They dominate over all maturities that are the benchmarks for all other yields, including earnings and dividend yields in the share market.

The US Fed will soon own 25% of US debt. The number was 10% in 2009. The Bank of Japan has grown its share of government debt from 5% in 2012 to over 40%. The European Central Bank held no European government debt in 2015. It now holds 25% of such debt. The Bank of England now holds 27% of UK government debt. Thus it would be incorrect to describe the low rates of interest on debt as market determined. The flat slope of the yield curve is under central bank control and they are likely to want to keep it that way, because there is no inflation or higher interest rates in sight. Economic revival is their priority.

When will the splurge of (always popular) spending end, while it can still be financed so cheaply? Only when and if inflation rears its ugly head again. And politicians and central banks may then do what their electorates have demanded in the past from post-war regimes: bring inflation down by raising interest rates and reducing money and credit growth (especially by governments) to better balance supply and demand in the economy. Inflation therefore will have to rise, surprisingly and sustainably so, before interest rates do, as the Fed has clearly indicated this week. Asset price inflation in such circumstances should not come as a surprise.