Tuesday, 27 April 2010

The coming financial disaster

John Mangun
Outside the Box
Business Mirror
http://www.businessmirror.com.ph/index.php?option=com_content&view=article&catid=28:opinion&id=24569:the-coming-financial-disaster&Itemid=64

‘The Bank for International Settlements or BIS is an international organization which fosters international monetary and financial cooperation and serves as a bank for central banks. The BIS fulfills this mandate by acting as a forum to promote discussion and policy analysis among central banks and within the international financial community, a center for economic and monetary research, a prime counterparty for central banks in their financial transactions, and agent or trustee in connection with international financial operations. Established on 17 May 1930, the BIS is the world’s oldest international financial organization.”

Last month, the BIS released a short 26-page working paper titled,“The future of public debt: Prospects and implications” by Stephen G. Cecchetti, MS Mohanty and Fabrizio Zampolli [CLICK HERE TO DOWNLOAD FIRST EDITION--FEBRUARY 2010. CLICK HERE TO DOWNLOAD REVISED EDITION--MARCH 2010]. I mentioned this report in a previous column last week. The facts and conclusions of this report are nothing less than staggering in their implications for the future.

The economic prosperity of the developed countries over the last 20 years is an illusion. That prosperity was paid for with borrowed money that cannot be repaid. In order to protect the global financial system, debt levels have exploded in the last two years. The current debt levels are unsustainable, virtually unsolvable, and will inevitability lead to a fundamental change in the world economic structure.

Assume you earn P1 million per year. That makes you a high-roller, income-wise, by local standards. Assume your debt load is P600,000, which is probably on the low side. Your annual debt repayment would be about P120,000. As long as your income remains the same and you do not add more debt, you are in pretty good financial shape.

Now assume your debt is P1 million and your repayment is P200,000. Your financial condition is marginal and a little tight.

Go further and raise your debt to P2 million with repayment at P400,000 and you are in big trouble.

Perhaps the most fundamental indicator of government financial health is the debt-to-GDP (gross domestic product) ratio—how much debt is a government carrying in relation to the total economic output of the country. Of course, this does not take into account the “income” the government earns from taxing the GDP, but that is another story. But basically this debt/GDP ratio is an indication if a government is borrowing ahead of the nation’s economic production. The financial fear is that a nation carrying too much debt will default, causing an economic collapse.

The Philippines Debt/GDP is about 60 percent. Many developed nations exceeded 100 percent after World War II and none defaulted. Japan has been running at 150 percent for years and it has not defaulted. Greece is now at 130 percent and will default without immediate help. The US is at 90 percent, the UK at 80 percent, with Asia at 40 percent. So is there a reason for concern? Most definitely.

First, the amount of government debt has increased by 75 percent to 100 percent in the developed countries over the last two years. Debt bubbles have happened before, but not combined with the impact of a major economic slowdown. Previously, the problems of exploding debt bubbles were solved by economic growth. This time the economic growth was fueled by the debt bubble. The past 10 years has been like maxing out one of your credit cards and calling that an increase in income. Never in history has so many large economies borrowed money and called it economic growth. For example, all those houses that were built in the West that employed tens of millions were paid for with borrowed money. Cut off the credit like now and all those jobs disappear, perhaps never to return, because there is no real wealth creation to keep the economies going.

Further, in the West and particularly the US, hundreds of billions of dollars were borrowed to buy goods (primarily from China) that created little, if any, home-country economic activity. What is going to generate the income to pay that debt? Every business owner knows this truth. You never, if possible, borrow money unless you can use that money to make more money.

Second, if you have ever run into trouble with your personal credit cards, you know exactly what I mean. Borrowing creates the illusion of wealth. You use your credit card to buy that huge imported refrigerator and wall-size TV, in addition to sensibly fixing up your house, increasing its value. But the big electricity bill that comes in every month must be paid for with real income. And if you do not have the income to cover the additional expenses, you borrow more.

Governments and people think exactly the same. Hard-earned money is spent wisely; too often, borrowed money is spent extravagantly. During the borrowing boom of the last two decades, governments created spending programs that can only be funded with borrowing. There is not enough tax revenue—income—to cover these expenditures.

There are other factors in this situation that I will discuss on Thursday, as well as looking at the long-term consequences and the solutions that governments may resort to. And, of course, we must look at where the Philippines figures into this global chaos. This is a grave matter that is changing the world we thought we knew.

In the meantime, if you would like a soft copy of this BIS paper, send me an e-mail. I guarantee it is worth your time to read it.


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