Lessons from the global economic crisis

The economic crisis in the West holds some important lessons for South Africa’s attitude to debt and the culture of easy money that breeds it.

In short, “failing to deal with the culture, system and incentive structures that create excessive debt and leverage, and then simply kicking the can down the road has prolonged the crisis and increased the pain experienced,” argues Glenn Silverman.

Silverman believes the economic challenges that Europe, the United States, Japan and certain other Western economies are currently grappling with should have come as little surprise.

With debt having built up amongst Western consumers, banks and sovereigns over many years, it only took the failure of a single pivotal bank, Lehmans in 2008, to bring the debt skeletons out of the closet. To avoid a second great depression and the implosion of the Western banking system, the authorities chose to bail banks out, moving debt onto already stretched sovereign balance sheets, effectively socialising the problem.

Ultimately the average man-in-the-street, as tax payer, will have to service this debt.

Since moving debt to government never resolved the debt problem, but simply transferred it, this solution amounted to little more than “rearranging the deck chairs on the Titanic.” Instead, measures should have been taken to change the culture, system and incentive structures that created the debt crisis in the first place.

In some cases, it may have been preferable for certain banks and even sovereigns, like Greece, to be allowed to default. “Pruning dead branches may have left the rest of the tree better positioned to regain its health” says Silverman.

Since the implications of choosing the wrong solution are enormous, and the issues increasingly complex and  inter-connected, it would be presumptuous for anyone to attempt to offer a solution to the West’s financial woes. This is especially so since now that a course has been chosen, path-dependency comes into play, meaning that “since we cannot reverse past decisions, we can only deal with their consequences” explains Silverman.

Lessons

Some salient lessons however seem to be emerging:

• The current economic crisis has shown us that there is a certain level of debt which countries’ should not exceed. The 90% debt to GDP ratio, as suggested by Reinhardt and Rogoff in their paper Growth in a Time of Debt seems to be a good approximation of the critical level.
• Secondly, overly low interest rates, especially rates tending to zero, as in the United States, the United Kingdom and Japan seem to lose their efficacy, distorting the functioning of capital markets and the efficient allocation of capital. Too low interest rates are equivalent to pushing on a string and should be avoided, however attractive they may appear as a short-term solution. In short, the financial system requires a fair cost-of-capital, if distortions and misallocations of capital are to be avoided.
• Thirdly, there seems to be a natural, albeit possibly undefined, limit to the size of governments as a proportion of their economy as well as how much can, and should, be promised as inducements to the voting public. While this is often indicated by increasing fiscal deficits, it is more often hidden, in the unseen liability side of sovereign balance sheets.

Government exceeding these bounds or attempting to deliver above and beyond these levels is not only unrealistic, it’s also potentially dangerous.

While Greece is an obvious example of the breach of this delivery ceiling, other countries include the United States and Japan where official debt to GDP is above the critical 90% level. In the United States once all promises-to-pay, namely, entitlements and liabilities are accounted for, debt to GDP in fact exceeds the 500% mark. Since many of these government promises are simply never going to be met they only serve to accentuate an already unstable political and economic environment. Instead, governments will need to reign in their promises, and better manage the expectations of the electorate.

Certainly, “where the system fails to manage expectations, the invisible hand of the market takes over, often to devastating effect, as observed since 2008” says Silverman.

The fourth powerful lesson for South Africa is that banks are critical components of a functional financial system. As such, they need to be closely monitored, regulated, and capitalised. Fortunately, on this front “South African banks seem to have weathered recent crises particularly well” says Silverman. That said, both the banks and the authorities need to remain vigilant since the current turmoil seems far from over.

The fifth and final lesson is that taxing already over-burdened, over-levered and under-employed consumers is unlikely to solve the problem. In spite of this, increasingly desperate Western governments continue to propose ever more creative taxes in the misguided belief that this will somehow reduce debt levels.

Instead, Silverman prefers lower taxes, smaller government, less regulation and the facilitation of greater business opportunities since these boost the productive sectors of economies. Some also argue that corporates’ in the West should pay a higher share of the tax burden, especially considering that effective corporate tax rates are often well below the official rate.

These are, however, tough choices for politicians to make, and ones that tend to get them voted out of office. Since few governments are prepared to swallow the bitter pill, the crisis looks set to continue without resolution, for some time to come.

In the meantime public distrust of current policies increases as evidenced by the growth and spread of anti-capital and anti-government demonstrations globally.

South Africa is, by contrast, a relatively safe haven with government debt to GDP around the 40% mark, a real interest rate policy intact for some years, and a broadly balanced fiscal position, observes Silverman. Any signs of these being abandoned, however, should be strongly opposed. What the Western economy shows us is that once the authorities lose control of debt it is extremely difficult to rectify.

This is also why Silverman believes that South African interest rates, currently at 30-year lows, are low enough. “Cutting them too low will create a disincentive to save, will misallocate capital, and risk of increasing debt levels to unsustainable levels, repeating the mistakes of the West,” concludes Silverman.

Glenn Silverman is Chief Investment Officer, Investment Solutions. ( This e-mail address is being protected from spambots. You need JavaScript enabled to view it )