By Satyajit Das
NATIONAL and international "committees to save the world" have rushed to announce and occasionally even implement a bewildering and constantly changing array of measures dubbed WIT ("Whatever it Takes") by Britain's Prime Minister, Gordon Brown to counteract the financial and economic effects of the global financial crisis.
Governments and central banks have sought to remove toxic securities from bank balance sheets and supply share capital to cover losses from bad debts. In some countries, such as Australia, the government has guaranteed banks' borrowings to allow them to continue to raise funds.
Bank of England governor Mervyn King summed up the nature of Britain's support for the banking system with a Freudian slip: "The package of measures announced yesterday by the Chancellor are not designed to protect the banks as such. They are designed to protect the economy from the banks."
Governments have gone into huge deficit providing fiscal stimulus and, in the US, support for the housing market. Central banks have cut interest rates to levels not seen for decades.
The success of these actions is not assured. John Kenneth Galbraith once observed: "In economics, hope and faith coexist with great scientific pretension."
Credit conditions have not eased significantly. Money supplied to banks is not flowing into the real economy. Governments and central bankers, frustrated at the failure of policy actions to help the resumption of normal financial activity, have started to lend directly to business or drifted towards "directed lending" policies in an effort to get the economy going.
The policies miss the point that debtors still have more debt than they can service. Until the debt is written down and restructured, credit growth may not resume.
In the TARP (Troubled Assets Relief Program) Oversight Panel Report of April 8, Professor Elizabeth Warren observed: "Six months into the existence of TARP, evidence of success or failure is mixed. One key assumption that underlies Treasury's approach is its belief that the system-wide deleveraging resulting from the decline in asset values, leading to an accompanying drop in net wealth across the country, is in large part the product of temporary liquidity constraints resulting from non-functioning markets for troubled assets.
"On the other hand, it is possible that Treasury's approach fails to acknowledge the depth of the current downturn and the degree to which the low valuation of troubled assets accurately reflects their worth."
Well-intentioned government spending programs, such as infrastructure spending, will take time to have any meaningful effect. The return on poorly costed and targeted infrastructure investment is also not necessarily high.
Governments, some with significant budget deficits and substantial levels of public debt, must borrow to finance their spending. This year governments around the world will have to issue $US3-4 trillion ($A3.9-5.2 trillion) in debt.
The US will need to issue about $US2 trillion in bonds. China, Japan, Europe and other emerging countries have been major buyers of this US debt.
China's Prime Minister, Wen Jiabao, provided a reminder of this in February: "Whether China will continue to buy, and how much to buy, should be in accordance with China's needs, and depend on the safety and protection of value of foreign exchange." Yu Yongding, a former adviser to the Chinese central bank, recently sought guarantees that the value of China's large holdings of US government debt would not be eroded by "reckless policies".
Two German bund (government bond) auctions have failed this year, with insufficient bids to cover the amount of issues. An auction of British gilts and more recently a US 30-year bond auction encountered significant difficulty and lack of investor support.
At best, the government debt may crowd out other borrowers, exacerbating existing financing problems. At worst, there is a risk of a collapse of the growing "bubble" in government debt markets as investors refuse to buy debt at current rates, triggering additional losses.
Since January, long-term interest rates throughout the world have moved up sharply as markets start to absorb the import of government initiatives.
Governments' current strategy is a variant of the "hair of the dog that bit you" cure. Current problems can be traced to high levels of debt accumulated by banks, consumers and companies that is now being replaced by government debt. Debt-fuelled consumption by consumers and companies is being replaced by debt-funded government expenditure.
The ineffectiveness of repeated fiscal shock therapy to rouse the Japanese economy from it somnolent state provides a worrying precedent for current policy.
Government actions seem primarily to be based on the recognition that Ponzi or pyramid games are only bad if they end. All efforts are now seemingly directed at keeping the game going for as long as possible.
Governments and central banks can smooth the transition but they cannot prevent the necessary adjustments taking place. In 1976, Britain's then prime minister, James Callaghan, delivered a grim assessment of the country's economic situation: "We have been living on borrowed time. We used to think you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists." That warning is still relevant today.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives. This article draws on ideas published last month in The Monthly magazine. This three-part series will continue next Saturday.