Waking Up on the Wrong Side of History, Part IV

“Brexit changed everything.” – Paul Singer, Elliott Management Corp.

My thesis in this group of posts on Brexit is that Leave voters were concerned about four issues: the lack of democracy in the EU, the increasing financialization of the UK economy, the ever-growing mountain of debt that had resulted from globally coordinated central banker policies, and soaring inequality. I’ve discussed democracy and financialization. In this post I’ll take up debt.

Loyal readers of my blog are probably sick of hearing me say this, but I’ll say it again since it played heavily into the Leave vote: the more debt a government takes on the slower its economy grows. We know this based on close examination of 800 years of government borrowing all over the world (see Reinhart and Rogoff, This Time It’s different: Eight Centuries of Financial Folly).

Which raises an awkward question: what in God’s name do the world’s central bankers think they’re doing? The US Fed, the EU ECB, and the Japanese BOJ have become the Larry, Curley and Moe of the financial world, merrily leveraging up and up and up and then wondering why their underlying economies are growing like the Madagascar palm – which takes 100 years to bloom.

The Bank of England is a Mini Me version of the Three Stooges Show, but even so it has managed to saddle the Brits with staggering amounts of debt. Before the Brexit vote the BOE was thinking seriously of getting out of the debt-growing business, but post-vote the Bank has doubled down on QE.

But now there’s a difference. Pre-Brexit the BOE had to mimic whatever Curley (Mario Draghi) was doing over at the ECB, because the Brits were part of the EU. Now, however, Mini Me (Mark Carney) can be sent packing and the BOE can begin to adopt sensible policies, as it did, until recently, for more than 300 years.

The mechanisms via which high government debt slows GDP growth can be complicated. For example, high government borrowing tends to crowd out private borrowing. The resulting lack of capital investment slows the growth of labor productivity, with the result that high-debt societies (defined as those with government debt north of 90% of GDP) grow roughly one-third slower than moderate debt societies. The slowdown accelerates as the crowding-out phenomenon escalates, and eventually the economy simply collapses, either via hyperinflation or hyper-recession (i.e., a depression).

The problem slowly feeds on itself. As growth slows, taxes have to rise because governments have to take on the burdens normally discharged by a growing economy. It’s tough to raise taxes on the middle class because they are suffering from slow growth and they have all the votes. So taxes rise for the affluent, the very folks who might otherwise have invested that money productively. And so on and so on.

Voters in London failed to understand the debt issue because, if you work in the financial world, debt is good. Debt is great. Debt is the best thing ever. If you buy an asset for cash, it might produce a 5% return. But if you borrow the money and leverage the asset 100%, it produces a 10% return! Debt is magical! But this is a comically stingy use of leverage, a mere 2-1 ratio. Before the Financial Crisis investment banks were leveraged 30-1, and institutions that had a “good faith” government guarantee (Freddie and Fannie) were leveraged 100-1. The more leverage, the higher the returns. The higher the returns, the bigger the annual bonuses. The bigger the bonuses, the faster your Kensington townhouse appreciates.

Leave voters may not have appreciated the economic underpinnings of the debt-chokes-growth phenomenon, but they showed far more common sense than the Remain voters in London. Leave voters were, each and every one, a mini-economy consisting of one family. They knew from long experience that their family economy – call it aggregate family happiness – improved when they first began to borrow money. After all, nobody can afford to buy a house or a car without borrowing, and owning those things increases happiness. But as borrowings get greater and greater, happiness stops improving because at this point all available resources are going to pay the mortgage, the auto loan and the credit card debt. If borrowing continues after that point, the family economy – and its happiness – collapses, as the mortgage is foreclosed on, the car is repossessed and the family’s creditors force it into bankruptcy.

This simple lesson, understood by every voter outside London, is hopelessly lost on our central bankers, perhaps because the only way to become a central banker is to trade your common sense for it.

Will separating themselves from the EU, and separating Mr. Carney from the BOE, actually lead to more sensible monetary policy in the UK? I have no idea. But at least they now have a chance.

Next up: Waking Up on the Wrong Side of History, Part V