Greece succumbs to Stein’s law

by Michael Collins, Investment Commentator at Fidelity

July 2015

Herbert Stein (1916 to 1999) was a US economist who was influential in his time. Among his achievements, Stein was chairman of the president-guiding Council of Economic Advisers under Richard Nixon and Gerald Ford, was attached to the American Enterprise Institute think tank, contributed to The Wall Street Journal and taught at the University of Virginia. Stein wrote books that are still available and was the first columnist of Slate’s “Dear Prudence” advice column, penning everything from “Dress to thrill: you’re only as pretty as you feel” to “Alice in Watergate: how impeachment looked to an innocent inside the Nixon White House”.[1]

Amid all his feats, Stein seems most renowned nowadays for one sentence he wrote in 1989 as a sub-heading for a magazine article headlined “Problems and not-problems of the American economy”. The sentence became famous because it sums up so much about economics in just nine words (while it could equally be used in a Dear Prudence post). The sentence is: “If something cannot go on forever, it will stop.”[2] Another way of saying the same thing would be that days of reckoning do arrive.

Greece and its creditors are shuddering under this truth right now. The uncompetitive and over-indebted country is broke and is facing economic collapse. Greece has imposed capital controls, declared a bank holiday to prevent the disintegration of its banking system, defaulted (or at least missed a payment) to the IMF and asked creditors for more money to prevent more defaults and a forced exit from the European Monetary Union. Any rescue without substantial debt relief would only delay an inevitable exit from the euro.

Investors beware; Greece is not the only nation running up against Stein’s law. Countries including Australia, Germany, Japan and the US will nudge against Stein’s law if they persist with ignoring imbalances within their economies. In fact, the economic model of the advanced world is testing Stein’s acumen. The eurozone is finding out how perceptive Stein’s law is. These countries, groupings and regions need to overcome their challenges, otherwise they will face a reckoning too.

Stein’s law is invoked to warn of the dangers of a set course of action. It can be hard to judge which imbalances can persist for a long time without causing too many problems, so Stein’s law is probably overused as a predictor of gloom. At its best use, Stein’s law can prompt the reforms that avert these hazards, making the person who invokes them look a doomsdayer in retrospect. To keep Stein’s law at bay, for instance, China is acting to overhaul its broken economic model based on cheap currencies, exporting, amassing foreign reserves and government-directed investment. Alternatively, even doing nothing might save some countries, if events shift in their favour. Australia can escape most problems if there is a commodities boom every few years. It must be said too that any economy has some imbalances at any one time and authorities are always watching them; think central banks and inflation. Few of the situations that summon Stein’s law these days are likely to trigger the damage an uncontrolled Greek default could. Most of the menaces invoking Stein’s law would probably only lead to sub-par growth or a mild increase in the jobless rate rather than the mayhem Greece is suffering. Remedies to avert Stein-law-related damage can spawn different risks. (China reform drive is breaching Stein’s law by creating a credit bubble.) Yet Stein’s law stands as the best warning against buck-passing, fudges, half-measures, inaction and repeated mistakes. If policy-markets and investors need a reminder of the folly of ignoring Stein’s law, they need just reflect on what happened when the US housing market smashed into its truth in 2007.

Continental toyers

Greece’s collapse traces back in no small way to how the euro was created in breach of Stein’s wisdom. Europe’s monetary or currency union was designed in 1999 in a way that flouted the structure of successful currency unions such as Australia’s and that of the 50 US states. Influential bodies such as the Bundesbank and respected economists including Milton Friedman warned against a monetary union without fiscal, banking and political integration only to be ignored. Alternatives such as the UK-proposed Hard European Currency Unit, which was a mooted pegged exchange-rate system that would have allowed members to retain their own monetary policies and currencies, were overlooked. Instead integration zealots created a monetary union that provoked imbalances that can’t be corrected under a fixed exchange-rate system. It’s not farfetched to say that the final victim of the euro could be the EU, such is the political poison seeping from the euro’s economic and social damage. This political backlash is, at least for now, breeding nationalism that prevents the integration that the euro needs to escape Stein’s law.

Within the eurozone, Italy and Portugal are just two other countries on a debt trajectory headed straight for a Stein’s-law reckoning. Gross government debt to GDP stands at the default levels of 132% for Italy and 130% for Portugal, up from 115% and 96% in 2010, from when creditor nations forced them onto Europe’s self-defeating austerity drip. The best way for Rome and Lisbon to improve their debt ratios is to fire up their economies with counterintuitive fiscal stimulus. If there’s fat chance of that, Stein’s law says something must break eventually, more so if investors demand higher yields on Italian and Portuguese debt to compensate for this risk.

What’s depressing about the eurozone is that the area’s largest creditor nation is on a collision course with Stein’s law. Germany’s economic outlook is clouded because any large economy whose exports amount to 50% of GDP (compared with 13% of the US) is inherently unstable for it relies on the health of others. This is more so when Berlin is inflicting austerity on its biggest export markets; its euro-sharing neighbours. Germany’s advantage is that its remedies would be politically easy anywhere else. Berlin has only to stimulate domestic consumption, boost public spending and allow some inflation. Such solutions would not only curb Germany current-account surplus, which stands at 7.5% of GDP in breach of EU regulations, but help surrounding countries.

Advanced offender

The economic model of advanced countries appears in danger of breaching Stein’s law in four, sometimes related, areas. The first is chronic fiscal deficits, which largely stem from governments promising to supply more services without imposing the higher taxes needed to pay for them. These fiscal deficits in turn lead to debt burdens. France, for instance, last posted a fiscal surplus in 1974. Little wonder Paris’ gross government debt stands at 95% of output. Japan, after years of overspending and stimulus so half-hearted it never got its economy moving, is the most indebted; Tokyo’s gross debt amounts to 246% of output while its fiscal deficit stood at 8.5% of GDP last year.[3] Stein’s law would say that at some point debt-crippled governments will need to either default (politically difficult and damaging), inflate away their debts (politically hard) or grab more of their citizens’ wealth (not difficult if done by stealth).

The second area is that governments are overcommitted to paying for welfare programs that are expanding as populations age. In the US, for instance, social security and health now devour half the federal budget, up from an average of about one-third from 1965 to 2014.[4] These expenses have helped nudge up Washington’s gross debt to 80% of GDP and keep its fiscal deficit at 5.8% of GDP last year. Stein’s law says that state welfare cannot endlessly suck too much out of its host economy without crippling that economy. Societies need to have a debate to settle on a level of welfare spending that is affordable and fair.

The third problem is housing bubbles. In descending order, housing prices in Belgium, Norway, Canada, New Zealand, Norway, Australia, the UK, France and Sweden are between 47% to 21% overvalued against income, according to the OECD. In a slightly different order, house prices in these countries are 70% to 29% overvalued against rent.[5] While vested interests can cite seemingly endless reasons why housing prices won’t drop, housing is not exempt from Stein’s law, even in Sydney and Melbourne. Whatever the spruikers are saying, remember this longer-term truth tied to Stein’s wisdom; it would take unusual circumstances for housing to stay priced beyond the reach of younger generations as they appear to be now. (Excessive demand from foreigners may be one of these circumstances.) Prudential controls may be the best way to control undue lending fanning housing along with steps to boost supply.

Related to the housing bubble, an unsustainable trait of the advanced economic model is its reliance on consumer debt. In Australia, the ratio of household debt to disposable income has jumped from 34% in 1977 to a record 154% now.[6] This number, which admittedly has exceeded 200% in European countries without triggering mayhem in all the offenders, cannot rise forever.[7] The only way for this ratio to come down is for people to prioritise repayments over spending, a decision that would undermine economic growth and thus incomes overall.

Australia is pursuing an additional breach of Stein’s law, one that Paul Keating warned about with his Banana Republic comment in 1986. Our 23 years of uninterrupted growth has been helped along by accumulating a record amount of foreign debt, the result largely of 42 consecutive years of deficits on the current account.

Australia’s net foreign debt stood at $955 billion on March 31. This is equal to a record 59.7% of GDP,[8] a high ratio by global standards, and up from 30.5% in 1988. About $376 billion[9] of our gross foreign debt of $1.8 trillion[10] has a maturity of less than 90 days. This means that this amount of money needs to be renegotiated at acceptable rates every three months for Australia’s economy to run smoothly. There is a risk that global investors will one day baulk at this. Alas for Australian officials, there is little they can do to reduce this risk because it comes with running an open economy. All they can do is pursue enhancements to productivity to boost Australia’s competiveness, while hoping that some of this foreign debt will have been invested in projects that will earn the foreign exchange needed to repay the debt.

Greece’s plight will no doubt remind policymakers everywhere of the insight that Stein crammed into just nine words. If Stein were to have added another nine, perhaps he might have drawn out his implicit warning by saying: “Problems solved sooner rather than later avoid bigger ones.”

Source: Greece succumbs to Stein’s law, fidelity.com.au

 

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[1] Slate. Collection of Herbert Stein’s Dear Prudence columns. https://www.slate.com/authors.herbert_stein.html