John Bolton takes a look at the big, long-term economic picture and finds pre-GFC fundamental problems are yet to be tackled

John Bolton takes a look at the big, long-term economic picture and finds pre-GFC fundamental problems are yet to be tackled

By John Bolton*

With incredibly loose monetary policy implemented around the world we are going through uncertain economic times.

Nobody convincingly knows what will happen and over what timeframe. In the media we are dished up with a succession of short-term views on the currency, growth, and interest rates. None of which capture the big structural issues lurking ominously in the background.

Stepping above the day-to-day noise we face an ageing population and the need to repay huge levels of debt. As much as we try, neither will change with wishful thinking. Add to the mix a healthy dose of geopolitical instability, which won't get any easier with most developed countries facing tough economic choices. And then throw in high youth unemployment across Europe, and no real wage growth in developed countries for over 20 years as we struggle to adjust our workforces to globalisation and technology.

Whilst we have some short-term growth prospects in New Zealand (ra ra) these bigger trends could bite us at any time.

Our fixation with short-term news delivers a false sense of security. We’re quick to pick up on positive sentiment, “green shoots” and equally quick to ignore the risks that sit outside of our expectations. The bigger trends go unnoticed until it’s too late and we have some sort of calamitous event or market correction. Arguably our “boom/bust” cycle reflects our inability to adjust to gradual change, similar to how you can boil a frog in water because it doesn’t notice the change in temperature.

Early in 2014, NZ economists were forecasting that mortgage rates would hit 8% by the end of 2015. Rates would be fuelled by our rock-star economy, confidence, record commodity prices and full capacity leading to underlying inflation. All of this was based on short-term signals. There was little regard for 2014 being the peak of a commodity cycle, which has since fallen back by around 40%. Inflation sits at 1% and it is now clear that interest rates will remain low.

It’s not rocket science that NZ only produces around 7% of global dairy output so high prices would encourage production elsewhere in the world like Uruguay and Brazil, and that other countries like Australia would eventually negotiate free-trade agreements with China. Sure hindsight is easy, but this isn’t hindsight as we’ve been talking about these risks for over 18 months now in “The Economic Risks that Lurk Beneath” and “Mortgage Rate Forecast – August 2013.”

Fundamental problems untackled, still up to our eyeballs in debt

The fundamental problems that caused the Global Financial Crisis still exist. The GFC was primarily concerned with unrestrained lending practices, credit derivatives, and a lack of integrity across the financial system. It’s a trend that had been building since the early 1990s with debt-fuelled growth throughout the world.

In December 1990 household debt sat at $21.5 billion. Twenty-four years later it sits at $211 billion, a compound annual growth rate of 10%. Much of that was driven by an ability to borrow more at lower interest rates, so servicing costs haven’t increased that much. However, our debt-levels are such that we are close to saturation. Interest rates do not need to increase much to bring the economy to its knees and that’s one of the primary reasons you wont see rates go that high. They simply can’t and that’s not just a NZ phenomena.

Although not as bad as it was in 2008, we are still up to our eyeballs in debt and bankers haven’t miraculously become ethical. Global growth has stalled and countries are keeping interest rates low to compensate. In the absence of strong growth, interest rates couldn’t increase much before quickly draining any disposable income.

What if, without sounding alarmist, the GFC is just the start? Governments and Reserve Banks cannot grow debt and print money indefinitely. With more and more of our income needed to service debt, and an ageing population, it’s hard to see where growth will come from. If there is no consumption growth, then we face over supply of consumer goods and deflation. Across most consumer goods we already have deflation driven by technological change, the speed of redundancy, and massive supply. Who’d have thought consumers could buy a 70-inch flat screen LED TV for less than $3,000 (12 months ago the same TV was $12,000. Ten years ago you’d have paid $12,000 for a 42 inch flat screen).

Recently some key commodity prices have plunged – iron ore is down 50% and dairy (milk powder) is down 40%. Even oil and gas prices have recently tanked. Commodity prices increased off the back of unprecedented demand, but those prices encouraged investment and gradually supply has caught up and even passed demand. This is one of the most basic economic principles that people have forgotten or choose to ignore.

The impact on our part of the world cannot be understated. Over 50% of Australia’s exports are made up of iron ore, coal, petroleum and natural gas. Iron ore has fallen from around US$130 per ton to US$66 per ton and will wipe out about $16 billion of income. Closer to home Fonterra has forecast a reduction in price for milk solids from $8.40/kg to $4.70/kg, wiping out $7 billion of income.

What happens when China’s property bubble goes pop like Japan’s did in the early 1990s?

The Australian dollar has slipped to 95 cents against the New Zealand dollar and dropped about 30% against the US dollar in the past 18 months. The drop against the US dollar will partially compensate for the fall in export earnings, but at the same time imported goods will become more expensive and make it tough for retailers. For New Zealand we’ve suddenly become more expensive to one of our key export markets and a major market for tourism. The Queenstown ski holiday will be about 25% more expensive this year for Australians.

At the same time we have these negative macro trends, asset markets are hitting new record highs. The NZX50 hit a record high of 5,552 on the 23rd December. NZ shares have doubled since the height of the GFC in 2009. Offshore, the S&P also closed the year on a record high of 2,082 and if they’re not at record highs, then most stock exchanges around the world are near record highs.

Of course the same thing has occurred across property markets. Auckland is at record highs and house prices in major metropolitan areas are going equally nuts, from Sydney to London. The most ominous property bubble is China where houses are 30 times income compared to New Zealand at 9 times income. Iron prices are already falling. What happens when China’s property bubble goes pop like Japan’s did in the early 1990s?

Asset markets are driven by surplus money buying up assets at higher and higher prices, and lower yields. There is too much money floating around and not enough places to invest it. Businesses have surplus capacity and face weaker demand and lower prices. All of this is a recipe for a massive market correction when it finally arrives.

I once heard an Indian proverb about rivers that is a great analogy for printing money. I can’t for the life of me find it, so here goes the JB version …

When Man diverts rivers, the river responds by building up sediment and so the water level increases. Over time Man builds a higher riverbank, and yet more sediment forms. This repeats until the riverbank is too high and eventually collapses during a flood. Whereas once a flood was manageable it now destroys the entire valley.

.. and so it is that history repeats.


John Bolton is managing director at Squirrel Mortgages. This item first appeared here and is used above with permission.

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Always good to have a selection of views, but after reading that I feel like curling up under my desk

Great article JB - of course pre-GFC central bank / Government balance sheets were in much better shape. The ammo is mostly spent now.

Short term reporting.  Knew somebody who worked at EBay.  The obsession there was the quarterly reporting.  ie. every thirteen weeks.
Managements major objective was to keep the reporting the same.  And all sorts of manipulations were done to maintain that illusion.  Apparently the problem was that any variation reported caused shock waves.  The market operatives operated on a hair trigger and the stock price would wildly jump all over the place.

Always better to under promise, over deliver and keep something up your sleave for the unexpected.

JB thank you for a great article. Best i have read for a long time.

Which is why the Swiss central bank has today decided to stay away from the money printer lunatics at the ECB. Good on them. And good on the RBNZ that it is at least to a degree avoiding the most pathetic excesses, too. Still, when the house of cards finally collapses, NZ will of course also be affected. It wont be pretty.

Today all that changed. In a word, the Swiss Central Bank was on the verge of printing itself into oblivion. It had to stop pegging the CHF at 120 before the madman Draghi turned on the ECB printing presses and submerged the SNB’s vaults in a deluge of wasting euros that would have soon reached the tops of the Alps.
Here’s what it had come to. In about 84 months, the SNB’s balance sheet had expanded by 5X. It now stands at nearly 100% of GDP, towering far above even the lunatic monetary emissions of the BOJ.
Had the SNB not finally blinked, the Swiss economy would have been obliterated in a orgy of export sector malinvestment, virulent domestic speculation and incendiary asset-inflation. At length, even Swiss mountainside real estate would have become too expensive for cows and ski lodges alike.

And if you want to look properly long term:
''Steffen said the research showed the economic system was “fundamentally flawed” as it ignored critically important life support systems.
“It’s clear the economic system is driving us towards an unsustainable future and people of my daughter’s generation will find it increasingly hard to survive,” he said. “History has shown that civilisations have risen, stuck to their core values and then collapsed because they didn’t change. That’s where we are today.”

Yep, always cracks me up when some smart alec thinks because he's looking  little further out than most that he has a clue about what is really going on.
yet another that doesnt  ***plonk***--->bin

JB to JB ... the most insightful article I have read in a long time. 
This cannot end well for anyone and as a minnow in the great southern ocean irrespective of what we do or fail to do we will not escape unscathed. The huge external imbalances  in the NZ economy remain and are accelerating as commodity prices head south for what may be some time. The thought we can run current account deficits for 45 consecutive years without consequences is crazy.
I am starting to question economics sacred cows -  eg lump of labour theory. Do we seriously believe the massive numbers of unemployed youth of Europe are going to get jobs in the next 10 years in the " new " economy ? 
Do we really think dairy prices are going to return to their previous peaks this year when EU production limits have just been lifted  ?
Do we think the long term trend of all real commodity prices falling for 150 years is going to reverse itself anytime soon.
Why do we think we can leave the sky high FX rate detached from any fundamentals unmanaged when the Singapore's of this world have shown us how to do it ?
Do we think our tourism is going to prosper at current FX rates and drag us out of the crap with the lowest paid sector wages in the country.
Structural changes like enhancing real returns to savers by taxing net of inflation, and  removing tax deductability of debt aren't going to happen anytime soon  - yet it's pretty simple.
We incentivise behaviours we want to encourage and tax those we want to constrain. We need huge structural chnages to the NZ economy but vested interests are going to win keeping the status quo and the huge Tsunami it has built up that threatens to overwhelm us. The fact that our government bond spreads are second only to Greece and ahead of Portugal, Iceland and Ireland who all defaulted or were saved from default in the G20 tells us something and it's not good. The old bond traders are not taken in by our so called rock star economy label.
Typically Auckland Airport's balance sheet built on debt and revaluations may be great for shareholders but as this marginal debt finds it's way to external debt - this is typical of what we as a nation should not be doing. As investment exceeds savings - by definition under a current account deficit - there's no other way it can be financed.
" May you live in interesting times " - an old Chinese proverb - and that's what it's going to be.

"Do we think the long term trend of all real commodity prices falling for 150 years is going to reverse itself anytime soon."
Has not oil? 
and yes I think since we are about peak production per year of most commodities that their price will rise, or if we cant pay that price will disappear/stop.

Dont tell me you are one of the saved.
"Structural changes like enhancing real returns to savers by taxing net of inflation, and  removing tax deductability of debt aren't going to happen anytime soon  - yet it's pretty simple."
Once you stop taxing all interest gained, ie profit than you either distort the investment market, or corporations pay even less tax on their profits in turn.
Let alone why should benefit in such a way.

"Do we seriously believe the massive numbers of unemployed youth of Europe are going to get jobs in the next 10 years in the " new " economy ? "

Not too unlikely.
Question burning in my mind is, jobs doing what?

Many European and Arabric area already have a "too good for menial work" problem.
with commodity price pressure downwards and that creating an economic austerity, just what value add are people going to be doing?  How thinly can each specialisation be sliced, as even Adam Smith noted, that for specialisation to work, you need a bigger customer base to pay for the increased production.

Good article, but one thing that John has missed is the other consequence of the very high debt loadings that will ensure interest rate cycles are much more muted in the past. Many countries in the world will have, indeed many already are seeing, multiple years of negative real investments returns (or very low returns and not enough to fulfill their obligations) - even the punting type global hedge funds have has terrible years. This is inevitably leading us towards two even bigger problems; firstly, massively unfunded pension and health scheme liabilities that could eventually impact those even in their 40's now, whether they save for their retirement of not. And secondly bigger and bigger risk taking in that search for yield, something that is already evident globally and will compound that inevitable fall-out, whenever that will be. And when that event does come, with interest rates already negative in real terms, and central banks balances sheets mostly fully extended, what can the central banks do and therefore just how bad are the consequences going to be?
Fortunately the RBNZ has inched rates a bit higher here to provide mostly positive returns, but as everyone points out, when it hits the fan offshore, we will get our share - but my guess is not this year

Ironic considering John Bolton has hitched his horse to the property train. What does it all mean? It does actually seem that the property market in NZ/Australia and the global economy are essentially based around 2 different solar systems. 

The statement was true then. The threat is much greater now, made all too clear by the howls of protest this morning from the Swiss export sector. Nick Hayek, head of Swatch Group, said the collapse of the floor would cause havoc. "Words fail me. Today's SNB action is a tsunami; for the export industry and for tourism, and for the entire country," he said.
The Swiss economy has been muddling through over the past year but the output gap is still -1pc of GDP, inflation is negative and the KOF index of business sentiment has been slipping lower for two years. On top of this, the country now has to grapple with the likely hangover from its own domestic credit bubble

Andrew we've seen this day coming for some time and its just another prime example of a major nation failing to successfully artifically manage its exchange rate, as so often argued for  by many in this country  - they tried it for some years, it cost them heaps, and now they've triggerred a real shock to their export community with no warning and ability to slowly adjust to it over time which would have been more helpful, and they have ended up with a bloated central bank balance sheet from their printing of Swiss Francs with consequences from that over time. Maybe it lessened a crisis back in 2008-12, but like many others, the consequences for long-term growth are the trade off.

as the artifice collapses whats left ?

Schlumberger to cut 9,000 employeesHOUSTON – Oil field giant Schlumberger said Thursday it will cut approximately 9,000 employees – around 7.5 percent of its workforce around the globe – as both petroleum prices and oil-company spending nosedive.

Apache Corp (another Houston based oil firm) laid off 5% of it work force yesterday too.
This is all good for the US economy, right?
Anyone else see the US weekly unemployment claims bounce 'unexpectedly' to a 6 month high this morning?

More than 10,000 people working at Mexican oil service companies were laid off this week as state-owned Petroleos Mexicanos cut contracts in the face of the global slump in crude prices. More job losses are expected.
Prof. Bill Gilmer of the University of Houston has crunched the numbers on some worst-case scenarios for Houston. Assume an average 33% reduction in oil company capital spending this year, followed by 5% growth in 2016. That, figures Gilmer, would result in the loss of 75,000 Houston jobs. This would be an enormous shock considering that Houston has added 100,000 new jobs every year since 2011.


Good Article.
When you look at the USA ecconomy it seems to be on an increasing cycle of booms and busts, with the over stimulation of one bust giving rise to the next boom and then the inevitable bust.  Somebody needs to sit down and address the fundamentals, but that may not suite those in a position to do so because I imagine that there is an obscene amount of money to be made by those wo know what is going on , if not actually controlling it.  The rest of the world seems to be catching the same disease, probably promoted by the same entities whose influence is now becoming global.  The old adadge is follow the money.  Who made all the money in the GFC?
Talking to some Swiss and German banking friends over christmass.  They said that the hedge funds were heavily betting in a drop in our currency.  I am not so sure as I am having trouble deciding which ecconomy is in the biggest mess.  I am beging to wonder if anybody really knows what is going on or what to do next.

Hope your friends are ok.
Been a shocker of a week over there.

Congratulations John on a great piece of writing.
Moreover, it is refreshing to see someone in business discuss these concerns openly and eloquently.  

Excellent article, thank you John.

"Fundamental problems untackledstill up to our eyeballs in debt"

The real difficulty with the solution here is that the only current "solutions" to 'up to the eyeball-ism' are
(1) deleveraging.  - expensive, slow hard to keep up profit margins that investors and governments are betting on.

(2) consolidate existing loans into bigger loans, and hope the profits (inflation) beat the market and give us enough to (theoretically) delever (which of course we won't, because double or nothing gets you ahead, and deleveraging ...see (1) )
(3) ?

(3) ... wait for the boom!
There is a lot at stake for the current model to keep working. So much so, that the kind of change required, will not happen.
A good follow up article would be to speculate at the consequences of total financial meltdown.
What a leveler that would be for people, although what could come from this could be quite scary.

The consequences are same as usual.  Public takes a massive hair cut, all private savings and debts are wiped clean/forgiven.  Government turns it's back on all debts issue some kind of bogus I.O.U. paper.  And the wealthy, connected and bankers... ie "the backbone and leaders" all rest on their foreign accounts.

Why do you think tin-pot dictators have hoards of gold and land off shore?
Why do you think I sweat when I see the "Chinese industry princes" doing same?

Plenty of quid pro quo going on ... but all of them secretly know that you're only as safe as your usefulness tomorrow.

I agree, though I think late this year at the earliest, though I'm happy to be prepared now :)
2016 seems more likely, most producers are still flush with cash from the boom, once that cash pile is gone, and the hedges/forward supply contracts, have been fulfilled then business will start hurting.  The weakest are already hurting now, but not a significant enough portion. 
I havn't been paying much attention to whats been happening 'round here, isn't it BH's job to peddle doom and gloom?  Where is he these days?

I'm a tempered optimist : ) Just want people to be careful.

The best way to be, two great articles.

Nice proverb. Quoted to fit the argument. However I suspect that that city was stupidly built way too close to the river in the first place! :)

Good article thanks John. 
The first half of my life was spent in conditions of hyperinflation when savers were heavily disadvantaged compared to equity and asset holders. Now we have deflation or near deflation where the same is occurring. We all need to think about what "boom" looks like, and my suspicion is that it is less apocalyptic than most commentators perceive.
The big break points  where new rules were written in the last 50 years have been 2004-1991 and 2008 through to the present. In both periods governments and central banks found new ways of operating to respond voters demands to meet their needs. We tend to forget how radical QE looked in 2009, but it's with us for as long as the US looks like a secure place to leave money.
Public needs aren't strong balance sheets but economic growth leading to jobs,  incomes and the ability to consume goods and services. ECB have taken a while but I think they will get on with printing money now, and they will do it for a long time too, so money will continue to flow into share markets to gain yield, driving growth.
As an investor, there is a risk in being outside the share and property markets while the conditions that brought about QE continue so strongly. And there is truly nowhere else to go.
The worse things look, the lower rates air, the more incentive for QE, and the band plays on. If confidence in the US outlook falls this could turn around, but the opposite is the case at the moment. 

I've been hearing the New Zealand debt dirge for around 40 years now. 
Well the terrible things our high debt is supposed to call down on us have never happened yet. Even at the height of the recent financial crisis. In fact the NZ ten year bond yield has been going through the floor trendwise since 1998.
Moreover the debt dirge seems to be sung by right wing politicians, commentators and those ghastly flat earth economists at Treasury as a reason for curtailing the living standards of middle and working class New Zealanders.
Consequently instead of singing the debt dirge we need to know why the NZ yields are so high against other comparable economies. Perhaps the manner in which the bonds are being managed needs investigation or the ticket is being clipped in some manner. 
i know the screams against my suggestion will be magnificent but the facts are that over a prolonged period of high debt the crisis so widely and so long forecast has never come to pass.
Perhaps some new thinking is required rather than the old debt dirge and its accompanying cries to destroy the living standards and working conditions of ordinary New Zealanders.

Our middle class living standards are being eroded by debt - 45 years of consistant current account deficits - no crises required. A national failure to save means our consumption and investment must be funded by the savings of others - we are forced, in fact, into futher borrowing and the sale of productive assets to fund the interest payments and investment returns to foreigners. Although the C.A. deficit is not as high as it has been (8 or 9% of GDP in the 2000s) this is almost entirely due to the current low interest rates and an impressive run for our commodity exports. How long is this likely to continue?
It seems unlikely that our debt will be erroded by high levels of inflation as occured in the 70's and eighties, we now have the extraoridnary situation that, try as they might, even the biggest central banks can't create it. The circumstance that gave rise to double digit inflation at that time simply do not exist in the Western world:
the coming of age of the boomers - massive demand increase
strong unions
widespread protectionism
the rise of the OPEC cartel and their market price fixing
end of the gold standard (1971)
and the consequent exponential rise of new debt money to saturation point
Our "Rock Star" economy has some serious and fundamental issues.

I agree on your debt level point Kiwidave. Thats because most of us spend more of what we earn than we should, and many of us more than what we earn.
If you dont do that  someone comes along and tells you  the gap between rich and poor is widening as if the game is rigged in favour of the rich, and   needs some sort of intervention to rebalance in favour of the spenders again.  
Sorry, but it look to me like those who save  and invest will continue to do pretty well. My  lesson from 2008-2009 was that companies create jobs so hold your nerve and invest in shares. We are nt likely to go into a 1930  situation, or even a Japan c. 1991-2, so any sharemarket coirrection is likely to be short lived at current PEs.
Its a real pity so much of our national superannuation savings are in so called"balanced" and conservative" funds - they seem nothing like either to me - deposits and bonds  are pretty sure to lose ground against equities and real assets while deflation is the concern.