Thursday, July 12, 2012

The Debt Crisis Goes On and On

When it comes to a debt crisis almost everyone seems to quote from the book “This Time Is Different” by Carmen Reinhart and Kenneth Rogoff.  A debt crisis takes a long time to create and it takes a long time for a debt crisis to unwind.

Yet, no one seems to heed this conclusion.

Instead we hear that we need more monetary stimulus, a QE3, before the upcoming presidential election in the United States.  We need immediate tax cuts.  We need fiscal stimulus.  We need an export policy to spur on the economy.

Let me repeat the conclusion written above: it takes a long time to create a debt crisis.

In my mind it took the United States approximately fifty years to create its debt crisis. 

Now, the second part of the equation: it takes a long time to unwind a debt crisis.

How long?

Jamil Baz, chief investment strategist at GLG Partners, a part of the Man Group, suggested that the current debt crisis “will take a minimum of 15 years for the economy to reach escape velocity and attain a level consistent with healthy growth.  This is because debt levels need to come down by at least 150 percent of GDP in most countries.  History suggests that you cannot reduce debt by more than 10 percentage points a year without social and political dislocation.”

Fifteen years!


Over the past five years, the debt situation has gotten worse.  According to Mr. Baz, for eleven the eleven developed countries most mentioned when it comes to the debt crisis, the weighted average of government debt to GDP has risen from 381 percent in June 2007 to 417 percent at the present time.

Deleveraging, at least in the public sector, has not taken place during these sad economic times…in fact, just the opposite has occurred.

And, when you add on the private debt the situation has deteriorated even more amongst these developed nations.

Why aren’t businesses hiring?  Why aren’t people spending?  Why aren’t government policies working? 

Because, Mr. Baz argues, deleveraging has not even started yet! 

All we have heard is a lot of hot air escaping from the balloon.  But, the balloon is not taking off and will not take off as long as there is still substantial deleveraging left…in the United States…and in most of the rest of the developed world.

And, when the debt begins to be reduced…watch out for economic growth.  The International Monetary Fund has estimated that, under current circumstances, every dollar cut from government deficits will lead to a two-dollar reduction in GDP.  This multiplier effect is higher now, the IMF states, than it was before 2008…four times higher!

The policy tools that people are turning to are not effective.  Additional government stimulus, or even the talk of it, points to even more debt being created which, in a cumulative way, just adds to the problem.  Monetary stimulus that creates inflation to reduce the real value of the debt will just result in higher bond yields that would raise the costs of servicing the debt and this just will exacerbate the problem.  And, policies to cause exchange rates to fall to jump-start an export-driven recovery are being tried by just about everyone with no one winning the game.

Fifty years of credit inflation…here in the United States…and in Europe…have created the debt crisis.  More of the same policy will only add to the crisis…not solve it. 

But, for fifty years, public officials would not listen to warnings that more and more credit inflation would result in a situation like the one we are now in.

Another five…or, ten…years of credit inflation will not heal the situation!

Unfortunately, there are no good, painless solutions. 

The ironic thing is that interest rates are so low in this situation!  The ten-year United States Treasury issue is trading just under 1.50 percent.  The ten-year German government bond is trading around 1.25 percent. 

The investment community is so spooked by the debt crisis that the “safe” bet today is in either US Treasury securities or German Bunds.  And, some US Treasury indexed bonds are trading at more than a NEGATIVE one percent rate of interest.  The ten-year indexed bond is trading around a NEGATIVE 0.60 percent.

In economics, everything is relative.

However, officials don’t acknowledge the problem.  Debt is subject that is best not discussed.  For most of the past fifty years, debt has not been present in aggregate models of the economy…academic, private, or government models. 

Still, it takes a long time for a debt crisis to become the dominant factor of an economy.

Unfortunately, it takes a long time for the debt crisis to subside.  This debt crisis will not be over when the next president of the United States is elected.  In all likelihood, the debt crisis will not be over when a president of the United States is elected in 2015. 

Maybe it is time to acknowledge this problem and really start to deal with it.  We have seen what continuing to ignore it does.   

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