Systemic Risk in the Global Economy

March 9, 2011

I read another enlightening post for John Mauldin’s Outside the Box blog entitled The Cognitive Dissonance of It All

He starts off with a quote from Charles Mackay —

“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”

The post is Mauldin’s attempt to shed light on the current “short-term” (in his mind) rebound in both the equities and commodities market.  He believes it is simply a product of the “goosing” by the Federal Reserve printing press.  As a result of these beliefs, his investment firm portfolio consists of short duration credit with moderate equity exposure.  The big concern is sovereign defaults which he discusses in the blog.

Mauldin believes the term “academic” has become a synonym for “central banker” around the world as so few of them have ever run a business.  These rulers of the world finances quickly arrive at a fork in the road (inflation versus default) when they initiate government policies on which evil to fight.  They tend to favor inflation because they perceive it to less painful and less noticeable while kicking the can down the road as many bankers are currently doing in their own loan portfolios.

In his opinion, this is what Greenspan did when he dropped rates to 1% and traded the dot com bust for the housing boom.  Knowing he was creating an “irrational exuberance” in the housing market, he turned over the reins to Bernanke and quit before everything collapsed.

Mauldin believes central bankers choose either inflation or default since they believe one path is separate and exclusive of the other.  Due to the extent of the debt crisis around the world today, Mauldin believes these choices are synonymous with one another since one actually causes the other.

He uses the term ZIRP (Zero Interest Rate Policy) and believes it is a hideous TRAP, as few developed Western economies bounce along the zero lower bound (ZLB) realize or acknowledge that ZIRP is inescapable. As these countries (including the U.S.) pursue ZIRP to avoid painful restructuring within their own debt markets it facilitates a pursuit of aggressive Keynesianism that only perpetuates the reliance on ZIRP. According to Mauldin, the only meaningful reduction of debt throughout this crisis has been the forced deleveraging of the household sector in the US through foreclosure; one of the reasons we will be in a protracted “soft” economy for some time to come.

Total credit market debt has increased throughout the crisis by a transfer of private debt to the public balance sheet while running double‐digit fiscal deficits. This is where the rubber meets the road as central bankers presuppose that net credit expansion is a necessary precondition for growth.   The risky game of ZIRP soon becomes a major inescapable problem the longer a country stays at the ZLB.  The consequences will be deadly when short rates eventually (and inevitably) return to a normalized level. 

He uses the United States’ balance sheet as an example. As the United States approaches the congressionally mandated debt ceiling ($14.2 trillion dollars including $4.6 trillion held by Social Security and other government trust funds), every one percentage point move in the weighted‐average cost of capital will end up costing $142 billion annually in interest alone.  Assuming a move back to 5% short rates, the increase in annual US interest expense will be about $700 billion against the current US government revenue of $2.228 trillion. 

Mauldin quotes Professor Ken Rogoff of the Harvard School of Public Policy Research.  Rogoff believes that sovereign defaults tend to follow banking crises by a few short years.  His recent book  shows  that  historically,  the  average  breaking  point  for  countries  that  finance themselves externally occurs at approximately 4.2x debt/revenue. 

Mauldin believes that the two critical ratios for understanding and explaining sovereign situations are: 

(1)  Sovereign debt to central government revenue and

(2) Interest expense as a percentage of central government revenue.

Using these  yardsticks, he finds  that when debt grows  to such  levels  that  it  eclipses  revenue multiple  times over, there  is  a nonlinear relationship between revenues and expenses in that total expenditures increase faster than revenues due to the rise  in  interest expense from a higher debt  load coupled with a higher weighted‐average cost of capital and the natural  inflation of discretionary expenditure  increases. 

This is one of the reasons why the U.S. Federal government MUST get its house in order and deal with the “non-discretionary” portion of the budget before it is too late.

Mauldin notes a recently published paper by The Bank of International Settlements which  painted a  shocking  picture  of  the  trajectory  of  sovereign  indebtedness. The study focused on twelve major developed economies and found that debt/GDP ratios will rise rapidly in  the  next  decade,  exceeding  300%  of  GDP  in  Japan;  200%  in  the  United  Kingdom;  and  150%  in Belgium,  France,  Ireland,  Greece,  Italy  and  the  United  States. 

Additionally, the paper found that government interest expense as a percent of GDP will rise from around 5% [on average] today to over 10% in all cases, and as high as 27% in the United Kingdom.

Mauldin uses the example of Japanese government which for years has used government bonds (JGBs) to “self‐finance” its growing debt.

The available pools of capital to finance their debt is comprised of two accounts – household and corporate sector. Household is the incremental personal savings of the Japanese population, and corporate is the after‐tax corporate profits of Japanese corporations. As long as the sum of these two numbers exceeded the running government fiscal deficit, the Japanese government had the ability to self finance or sell additional government bonds into the domestic pool of capital.

This policy is quickly coming to an end.

As the Japanese government’s structural deficit grows wider driven by the increasing cost of an ageing population, higher debt service, and declining revenues, the divergence  between  savings  and  the  deficit  will  increase. 

Mauldin compares this approach to Alan Stanford and Bernie Madoff who showed us what tends to happen when this self‐financing relationship inverts.  When  the  available  incremental  pool  of  capital  becomes  smaller  than  the  incremental financing needs of  the government a Ponzi scheme develops and, as noted above,  the rubber  finally meets  the road.

As Japan’s severe decline in the population continues (in addition to Japanese resistance to large scale immigration), the ingredients of a toxic bond crisis are inevitable.

He notes a potential parallel between JGBs and US housing.  In the last 20 years, Japanese stocks have dropped 75%, Japanese real estate has declined 70, and nominal GDP is exactly where it was 20 years ago.

While the drop has occurred in the real estate market, the buyers and owners of JGBs have never lost money in the purchase of the JGBs as their interest rates have done nothing but fall for the better part of the last two decades.

With  all  of  the  evidence  literally  stacking  up  against  Japan,  he notes that a  few members  of  some  of  Japan’s major political parties are beginning to discuss and plan for the ominously named “XDay”.

X‐Day is the day the market will no longer willingly purchase JGBs. Many economists are worried this may happen in the U.S. as the Chinese abandoned the market for U.S. Treasuries. 

Mauldin is also unsure of German commitment to fiscal and debt integration with the rest of the Euro zone.  He believes Germany will gradually show a decline in support for the Euro and, as a  result,  set a  series of  substantial  criteria  for any German approval of further reform including balanced budget amendments,  corporate  tax  rate  equalization,  elimination  of  wage  indexation  and  pension  age harmonization similar to theirs.

In  the  end,  he believes the  German  people  will  not  go  “all‐in”  to  backstop  the Euro zone without a credible plan  to  restructure existing debts and ensure that they can never reach such dangerous levels again. 

What relevance does all this have with us in the United States?

It seems to me that at least State governments are trying to get a handle on their finances even if our Federal government continues to kick the can down the road.

Europe has Germany putting pressure on Greece, Italy, Ireland, Spain and Portugal to get their finances straight.  In the U.S., the ultimate pressure will come from the municipal bond market which is forcing fiscal discipline upon State governments to balance their budgets.

Mauldin is brief and straightforward on the resolution to these problems.  While the  inflation/deflation debate  is  vigorously  defended  on  both  sides, he   recognizes  the  ongoing  need  for deleveraging  which  will apply  deflationary  pressures.  This will not be without pain but the end result for not deleveraging will be the eventual default of central governments or hyperinflations caused by public budget deficits which are largely financed by money creation.

Mauldin knows that it was excess leverage and credit growth that brought the global economy to its knees and notes in his posting that since 2002, global credit has grown at an annualized rate of approximately 11%, while real GDP has grown approximately 4% over the same timeframe.

This simply is not sustainable.

Full Article

Posted by Scott R. Lodde

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