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 “X‐Day”.
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.
Posted by Scott R. Lodde