Cutting through the debt crisis

The explosion of debt for the developed world, and its growing evolution into a full-blown debt crisis, has been an extraordinary development. Ben Hunt provides a summary of where we are today, and reports on some of the latest thinking about the growing malaise.

In the space of just a few years, debt has become the biggest economic and political issue facing the developed world. If further austerity measures or volatility come to pass, it could well turn into the biggest social issue too.

In many ways, it is already negatively impacting the world economy, exacerbating worsening short-term growth prospects, especially via the slow-down of European economic demand. And on many levels it is proving to be a historically new phenomenon that defies easy analysis and explanation. For example, where debt was largely seen as a third-world country phenomenon in the past, today it is the world’s richest countries that are in trouble, often owing money to those with a much lower GDP per capita.

The extraordinary development of debt can be seen by a few of the raw statistics. At the global level, recent research by the American hedge fund Hayman Capital Management suggests that while total global debt has grown at a compounded average growth rate of 11% over the last decade or so, from $80 trillion (£50.5 trillion) to about $210 trillion, global real GDP has only grown by 4%. The global debt to GDP ratio is now 310%, but Hayman notes that historically only in wartime has it surpassed 200%.

Figures such as these have prompted the widely-held view that most of the debt today is un-repayable. A large part of it is likely to be defaulted on or inflated away by stealth.

As noted above, the accumulation of debt has also become a key new differentiator between the developed world and emerging markets.

“The IMF estimates that average debt/GDP of advanced economies will exceed 100% in 2011,” says Helene Williamson, the head of emerging markets debt at First State Investments, a specialist in emerging markets funds. By contrast, average debt/GDP for emerging market countries stands at 34%.”

Developed country ratings have experienced 68 downgrades since the financial crisis of 2008, while emerging markets have seen more ratings upgrades than downgrades, says Williamson.

“High fiscal deficits and low GDP growth rates in developed countries make a return to sustainable debt dynamics difficult in many countries.” (Cover story continues below)

The biggest short-term risks of disruption and volatility, with risks of defaults and huge banking losses – and hence the most frenzied crisis management efforts – have, of course, come in Europe. With the latest bailout at the end of last month, the saga to avoid a Greek default continues to unfold. As many have observed, the objective of such moves is as much to shore up the stability of the eurozone and prevent contagion to Italian and Spanish sovereign debt markets, as to help Greece itself. The consensus is that the country is incapable of paying back new or old debt and has become a clear candidate for default at some point.

Meanwhile, the politics of the European situation have become extraordinary. Elected governments have been replaced by unelected ’technocrats’ with the objective of pushing through tougher austerity packages.

The same crisis conditions may be absent in other developed nations but there is a feeling that a slow-motion car crash may be in process. The American budget deficit and national debt is seen as unsustainable – it is just that nobody knows if, or when, it will lead to a crisis. The same applies to Japan’s situation and there is considerable disagreement over the problem of time-frames.

The debt crisis has therefore provoked a huge amount of analysis and debate, with many points of disagreement and shades of opinion. Discussions have raged on many levels.

A basic distinction is between public and private debt. In the former category, there is a huge political discussion on the rights and wrongs of austerity packages. On the more technical side, economists and analysts have tried to quantify sovereign default risks by looking at various debt and economic ratios, historical examples and contextual factors, such as the composition of debt ownership and maturities.

The objective is to identify ’tipping points’ where investors lose confidence, governments face hikes in interest payments and new crises can occur. The fear is that bond market investors will come to see sovereign debt markets almost as ponzi schemes, where new refinancing takes place simply to pay the interest on old debt.

According to Hayman Capital Management, insolvency risk looms when more than 10% of central government revenues are diverted to servicing interest payments, and where total debt is more than five times revenues.

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In reality this has been a difficult and contentious area of debate. Levels of investor confidence are intangible and there are a huge range of contextual factors that come into play.

For instance, some may not feel happy owning American treasury bonds, but they have ironically become a safe haven given the crisis in the eurozone. For a number of other reasons many other investors have little choice but to own them. Japan has been able to sustain rising public debt for some time.

A secondary – and arguably more important level of discussion – is on the private debt side. To what extent have the mature economies developed a dependency on credit for economic growth? And to what degree are they deleveraging?

Clarity in this area is also important for the public debt discussion. For instance, if economies have been overly dependent on debt, but have a poor underlying growth potential and are now deleveraging, to what extent does state spending need to offset this?

And what are the dangers of too much fiscal contraction?

”High fiscal deficits and low GDP growth rates in developed countries make a return to sustainable debt dynamics difficult in many countries”

In practice this level of analysis is also proving difficult. It is openly acknowledged that conventional economics has largely ignored the role of debt in the workings of economies. Not surprisingly, the few who have had something substantial to say, such as the American economist Irving Fisher, are being rapidly reappraised.

“Standard economic theories conceptualise debt pretty badly,” says the financial analyst Karl Denninger.

In a new book Leverage: How Cheap Money Will Destroy the World, Denninger examines the mathematical underpinnings of the historical divergence between debt and economic growth in recent decades. He argues that ignorance of these principles has led to negligence of the growth of debt.

“The trouble is that debt is looked at as a time-shift – I buy a car today that should have been bought in the future. The assumption is that debt gets paid off, but we know this view is wrong – it does not, either for governments or the private sector. Other schools see debt in productive terms, and of course it can be, but not necessarily. It may be used for consumption or speculation.”

One contemporary economist who has also examined the various relationships between debt, asset prices, deleveraging, asset deflation and the impact on the productive economy is the Australian Steve Keen. Among other things, he has argued that the recent recessionary downturn in America and upturn in unemployment was a product of the hit to aggregate demand coming from the falling away of credit.

The economic historian and chief economist for Asian firm Blackhorse Asset Management, Richard Duncan, has also studied these relationships in depth over time.

In a new book, The New Depression: The Breakdown of the Paper Money Economy, Duncan argues that the American economy over recent decades became highly dependent on the extension of credit and ever-more indebtedness. He has developed a new concept, The Quantity Theory of Credit, which modifies an earlier model developed
by Fisher.

“The growth dynamic in our economic system has changed completely,” says Duncan.

“Under capitalism, the growth dynamic was driven by investment, profit and capital accumulation – hence the ’capital’ in capitalism – and that was slow and hard. Things have not worked like that for a long time. Our economic system, which should be called ’creditism’ rather than capitalism, has been driven by credit creation and consumption, and more credit creation and more consumption, and so on.”

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In America, says Duncan, the ratio of total debt to GDP was 150% until the early 1980s. From there it rose to 360% on the eve of the crisis. For six years in a row the US experienced a trillion dollar increase in household sector borrowing each year. But 2008 marked the point where it became obvious that the private sector could not repay so much debt, and it was cut off from further borrowing. It was then that the crisis began.

Duncan says that since 1952, there have been only nine years when credit (adjusted for inflation) grew less than 2%. Each time there was a recession; and the recession did not end until there was another surge of credit creation. Only a couple of times in history has the American economy experienced two years of no credit growth whatsoever.

Today, however, three years have gone by without any credit growth. The trouble is, there is little basis for credit growth going forward. The private sector cannot repay the debt it has already.

Others have echoed these themes when pointing out the American economy is likely to experience considerable deleveraging in the years ahead. A recent report by the McKinsey Global Institute pointed out that America is one of the few advanced countries to have already experienced it.

”Our economic system, which should be called ’creditism’ rather than capitalism, has been driven by credit creation and consumption”

This gives rise to a further problem. Without credit, and as deleveraging continuing apace, but with a weak fundamental economy, the state’s fiscal and monetary policies have kept the economy from sliding into depression. But as government creditworthiness is questioned, this in turn comes up against limits. And monetary expansion, which has taken over from fiscal expansion, also comes up against limits with record low interest rates.

For Duncan, the world is missing the one unique opportunity arising from the strange global imbalances and America’s ’exorbitant privilege’: American government access to huge amounts of capital at very low cost. This provides an opportunity to build new productive capacity to restore economic health and reduce the public debt burden.

Other economists, however, take a different stance.

“Neither the Keynesian or monetary solutions are effective policy responses to over-indebted periods,” says Lacy Hunt, the chief economist with the American firm Hoisington Investment Management.

“But the only way to solve the problem is to heal the economy over time, and that requires deleveraging and austerity,” he says.

In today’s over-indebted period, he says, asset prices have fallen and there has been extreme pressure on debtors, expressed in negative equity in housing and commercial real estate.

”The only way to solve the problem is to heal the economy over time, and that requires deleveraging and austerity”

“The economy is operating but not in normal fashion. You can get a cyclical response from monetary and fiscal stimulus, but it is not sustaining.”

What Hunt suggests has been echoed by others – that the economy may see many ’false dawns’ going forward. He does not think the economy is improving despite GDP growth.

“GDP measures spending, but income measures prosperity,” he says. “Yet real disposable income has been declining for several consecutive quarters,” while the economy is saddled with debt and undergoes deleveraging.

Another nuance is given by Denninger. He says recessions are needed in order to clear the build-up of debt that has accumulated over time, but the business cycle became more muted in recent decades with the “great moderation”.

In various ways, governments constantly intervened to prop up firms that could have been allowed to go under. Creditors and debtors were saved from pain, but debt was kept on the books.

For others, simply writing off the debt is what is needed – a debt jubilee. Rather than going through years or even decades of deleveraging, debt could be wiped off the books so that new credit or investment could flow again, with a new phase of growth. A new book by the anthropologist David Graeber – Debt: the First 5000 Years – has attracted much attention with an argument for debt forgiveness.

”GDP measures spending, but income measures prosperity”

For other economists, the key is to look afresh at the private sector to get growth. Fiscal contraction may be necessary but companies need to invest more cash to offset that.
In Britain, says the economist Andrew Smithers, the chairman of Smithers and Co, “companies used to run persistent cash deficits but now run a cash flow surplus of 6% of GDP. The causes of this are that profit margins have risen but business investment has fallen, relative to capacity utilisation.” The problem is not that companies have a high stock of cash – cash ratios are not particularly high – he says, but a problem of cash flow.

Smithers argues that perverse incentives have changed the nature of investment in Britain. Companies have to balance short-term risks with long-term risks. Investment involves the short-term risk of falling profits, but failure to invest involves the longer-term risk of losing market share and failing to keep pace with competitors’ efficiency.

However, “bonuses depend on short-term metrics such as earnings per share, return on equity and share prices,” says Smithers. Profit margins have risen but investment has fallen. Bonuses have also encouraged share buy backs instead of investment.

For others the key is to take a step back and look at the structural causes of debt. A new development, detectable in the last year especially, is the growing sense that there is more to the debt crisis than meets the eye. Structural flaws in monetary systems and particular models of economic growth need to be more fully appreciated.

This has become evident in the debate over the eurozone. Patience with ’band-aid’ solutions is wearing thin. There is a near-consensus that the single currency contains structural flaws and contradictions.

Conceived as a political rather than an economic project from the beginning, countries with different levels of productivity and competitiveness were forced into unity but without the pressure release of currency depreciation which would allow the correction of trade imbalances. Politicians in the peripheral states took advantage of the new lending opportunities afforded by the euro. By raising living standards via increases in debt-fuelled state spending, they compensated for more fundamental competitive problems.

For the global level, however, a convincing historical narrative of why the accumulation of debt occurred in the first place is also being pieced together.

The starting point is the breakdown of the quasi-gold standard under Bretton Woods in the late 1960s. As the dollar was no longer tied to gold, this paved the way for unlimited credit creation.

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However, there were problems in getting investment into the real economy. Over time more credit was diverted to bubbles, speculation and consumption rather than building productive assets. The divergence between the ability to create new wealth and organic growth in the real economy, and the rise of debt and fictitious capital values, gave rise to the crisis that we see today. Facilitating this at a foundational level is the fractional reserve banking system. Loans are advanced not from existing deposits, but from the creation of new money in relation to existing reserves. This creates the problem that new money issued is money-as-debt: a greater volume of money must mean greater indebtedness of society.

This narrative, and other concepts, are explored in a new book by journalist and financial historian Philip Coggan, Paper Promises: Money, Debt and the New World Order.

“Historically, the debt crisis is not about Lehman Brothers or Credit Default Swaps, it is about the monetary system and a range of other factors,” he says.

Echoing Duncan and others, he says: “Since the end of Bretton Woods, there has been no constraint on the growth of credit. This has led in turn to huge debt and continuous asset bubbles. Debt, however, has outstripped growth.”

Coggan adds that: “There has been a constant need of central banks to keep the show on the road. They are so much involved in markets than before. The European Central Bank, for instance, is underwriting the banking system, buying government bonds, propping up equity markets. Elsewhere, with governments retreating from fiscal policy, quantitative easing and other measures are the only thing left.”

”The decline in the working age population could be more important than the issue of poor investment”

Coggan suggests that “there has been a problem with long-run growth, with investment not going into real assets but speculation. Going forward, there is a demographic problem which could be more important than the issue of poor investment. This is the decline in the working age population, now seen in many countries. Trying to grow an economy in this context becomes an uphill battle.”

The picture over the debt crisis continues to be immensely complex. A key dividing line seems to be over attitudes to further economic growth. Some are sceptical that economies can “grow their way out of the problem”, and argue that history proves them right.

In parallel, it is said that exporting as an escape route is difficult: not everyone can run a trade surplus at the same time.

On the other side are those who feel that new things should be tried to create new avenues of growth. But there are many nuances. Countries such as Greece seem far more trapped than their bigger counterparts, with a long path ahead in terms of restoring economic health to match expectations of living standards. The picture is more cloudy for countries like America, Britain, France and Japan.

Despite the disagreements there are some areas of consensus emerging. One is that overall debt cannot be paid back at all in full – it is just too large relative to the economy.

Another is that politicians have been very poor in clarifying the situation and the choices available. The idea that there is a crisis of political leadership as well as a debt crisis, that politics has become dysfunctional, is widely held.

For investors there are risks, but also opportunities for those who can remain several steps ahead of the game. The debt crisis, however, is still in its early stages. No doubt further drama will unfold in the coming period.