Seeking Alpha
Small-cap, macro, value, momentum
Profile| Send Message|
( followers)  

Bass didn't explicitly say it would be in Europe. However, he did say this:

I don't know who's going to fight who, but I'm fairly certain that in the next few years you will see wars erupt, and not just small ones [CNBC]

He bases this view on the high levels of debt in the world, by his calculations this has reached 340% of global output, and the world has never lived with these levels in peacetime. He also doesn't expect the eurozone to survive in it's present form so it's fair to say that the eurozone is in the hot seat.

How realistic are these apocalyptic predictions? Well, there are a couple of mechanisms we can imagine that could spark conflict:

  • These high levels of debt have to be restructured or monetized, the chance that these can be reduced through normal economic growth and/or austerity is rather slim. This sets up creditors against debtors.
  • The main route through which countries, most notably in the eurozone periphery, have dealt with the high debt levels is through cutbacks in private (deleveraging) and public spending and tax hikes (austerity). But this has made matters worse, not better.

The latter point is especially important. Here is a scenario: Large parts of the population of a peripheral eurozone country don't see any improvement, only worsening of their economic plight. Falling wages, rising unemployment and little hope of a turn-around any time soon. Sacrifices are reasonable as long as there is light at the end of the tunnel, but there is still very little of that in most eurozone peripheral countries.

At the next election, this constitutes a platform for parties to argue that they're better off outside the eurozone, and there is a fair amount of rationale for this position (which we'll expand below). If these parties win, and a country actually manages to overcome powerful (domestic and European) elites and leaves the euro, other eurozone countries with large contingent claims on this country will suffer heavy losses.

These contingent claims come via all sorts of bail-out packages, ECB, EU, and IMF assistance and private claims, a large part of these have to be written off after a country leaves as the ensuing devaluation will make honoring these a rather tall order (especially as leaving the euro itself is likely to create considerable amount of economic chaos).

This isn't a pretty picture, but now the German, Finnish, Austrian, Dutch, etc. electorates, which have been promised that all the bail-out packages is just loans, to be paid back with interest, not subsidies, are waking up to reality. That reality is that hundreds of billions of euro's won't be coming back and have to be written off, by their private sectors, and public sectors (that is, tax payers) alike.

On top of that, the economic chaos created by a country (or countries) leaving the euro will produce a rather large additional economic shock to these countries, which have until now, escaped the worst of the eurocrisis (Germany has positively thrived on it).

It is still difficult to see war as a likely, let alone an inevitable outcome, but in really dire economic circumstances where countries embark on actions that are very detrimental to others, all bets are off.

Can anything be done?
The first thing to realize is that the present course chosen in the eurozone (but hardly limited to there) is misguided. Those that worry so much about debt are also usually those that demand immediate action to reduce that debt, that is, strong austerity. That is indeed what has been happening in the eurozone periphery, and both theory and experience shows that it has made things worse.

When the private sector is delevaraging, that is, paying off debt despite record low interest rates, they spend less. This not only depresses the economy but it has a host of secondary effects:

  • Businesses hire less and invest less with the prospect of lower, or slower growing sales.
  • It creates a savings glut which depresses interest rates, which cannot fall below zero hence the economy renders monetary policy rather impotent (the famed 'liquidity trap').

With monetary policy mostly out of commission, the task of reviving the economy falls on fiscal policy. However, the austerians have rendered that option not only powerless, austerity is compounding the economic downturn. When both the private and public sector are reducing spending, and monetary policy is largely impotent, the resulting sharp economic downturn can't be surprising.

The only new demand can come from abroad, but with most trading partners embarking on the same strategy, and with the possibility of currency devaluation rendered impossible through membership of the euro, this isn't happening either.

And all this was compounded by other characteristics of the eurozone, producing perverse capital movements from where it is needed most (the periphery) to where it's needed least (the center, like Germany). This is because:

  • Eurozone countries effectively borrow in a foreign currency, a currency over which they have no control. Unlike countries that issue debt in their own currency, eurozone coutries can default.
  • Sellers of peripheral government bonds get euros, which they can invest anywhere else in the eurozone, without incurring exchange rate risk, hence the flight to the center and capital draining from the periphery, making monetary conditions even worse. Compare this to sellers of, say, UK debt. They get pounds, which they can only invest in the UK, so the money doesn't leave. They could sell the pounds on the forex markets, but the buyers have the same limitation, the money can't leave the UK and the resulting currency devaluation when people sell pounds actually produces an economic stimulus to the UK.

So far the theory, and practice has born this out. Even the IMF and the Financial Times are now warning against too much austerity. Debt might be bad and too high, forcefully reducing it can easily make things worse.

Another thing to note is that the burden of adjustment falls almost exclusively on the peripheral countries. Most of these countries accumulated a large inflation differential with the core eurozone countries in the first decade of the existence of the eurozone, reducing their competitiveness.

They now alone have to remedy that, through a forced 'internal' devaluation as they cannot actually devalue their currency. Much better would be the center countries helping with this adjustment through reflationary efforts by these countries, but what's happening is actually the opposite. They compound the misery by embarking on austerity as well. This is basically a race to the bottom.

There are a couple of alternatives, but the situation is actually so dire it remains to be seen whether this could significantly change the picture. Here are some:

  • Reflation in the center
  • More emphasis on structural reform, less on austerity
  • A move towards debt mutualization
  • Debt monetization
  • Debt restructuring

The exact mix varies from country to country, and from area to area. There is ample room for reflation in the eurozone center countries, like Germany, Finland, the Netherlands. Germany hardly has a budget deficit and can borrow basically for nothing if one takes inflation on board (real interest rates are mostly zero or negative). A country like the Netherlands has a whopping 8% of GDP current account surplus, there already is a savings glut there.

Structural reform is difficult as it takes on organized interests, so it concentrates the pain while the gains usually don't materialize immediately and are too widespread, leaving them without anyone to champion them. But many eurozone countries have ample opportunities here, the is much low hanging fruit for reviving some market dynamism but don't expect miracles from this, it's very much a longer-term policy.

Debt mutualization would provide another partial solution. We say partial, as it doesn't address the imbalance in competitiveness and actually the ECB's promise to do whatever it takes has taken some of the bite out of the bond vigilantes that plagued the peripheral countries. Eurobonds would certainly divide the burden of adjustment more equally, but many people fear it provides disincentives for the periphery to address their problems.

There are schemes that could address the latter problem (like the German proposed redemption pact or the plan developed by Delpla and von Weizsäcker, the so called blue bond concept, or a stabilization fund proposed by Bloomberg), but since this is a political non-starter at the moment we'll leave it at that, with the proviso that this discussion will flare up anytime the ECB 'guarantee' isn't enough anymore to stem panic on the bond markets.

Debt restructuring is another way to deal with excessive debt. This is what often happens when countries can't be expected to service their debt anymore and are cut off from the markets. This happened to Greece.

That leaves debt monetization and debt restructuring as the main routes to prevent catastrophe. Historically, much public debt has been 'dealt with' by inflating it away, either as a purposeful policy decision or as a natural byproduct of inflation. Interesting is the contrast between France and the UK after WOI.

The UK basically tried what the eurozone peripheral countries are doing now. It returned to the gold standard and embarked on savage austerity to restore competitiveness and pay off debt. France devalued and inflated it's debt away. Here are the results:

(click to enlarge)

France was able to reduce its debt level way faster than the UK, and maintain much better economic growth in the process. In the 1930s, these roles were reversed, with the UK leaving the gold standard in 1931 and France returning to it in 1927 clinging to it through the mid 1930s.

After WWII the UK was saddled with crippling public debt, but inflation (and some economic growth) have reduced this to more manageable proportions, at least until recently, just what happened after the Napoleonic wars.

There is, of course, another, more direct way of debt monetization, purchases by the central banks, or money printing." Insofar as this is inflationary you get a double whammy. However, despite all the alarm, so far there is no sign of any uptick in inflation, despite central banks already purchasing large amounts of government debt, in Japan, the US, the UK, and even the eurozone.

If it isn't inflationary (at least under the present, depressed economic conditions) can't they just 'cancel' the debt already bought? Since central banks are part of the public sector:

No one in the private sector would lose out from the cancellation of these bonds, which have already been purchased at market prices by the central bank in exchange for cash. [Gavyn Davies, FT]

Central banks themselves would 'lose,' wiping out their capital base. But how much does this matter? It surely is more expansionary than bond financed public deficits, as the absorption of private savings through selling bonds to the public, nor the threat of higher taxes down the line exhort any restraint on private spending. But savings are already plenty as the private sector is deleveraging, absorbing some doesn't make much of a difference.

Once again, Japan might very well provide experience with this. Japan looks set to embark on something like this, and they'll have to, with a declining population and public debt/GDP in excess of 200%, and suffering from mild deflation, rather than inflation (the result of a much bigger financial collapse in the early 1990s).

The main risk is that inflation can't be controlled, but Japan suffers from mild deflation, this isn't very likely anytime soon. And the policy can always be stopped, or even reversed, when inflation threatens to accelerate in earnest.

Yes, debt levels are way too high, and the situation, especially in the eurozone, is still dire and potentially explosive. However, theory and historical, as well as contemporary experience show that savage austerity in the midst of an economic slump usually makes things worse, not better.

To deal with the sky-high debt levels will have to rely on other means, none of them pleasant, none of them without serious side effects, but all of them beat war, or even the present economic slump in the eurozone periphery.

A combination of debt restructuring, reflation in countries where there is still room (the eurozone central countries), debt restructuring, mild inflation or even central bank cancellation of debt provide ways to defuse the debt bomb.

After that, more efforts should go to preventing the run-up in massive debts (more especially in the private sector), but that's for another day.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Debt Crisis Could End In War, According To Kyle Bass