50% World-Wide Debt Forgiveness: Creditors And Debtors Could Both Win

by: Larry Trefz

About 60 years ago, Germany was drowning in post-war debt. After torturous negotiations in the early 1950s, over 70 creditor countries agreed to forgive half of the debt Germany owed. The results are still seen today in the relatively robust German economy.

As the developed world struggles with mountains of debt and near-zero interest rates, it might make sense to explore other options than simply enduring year after year of near-deflationary conditions and zero-interest rates.

The leverage for this argument is the current low interest rate environment in the developed world. With effective interest rates near zero, it could make sense to reduce the debt principal and raise the interest rates on the remaining balance. Let's look at how long it would take to recoup the writedown in principal with higher rates.

In order to double the principal, the following rates and time periods would apply. The figures are rounded to the nearest full year:

4% compound interest - 18 years

5% compound interest - 14 years

6% compound interest - 12 years

7% compound interest - 10 years

8% compound interest - 9 years

9% compound interest - 8 years

10% compound interest - 7 years

Let's suppose that in the interest of re-invigorating economic growth, everyone agreed to write the principal down 50% while starting with a relatively low teaser rate for a few years on the remaining principal. The rates could gradually be raised from there as growth and equilibrium returned to the developed world's economies.

The returns in overall economic growth and more normal interest rates could benefit both the creditors and debtors over the current deflationary struggle that shows no end and no real winners.

A lesson should be learned from the length of Japan's high-debt, low-interest rate, decades-long, deflationary slog. It may just be possible that a writedown and adjustment of this nature could make a significant positive difference for the global economy.

At the moment, a scenario of this nature does not seem to be in the cards, but what makes it a potentially viable alternative is the fact that the debt debacle is one that is shared world-wide - at least by the majority of the developed countries.

Another element that could facilitate this scenario is the size of the balance sheets of the developed country's central banks. By virtue of these organizations holding such a large portion of a country's debt, the negotiations could be made easier than it would be with numerous small creditors.

This being said, it would likely take a global market shock to bring a scenario like this to the front. The risk/reward factor would need to change the tide in favor of a scenario like this. If creditors start to believe that their losses could be significant by sticking with the status quo, it is likely that they will consider alternatives.

Debt forgiveness is not a new concept and has been practiced significantly since the 2008-2009 financial crisis by many corporate creditors and aided by government programs.

Should long-term global deflation start to be seen as a real threat by the majority of creditors, this scenario of a coordinated debt writedown could start to take shape.

I would watch Japan as a bellwether to see if their economy is able to reach take-off speed above deflation under Abe's new leadership and aggressive central bank action. If they sink back and are unable to effectively combat deflation, the scenario laid out here could become much more likely.

In an event of this nature, shorting bonds would likely be the preferred trade. Some ETFs to consider are: (NYSEARCA:TBT), (NYSEARCA:TLT), (NYSEARCA:HYG), (NYSEARCA:JNK), (NYSEARCA:AGG), (NYSEARCA:BND), (NYSEARCA:TYO), (NYSEARCA:TMV). Please remember that leveraged ETFs are designed for short-term trading.

Disclosure: I am long TBT. 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.