If you're part of my generation and watched enough Happy Days back in the day, you know that "the Fonz" had a keen understanding of human nature. And that projecting confidence was a huge part of his alpha male "badassness." He even admitted as much in episode #45:
Fonzie: I'm gonna do something for you, Cunningham, I never did for anyone before. I'm gonna teach you the secret of being tough.
Richie: Wow, you don't think I could ever…
Fonzie: WHO told you to talk?
Richie: I'm sorry Fonz.
Fonzie: That's the secret.
Richie: What? I think I missed it.
Fonzie: You see how nervous you just got.
Richie: Yeah, but I thought you were gonna kill me.
Fonzie: Hey, that's the point - I intimidated you. That's because I got a majestic bearing, I got style, I got an attitude, I got a tough voice.
Richie: Let's face it, you're a good fighter.
Fonzie: Hey, I'm the best. But in the entire time you've known me, have you ever seen me in a fight.
Richie: Well no, but that's just because the other guy backs down first.
Fonzie: I rest my case.
I still remember watching the episode and puzzling over the revelation that the Fonz's tough guy image was a confidence trick. And in the screwed-up way my mind works, Fonzie became my word association for other confidence tricks. For example, paper currencies are Fonzies because their value rests entirely on confidence in the governments that back them.
But some confidence tricks have characteristics that don't quite fit the Fonz. Take the swindles known as Ponzi schemes. These are tricks that need an endless supply of participants to sustain confidence and stay alive. Once the participant pool depletes as it eventually must, the tricks are revealed as scams. Whereas Fonzies can persist indefinitely (at least in theory), Ponzis eventually collapse.
This distinction can be especially important for the asset class I'll discuss here - government debt. Government debt usually fits the Fonzie category, but it moves into Ponzi territory in situations where public finances deteriorate. Needless to say, investors may like to know when this transition occurs. In other words, how can we tell when debt changes from Fonzie to Ponzi? I'll give our best answers below, first by checking briefly with the late economist Hyman Minsky and then by drawing on a variety of research published on CYNICONOMICS this year.
Although Minsky may or may not have watched Happy Days, he did establish the best known criterion for Ponzi debt. He said that debt becomes "Ponzi finance" when the borrower needs to raise fresh capital just to cover interest on existing loans. But he focused on private rather than public borrowing. With due respect to the prescient professor, we'll tweak the definition to apply specifically to government debt.
Defining the "Ponzi point" for government debt
Ideally, governments would cruise along in Fonzie mode at all times, relying on the confidence of their creditors without taking too many liberties with those creditors. This is what we've seen in America for long stretches of history, especially in times of peace. In recent decades, though, fiscal discipline has crumbled. Deficit spending has become addictive in America and elsewhere, leaving governments with two choices:
- Feed the addiction. Continue to borrow heavily and accumulate debt, kicking the can down the road.
- Cure the addiction. Acknowledge and accept the costs of past profligacy, eliminating deficits and possibly also haircutting creditors.
Our definition of the Ponzi point is based on the amount of austerity that's needed if policymakers were to choose the second option, as well as the effects of that austerity. But we won't use a numerical measure, at least for now. Instead, we'll keep it simple and say that restoring fiscal discipline at the Ponzi point would cause the economy to break down for an unusually long period, failing to create jobs or growth. The downturn may or may not meet the textbook definition of a depression, but it would lead to depression-like joblessness. Think of today's circumstances in countries such as Greece and Spain.
There are a few similarities between this "no growth, no jobs" scenario and a broken Ponzi scheme in the classic definition. The pipeline of new entrants to the system dries up in each case (in the government debt Ponzi, new graduates are unable to find work), while everyone else scrambles for a share of the dwindling wealth.
But the true Ponzi characteristics of the no growth, no jobs scenario are based on politics. Politicians are sure to second guess austerity in a depression or depression-like economy. Eventually, folks who insisted on fiscal responsibility lose sway and short-term thinking is reestablished. And with austerity considered a bad word, debt resumes its climb towards a different threshold, one that brings a far more devastating collapse.
This ultimate threshold - call it the Keynesian end game - is when investors refuse to lend more money, forcing the government to either default or start hyperinflating (probably with some wealth confiscation added in). It then becomes obvious to all that the government's borrowing was essentially a Ponzi scheme.
The difference between the Ponzi point and the end game is important. At the Ponzi point, the game isn't over just yet, but it's a foregone if not widely-recognized conclusion that you're on a path in that direction. The path is firmly established because serious action to reign in deficits would wreak havoc on the economy and change the political calculus about austerity. Also, most investors remain in the game at the Ponzi point, happy to hold government debt, in the same way that successful Ponzi schemers are able to find willing participants right up to the end. Large, developed nations such as the U.S. and Japan can sail right past their Ponzi points with nary a flutter in the financial markets. As I'll argue in a moment, Japan has already passed its Ponzi point.
Think of it this way:
You're swimming in the ocean on a perfect, sunny day, unaware of a riptide that's pulling you far beyond a swimmable distance from shore. Once you realize what's happened, you'll surely struggle against the current and may pay for your mistake with your life if there's no help at hand. But the mistake was made earlier when you didn't pay attention to the water conditions and drifted past your ability to swim back safely. Let's say it was halfway between the shoreline and where the rescue helicopter pulled you out that you unknowingly let yourself drift too far. That halfway spot was your Ponzi point.
In this swimming scenario, you should have turned around and swam back to shore well before reaching the Ponzi point, even as there may have been no obvious signs of danger. By the same logic, governments should take serious action well before public debt rises to Ponzi levels, even though they, too, may not get a clear warning of the eventual catastrophe.
The Fonzie/Ponzi thresholds
Now for our two cents on where the Ponzi point may lie for today's large, developed countries. Smaller and emerging countries are a different story, because they often lose the confidence of their creditors and choose to default or restructure debt before the Ponzi point comes into play. But here's our theory for the big countries:
Needless to say, thresholds are inexact in economics. As stated in earlier articles, that's why we use big, round numbers. It's also why we've chosen a broad range for the transition from Fonzie to Ponzi. At some point between 100% and 150% debt-to-GDP, we think the sovereign debt of today's large, developed nations fundamentally changes. Bondholders who were merely perpetuating a confidence trick become participants in a Ponzi scheme.
These conclusions are influenced partly by historical research, with a handful of studies marking the range from 100% to 150% as transitionary:
- We looked at all historical episodes of countries running debt-to-GDP ratios higher than America's pre-GDP redefinition level of 105% (recall that the Bureau of Economic Analysis rewrote GDP history in July.) In every large country episode in which debt was successfully reduced below 90% of GDP without slamming creditors, this was achieved by balancing the budget. Not one of the large countries kept its creditors whole with today's approach of running chronic deficits excused by Keynesian thinking. The small country results are more complicated but no less discouraging. See here for details.
- We looked more closely at all episodes of countries running debt-to-GDP ratios above 150%. Creditors were kept whole in a few of these episodes, but each one involved wartime debt that was relatively easily managed by either dismantling military apparatus (post-World War II) or exploiting the spoils of military success (19th century British Empire). Every other case is either still ongoing or required a debt default or restructuring. What's more, had we not restricted our threshold choice to a big, round number, we would have reached virtually the same conclusions at a threshold of only 120%. See here for details.
- Many researchers have found connections between high debt-to-GDP ratios and sub-par economic performance. For example, studies have consistently shown that public debt above 100% of GDP (and usually slightly below) is associated with slow economic growth. Moreover, these results have withstood determined attempts to discredit them, as discussed here and contrary to erroneous reports that flooded the media earlier this year. Here are a few relevant links: Reinhart-Rogoff, Cecchetti-Mohanty-Zampolli, Cecherita-Rother, Kumar-Woo, Baum-Cecherita-Westphal-Rother and Balassone-Francese-Pace.
But history doesn't do justice to current circumstances, which are more challenging than ever. This isn't 1946 anymore, when factories could be converted from military to ordinary use and staffed up quickly to meet pent-up demand from years of excess savings. Compared to the relatively painless fiscal retrenchment that followed World War II, the retrenchment that's needed today will cut to the bone.
Why the thresholds are lower than ever before
In a nutshell, most developed economies have unsustainable tax and benefit structures that are baked into current spending patterns. Due to rising dependency ratios, these tax and benefit structures will become less generous over time. And as they do, the middle class will find it increasingly difficult to maintain the same level of spending, let alone manage any growth.
To some extent, this story has already been playing out in Japan, parts of Europe, and also in the U.S. for the last 15 years or so. As of 2012, American median household income (inflation-adjusted) had fallen 9% below its all-time peak in 1999 and 1% below the previous cyclical peak in 1989. That's 23 years without any growth, whatsoever, even with the benefits of massive deficit spending.
Looking forward, America's finances are becoming even more challenging as baby boomer retirements bend the debt trajectory upwards, putting more pressure on the average taxpayer. We've illustrated this on several occasions, using projections from the Congressional Budget Office as well as our own research to correct for delusions in the CBO's work. (See here and here, for example.) These pictures show annual increases in debt-to-GDP getting larger and larger as interest costs grow and demographics worsen.
When even the CBO's optimistic number crunching shows debt ratios climbing exponentially, you have to wonder if Charles Ponzi is looking you right in the eye and making his best pitch.
We've also examined the CBO's projections more closely and put some hard numbers on the potential economic ramifications. The key question is: What are the differences between the primary budget balances that are cooked into existing policies and the balances required to stabilize the real value of debt? The answer is that these differences are bigger than ever and growing, which is disturbing because it tells us that any attempts to truly restore fiscal discipline would require unprecedented austerity.
We'll share the details of the primary balance analysis separately, as this is a key part of our argument behind the Fonzie/Ponzi theory, at least for the U.S. We already presented the debt stabilization math and one piece of the analysis, though, in this post. If you're willing to entertain our theory, we suggest reviewing it together with the other links showing our historical research and future debt projections, while checking back for more research on primary balances. The Fonzie/Ponzi thresholds are based on our interpretation of all of the above.
Note also that the U.S. has already passed its Ponzi point by Minsky's definition. According to Minsky, borrowing qualifies as Ponzi finance whenever fresh issuance is needed to fund interest on existing debt. Based on the common assumption that the U.S. would miss interest payments without regular increases in the statutory debt limit, this is indeed the case.
Where we stand today vis-à-vis the Fonzie/Ponzi thresholds
I'll conclude with a look at the International Monetary Fund's (IMF) projected debt ratios for 2013 for the ten largest "advanced" economies, ordered from highest to lowest GDP:
The chart shows two countries in our Fonzie/Ponzi range and one full Ponzi. But these happen to include the two largest of the advanced economies and three of the largest six.
If you're buying into our theory, this is not a pretty picture.