John Hussman: Violating the No-Ponzi Condition

Includes: DIA, QQQ, SPY
by: John Hussman

Excerpt from the Hussman Funds' Weekly Market Comment (5/3/10):

The credit picture remains mixed at present, though the next several months are likely to provide significantly more clarity. The Greek debt concerns are interesting in the lesson that investors are hoping to be taught, which is that all debt, no matter how foul, should be considered risk-free and can be counted on to be bailed out, so that market discipline need not provide any impediment to the poor allocation of the world's financial resources.

The basic problem is that Greece has insufficient economic growth, enormous deficits (nearly 14% of GDP), a heavy existing debt burden as a proportion of GDP (over 120%), accruing at high interest rates (about 8%), payable in a currency that it is unable to devalue. This creates a violation of what economists call the "transversality" or "no-Ponzi" condition. In order to credibly pay debt off, the debt has to have a well-defined present value (technically, the present value of the future debt should vanish if you look far enough into the future).

Without the transversality condition, the price of a security can be anything investors like. However arbitrary that price is, investors may be able to keep the asset on an upward path for some period of time, but the price will gradually bear less and less relation to the actual cash flows that will be delivered. At some point, the only reason to hold the asset will be the expectation of selling it to somebody else, even though it won't be delivering enough payments to justify the price.

Transversality forces the price of the asset to be equal to the value of the discounted cash flows. It's not enough for a borrower to keep the payments up over the short term, and it's not enough for price of an asset to be on an upward track for a while - over time, securities actually have to be able to deliver enough cash flows to justify the price that investors pay. When investors abandon this requirement (as they did with dot-com and technology stocks during the runup to the market peak in 2000), the price they pay stops having any relationship with the stream of cash flows that will be delivered to them over time. An increasingly large portion of the asset price represents real money that is being paid for a "phantom asset" in the distant future, that bears no cash flows, and yet gets assigned positive value because investors assume they'll be able to sell it to a greater fool. Every asset bubble fundamentally reflects this error in thinking. Ponzi schemes violate transversality conditions, as do sub-prime (not to mention Alt-A and Option-ARM) mortgages when they are assigned higher values than the expected cash flows can justify. If not for the ability to print money, which will become increasingly handy in future years, the U.S. government might be in the same situation, resulting from existing debt, probable future deficits, and unfunded liabilities.

Unless Greece implements enormous fiscal austerity, its debt will grow faster than the rate that investors use to discount it back to present value. Moreover, to bail out Greece for anything more than a short period of time, the rules of the game would have to be changed to allow for much larger budget deficits than those originally agreed upon in the Maastricht Treaty. One can't rule this out, seeing as how our own nation has proved quite adept at dispensing with accounting provisions and other discipline that might have threatened bondholders. But if that is the case, our concerns about inflation pressures in the second half of this decade will only become more pointed.