A Fate Worse Than Debt

by: Dorsey Wright Money Management

Is there a fate worse than debt? If there is, it seems to be not dealing with the debt.

When there is too much leverage in the system, there is always a risk that things go wrong quickly and unexpectedly. Ken Rogoff and Carmen Reinhart have an op-ed piece on Bloomberg today about the debt overhang and its implications for economic growth. They are the only commentators who have been consistently correct about the path of the financial crisis, probably because they are the only ones who have studied the actual data. That, and maybe because Ken Rogoff is a genius. But I digress.

Here is Rogoff and Reinhart on the debt crisis:

As public debt in advanced countries reaches levels not seen since the end of World War II, there is considerable debate about the urgency of taming deficits with the aim of stabilizing and ultimately reducing debt as a percentage of gross domestic product.

Our empirical research on the history of financial crises and the relationship between growth and public liabilities supports the view that current debt trajectories are a risk to long-term growth and stability, with many advanced economies already reaching or exceeding the important marker of 90 percent of GDP. Nevertheless, many prominent public intellectuals continue to argue that debt phobia is wildly overblown.

Although we agree that governments must exercise caution in gradually reducing crisis-response spending, we think it would be folly to take comfort in today’s low borrowing costs, much less to interpret them as an “all clear” signal for a further explosion of debt.

Those who would point to low servicing costs should remember that market interest rates can change like the weather. Debt levels, by contrast, can’t be brought down quickly. Even though politicians everywhere like to argue that their country will expand its way out of debt, our historical research suggests that growth alone is rarely enough to achieve that with the debt levels we are experiencing today.

Those who remain unconvinced that rising debt levels pose a risk to growth should ask themselves why, historically, levels of debt of more than 90 percent of GDP are relatively rare and those exceeding 120 percent are extremely rare. Is it because generations of politicians failed to realize that they could have kept spending without risk? Or, more likely, is it because at some point, even advanced economies hit a ceiling where the pressure of rising borrowing costs forces policy makers to increase tax rates and cut government spending, sometimes precipitously, and sometimes in conjunction with inflation and financial repression (which is also a tax)?

The relationship between growth, inflation and debt, no doubt, merits further study; it is a question that cannot be settled with mere rhetoric, no matter how superficially convincing.

In the meantime, historical experience and early examination of new data suggest the need to be cautious about surrendering to “this-time-is-different” syndrome and decreeing that surging government debt isn’t as significant a problem in the present as it was in the past.

I’ve done a massive cut-and-paste job with their essay and tried to hit the highlights. I recommend that you read the whole piece, which is more extensive and covers additional topics. Their thinking is important because they are neither alarmists nor happy talkers -- just economists who have actually done a careful study of how debt levels affect economies.

Why do I even bother with this, since I am certainly not an economist? I have two motivations in mind. First, I think it’s important to focus on the actual historical data, as Rogoff and Reinhart do. Without data, you’re just another dude with an opinion. Americans have been subjected to way, way too much ideology from blowhards in both parties in Congress on the debt issue, and no one is looking at the data. Second, how debt is handled will have a big impact on investment opportunities around the globe.

Think about the differences from country to country. The UK showed a stiff upper lip and enacted austerity measures immediately. Greeks are protesting in the streets about the debt, corruption, and proposed austerity and are edging ever closer to restructuring — a polite term for a partial default. Spain is pretending it doesn’t have a problem at all. Japan has endured 20 years of financial repression with low interest rates for savers, no economic growth, and has piled on even more debt. The US has gone from hoping for a grand bargain on tax reform and deficits to a mini-plan to squabbling about doing anything at all.

The investment climates will be very different as a result, and money always goes where it is treated best. Traditional strategic asset allocation will be very difficult in this environment, where responses to the debt problem are still being formulated. Reliance on past returns, correlations, and volatilities could be ruinous, much as they would have been in Japan in 1990. It seems to me that a relatively flexible, tactical solution is called for that allows investment in a wide variety of markets, to seek out returns wherever they may be found.