Several analysts have commented recently on the debate about how much debt a nation can sustain. Cullen Roche wrote about this at Seeking Alpha, noting that Time Magazine's recent cover story by famed analyst James Grant claimed that every man, woman and child in the US owes $42,998.12 of government debt. Stephen Gandel wrote in Fortune Magazine that this number is far too low. When you add in unfunded liabilities for Social Security, Medicaid and Medicare, the number rises to $59,607 per capita. There's even more liability at the state and local level. But when you add back in all of Social Security's current assets, Gandel says that all of the additional debt from Social Security is covered, with a surplus of $50 billion. In fact, when viewed as a percentage of assets, national debt is only about 13%.
Cullen Roche also argues that we have to consider debt in the light of the entire balance sheet, not just the liability side. Accordingly, when we compare US government debt to total assets (including land, buildings, infrastructure and mineral rights) the calculated net worth of the US is probably the highest on earth. In the same way, if we evaluate debt/GDP ratios, it is necessary also to look at net worth/GDP ratios, which for the US is now at about 445%. But in looking at Roche's chart showing this, I noticed the highly pro-cyclical fluctuations in the net worth/GDP ratio since 1994. This suggests that there is a problem with both Gandel's and Roche's arguments. This is because although net worth is an important factor, it is not the whole story.
Source: Cullen Roche, Pragmatic Capitalism blog
If national net worth/GDP ratios are pro-cyclical, then the big dips on Roche's chart represent massive corrections that can alter the debt dynamics at any time. Obviously what drives the big cycles on the chart are factors like the market meltdowns ending in 2002 and 2009, the epic housing crash ending in 2009, and the various intercalated booms in real estate, equities and commodities. As pointed out in the important paper on global debt by Buttiglione, Lane, Reichlin and Reinhart (2014; "Deleveraging? What Deleveraging?," International Center for Monetary and Banking Studies, www.cepr.org), a simple snapshot of a balance sheet is not enough to evaluate debt sustainability. According to these authors, "…the stock of financial assets does not provide a good guide to repayment capacity, since much debt is serviced through future income streams that are not typically capitalized in the balance sheet." For example, the major assets of both households and the government are very illiquid and unlikely to help in funding debt service.
As a result, it is probably more helpful to look at debt/income ratios in evaluating debt sustainability. But even this metric does not work sufficiently well by itself; both net worth (as used by Roche) and the mix between equity and debt are also key factors in determining debt sustainability. These in turn give rise to the procyclical dynamic (shown in Roche's chart) by which increasing net worth promotes confidence and thus increasing debt, which fuels more asset price appreciation, and so on, until the feedback loop is reversed by an asset price shock. High equity/debt ratios can provide a buffer of loss absorption capacity, but this fluctuates with banking standards for the housing sector, and tax and regulatory policies for corporations.
So where does this leave us in answering the question of debt sustainability? As Buttiglione et al. have pointed out, excessive levels of debt pose both acute and chronic risks. The beliefs of creditors are then very important, because if they panic, a self-fulfilling prophecy of debtor failure can rapidly make debts unsustainable, as they already have in Greece, Cyprus and Iceland since 2007. The same acute risk applies in my opinion to the current situation in Italy, where the banking system suffers from Non-Performing Loan (NPL) levels of over 21%, and a bailout is presently unavailable due to EU rules prohibiting international bank bailouts. Target 2 transfers out of the country suggest that many investors are already voting with their feet in anticipation of a crisis.
And it follows that chronic risks are associated with the clearly unsustainable debt levels in Japan and also China. Buttiglione et al. describe chronic risk as the impact of excessive debt or "debt overhang" on productive capacity and incentives. Both households and corporations tend to forego further investments once there is a significant debt overhang. In the banking sector, this is seen as a failure to fund new loans because of preoccupation with building equity and repairing balance sheets. At the national government level, debt overhangs drive up taxes and create policy uncertainty, both of which affect macroeconomic performance.
Reinhart and Rogoff (2009; It's Different This Time: Eight Centuries of Financial Folly, Princeton University Press, Princeton, NJ, 463p) have shown that some countries repeatedly default on their debt (e.g., Greece, Argentina), while others never do (e.g., United Kingdom, Japan) in spite of high debt overloads. Some countries repeatedly have periods of very high inflation (e.g., Brazil, Venezuela), while others never do (e.g., Canada, Australia). However, many countries have banking crises, and these can cause lasting damage to growth prospects.
Buttiglione et al. describe three kinds of crises with different outcomes. In a Type I Crisis like that of Sweden in the early 1990s or Thailand after 1998, there is a persistent loss of GDP level (output), but potential growth continues parallel to the previous trend line. In a Type II Crisis like that of Japan since 1990, there is no contraction in GDP level (output), because defaults and bankruptcies are not allowed to occur, and public debt inflates, but deleveraging lasts for many years and potential GDP growth is permanently slowed down. In a Type III Crisis like that of all Developed Markets in the 2008 Financial Crisis, both the level and the potential growth of GDP are negatively shifted, due to a combination of causative factors and the policy response.
Type I Crisis Example: Thailand in 1998
Type II Crisis Example: Japanese Nominal GDP Flat After 1990
Type III Crisis Example: UK After 2007
A final point on debt sustainability I would make here (based on the work by Buttiglione et al.) is that the path of nominal income is critical to the outcome. If real income is lower than when the debt was incurred, then repayment will be more difficult. Likewise, when inflation is lower than anticipated, the real rate of interest on the debt will be higher, again making repayment more difficult. Both appear to be happening now in a number of countries. The actual debt capacity of various countries, including the US, appears to be based on the complex interplay of factors discussed by Buttiglione et al. in their landmark 2014 paper.
It thus would seem that the somewhat more simplistic balance sheet argument provided by others, while clearly an important factor, is not sufficiently rigorous to explain what is actually observed in the wide array of countries that have historically or are now experiencing significant debt overhangs. Arguments that massive debt won't bankrupt the US or certain other countries may be true enough in the short run, as Roche maintains, but that does not preclude a persistent or even permanent decline in GDP levels or prospective growth, plus the potential for ever higher taxes to service the debt, and these are the real issues right now.
As an investor in a slow growth and low rates environment, I would favor dividend growth strategies, including Vanguard Dividend Appreciation ETF (NYSEARCA:VIG), T. Rowe Price Dividend Growth Fund (MUTF:TADGX) and Goldman Sachs Rising Dividend Growth Fund (MUTF:GSRLX). Market Neutral funds like AQR Equity Market Neutral Fund (MUTF:QMNIX) and Vanguard Market Neutral Fund (MUTF:VMNFX) have done well and should continue to do so. Another area worth considering is buy-write closed-end funds, e.g. Nuveen S&P 500 Buy-Write Income Fund (NYSE:BXMX).
Disclosure: I am/we are long QMNIX, VMNFX, BXMX.
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