How Long to the Point of No Return?

by: David Merkel, CFA

Alea posted a paper, and The Big Picture a slideshow on sovereign debts, by the same author. We have had a blessed period post-WWII, where there have been no defaults of major nations. But that is not normal. Nations default on their debts if they get too large, or they repudiate through inflation, or they raise taxes on a docile public.

The main point of the paper is that we are past the point of no return in most major nations, without significant changes that would diminish living standards for some time. Add the implicit obligations to the explicit debt, and there is quite a mountain to climb. Defaults are coming, the only question is what nations will default.

I often think that economists need to get out of the math ghetto, and study history. Math is not capable of capturing nuances. I write this as one who uses advanced statistical analyses regularly. History is more robust than mathematical analyses. Math occludes understanding in economics because it forces a numerical simplification of matters that have more dimensions than are admitted in the analysis.

Are there doubts about this? Here are some simple tests: How well do macroeconomic models forecast, particularly at turning points? On microeconomics, what kind of R-squared are they getting when they test the general equilibrium neoclassical model? Are many of the testable hypotheses not rejected? When last I looked, R-squareds were in the percentage single digits, and most testable hypotheses were rejected.

So why do we think that developed nations could not default on their debts? The book This Time is Different, should disabuse such notions. Major nations have often defaulted on their debts. It is regrettable, sinful, but normal.

Personally, I think that all of the developed nations as a group have gotten lazy, and also do not realize the degree to which they are interconnected, particularly through their banks. This is not a call for governments to reach out and help one another, but a yellow flag to say, “Don’t bail out other nations. Focus on the effects on your own country; if you must do bailouts at all, focus on your local financial institutions, and then create risk-based capital rules that penalize foreign lending, and encourage diversification in what foreign lending is done. This is logical in a credit-based system, because you only regulate one side of the transaction.

I am not arguing for isolationism in investing, but there is a tendency in the bull phase of the credit cycle to assume that nations don’t default, and so lending to sovereign credits that are weak becomes the trade of the moment. Good regulation of financials limits the ability of those regulated to be yield hogs, particularly in the bull phase of the credit cycle.

Nations are mortal. They don’t last forever, historically, if they last 200 years, that is significant. Even with nations that last so long, they can repudiate debts multiple times in their lives, though there is a cost — being shut out of the bond market for a time, until lenders forget.

So, what is the calculus on national default? It is an option, but what influences the choice?

  • Willingness of public to accept more taxes.
  • Willingness of the public to accept reductions in services.
  • Strength of the economy.
  • Willingness of foreign creditors to buy more debt.
  • Willingness of locals to save through buying national debt.

Default happens when a nation gives up; they conclude that there is no way that they can pay off the debts incurred.

Nations have not given up so far, but unless economic growth increases significantly, there will be defaults in many places eventually.