Carmen M. Reinhart and Kenneth S. Rogoff published a controversial book in 2009 covering their research on eight centuries of financial crises (Reinhart & Rogoff, 2009, Princeton University Press, Princeton, NJ, 463p). This work involved the study of data from 66 countries (representing 90% of global GDP) over the course of 250 financial crises. Although this work was academic in nature, its intended applicability to the Great Financial Crisis (NYSE:GFC) and its aftermath has made it pretty useful in interpreting what is going on now. Reinhart and Rogoff didn't use the following analogy themselves, but I was struck by how much their work parallels some of the seminal works I once read as a scientist. I would just point out that there is a tempo and mode to major changes in complex systems that helps to define each episode, and also all episodes taken in aggregate. Something tends to regulate or drive these changes, acting as a kind of catalyst to change. In this case, Reinhart and Rogoff have identified what I would term the catalyst to economic catastrophe. That catalyst is excessive debt.
Their work was roundly criticized because of errors found in their early data by later workers, but as economist Lacy Hunt has pointed out, at least three other academic studies have validated their claim that excessive amounts of debt can permanently reduce GDP, causing structural decline in an economy. For example, Bergh & Henrekson in 2011 reported a negative correlation between the size of government and economic growth. Checherita & Rother demonstrated in a 2010 paper that a government debt/GDP ratio above 90% has a deleterious effect on long-term growth. Finally, Cecchetti, Mohanty, & Zampolli showed in a 2011 paper that government debt/GDP of more than 85% diminishes growth. Well-known author and hedge fund manager John Mauldin and his co-author Jonathan Tepper have summarized the debate in their book, Code Red (2014, John Wiley & Sons, Hoboken, NJ, 354p). They also maintain that Rienhart and Rogoff's basic conclusions are valid: excessive debt is a drag on growth.
There is a long and storied history of excessive debt leading to defaults, even serial defaults, as the nearby chart shows. Note that in the 1920s and then in the Great Depression, literally dozens of countries defaulted on their debts. Hedge fund manager Ray Dalio's book, Economic Principles (2014, Bridgewater Associates LP, 210p) has reviewed some of the last century's deleveragings and defaults, paying special attention to case studies on big economies like Japan, Germany, and the U.S. In Germany for example, whose defeat in World War I raised their debt/GDP ratio to about 160%, a post-war credit crisis eventually led to default. Germany's debt burden had surged to a peak debt/GDP ratio of 913% (!) in 1919 as a result of war reparations imposed by the victorious Allies. It is interesting to note that the German stock market rose about 200% in nominal terms in 1919 and 1920 in response to the early stages of the devaluation of the currency, but that was reduced to a 124% gain in real terms. In any case, Germany could not conceivably cover the payments and eventually defaulted in 1922. The default led to a stock market decline in real terms of 89% in 1922. As Ray Dalio says, "When there isn't much chance that the government can service or pay back its debt via taxation there is always an implicit risk that it will print currency and depreciate the currency's value." Of course, that is what happened in this case, as the Weimar government famously printed money to try to escape the crisis, but instead only managed to cause massive devaluation and hyperinflation as bad as any ever seen in world history. During the period from 1920-1924, devaluation and default completely destroyed the currency and reduced Germany's debt to almost zero, but at a price certainly not worth paying in human suffering. Topping it all off, the chaos of these years led directly to the rise of a famous radical politician with big ideas - Adolph Hitler.
Excessive debt has been defined by Europe's Maastricht Treaty as any amount exceeding a 60% debt/GDP ratio. This is somewhat alarming, since the current public sector debt/GDP ratios for Japan, Greece, Italy, France, Spain, Ireland, Belgium, Portugal, the U.K., and Singapore will all exceed a debt/GDP ratio of 100% in 2016. Indeed, two countries (Japan and Greece) will exceed a ratio of 150% in 2016. Are these levels really dangerous? As Reinhart and Rogoff noted, "…when an accident is waiting to happen, it eventually does." Reinhart and Rogoff also pointed out that major sovereign defaults have often occurred at levels of debt/GDP ratio much lower than this; recent examples would include Mexico's 1982 default at a ratio of only 47%, and Argentina's gigantic ($95 billion) default in 2001 at a ratio of only 50%. This would seem to indicate that some countries suffer from the malady known as debt intolerance, which is the extreme duress many emerging markets experience at seemingly low external debt levels, based on a sudden loss of market confidence. Sustainable, safe debt levels turn out to depend very much on a country's history of default and inflation. This would explain why Greece, which defaulted several times in the 20th Century, has been viewed with such concern recently, while the United Kingdom, which has not defaulted in over 300 years, is viewed with considerably more complacency.
It is important to note that subsequent research by Reinhart and her colleagues, as discussed by Mauldin & Tepper, has shown that historically, most governments do not actually deal with excessive debt by defaulting. Instead, a form of debt restructuring termed "financial repression" is used. Financial repression includes actions like forced lending by pension funds to the government via regulations, caps on interest rates, capital controls on cross-border movements of assets, tighter controls on banks, and monetary actions promoting negative real interest rates, which tend to erode the value of government debt. Financial repression was a major contributor to the reduction in the debt arising from World War II. The new global banking regulations under the Basel III agreement are an example of financial repression, as Mauldin & Tepper have said, because the new liquidity requirements promote the holding of more government bonds at banks. This extra demand for bonds will help to maintain lower rates than would otherwise prevail. A side effect, or form of collateral damage, resulting from financial repression is the punishment of savers and retirees who depend on fixed income. Government's goal of low rates to facilitate low debt service costs leaves savers and retirees with much-reduced income. The effect on pension funds is also severe, and many are now in huge deficits relative to their expected obligations. Some observers have estimated the aggregate pension shortfall in the U.S. at about $4 trillion, so it is highly likely that public sector pensions will be greatly reduced in future.
Probably the first large advanced economy to really blow up in the modern era as a result of excessive debt will be Japan, whose government debt will exceed 225% of GDP this year. In fact, their total, or aggregate debt/GDP ratio will pass 500% this year! This presumed terminal Japanese debt crisis will likely only occur when total interest on the debt equals the entire annual budget deficit, probably sometime in the next five years. At that point, Japan will have been forced either to 1) seek significant partial funding from outside sources rather than internal savings, or 2) fully monetize their debt. The catch is that few foreigners will accept a 0.50% interest rate on long-term debt. However, in the meantime, the BOJ has already been helping the government by recently monetizing (via QQE) much of the current deficit, to the tune of about $655 billion/year, or about 77% of the $850 billion/year deficit.
Reinhart and Rogoff state in their book, "… highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked." They go on to say, "Perhaps more than anything else, failure to recognize the precariousness and fickleness of confidence…" is the key factor that gives rise to the 'this-time-is-different' syndrome. Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang! - confidence collapses, lenders disappear, and a crisis hits." And as the authors take pains to point out, there is little difference between a developed country crisis and an emerging economy crisis, although more slack is given to developed economies by the bond markets than would ever be given to an emerging economy.
Another interesting idea Reinhart and Rogoff put forward is that virtually all of the features of the U.S. financial crisis, its contagion, and the resulting GFC are standard parts of a debt-deflation cycle that's been in place more or less for hundreds of years. For example, the Spanish government under Philip II defaulted no less than four times in the period from 1557 to 1596, in the aftermath of the first few years of massive shipments of Peruvian and Mexican silver arriving at the royal treasury. The newfound wealth had permitted borrowing in excess, mainly to fund wars, and the result was high inflation due to increased money supply, and serial defaults on these massive war debts. Speaking of war debts, the highest number of defaulting countries in the last 200 years occurred right after World War II, when countries representing 40% of world GDP defaulted. There was also a veritable host of defaulting countries after the Napoleonic War ended in 1815. The debt-deflation cycle also hit the kingdom of France numerous times, with three defaults in the 1600s and four defaults in the 1700s. The French kings dealt with the debt problem severely, executing certain creditors on occasion. This was a convenient and very effective deleveraging tool in some of these episodes, but I doubt if confidence was restored. Financial crises associated with defaults have also been historically common when commodity prices periodically collapse, driving producer countries under as they find debt service impossible. This is part of what we are seeing in EM economies right now. The recent serial debt default by Greece follows the historical debt-deflation pattern well also.
Apparently, we are still subject to this cycle of crisis and default, in spite of the relative sophistication of the modern system. This also suggests that the excuse that many economists have used, i.e., that no one could have foreseen it, is poppycock. Rather, our economists and political leaders have opted for the conceit that "it's different this time," and we have all had to pay the price. Hopefully we will learn from the experience. Yet it is not at all clear that the western democracies have really learned anything so far. As pointed out elsewhere, EM economies have nearly tripled their debt in the last eight years. The burgeoning sovereign debt crisis in Europe, which owes its origins to the 2000s credit bubble and its collapse, is being dealt with in the usual manner, meaning no real solutions that would work permanently appear to be on the table. The actions of the last five years continue, with bailouts and ever-higher government debt nearly the only answers offered in the councils of EU government.
But as debt is the catalyst of economic catastrophe, we are still on the path to massive sovereign defaults and a potential global financial crisis in the future, certainly within just a few years. Until then, I will cautiously accept whatever the markets are willing to give us in periods of relative calm between crises. And of course, I will continue to help arm my investors for the battle that is surely coming if we stay on our current path.
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