Politicians in the U.S., and across the developed world, want you to believe that debt isn’t a big deal and that they can help their cities and countries grow their way out of indebtedness [as long as they are just given] a bit more time. A recent report by the Bank Of International Settlements, however, explains how difficult such a task will be. Let’s have a look at some of the report’s key passages.
So writes James Gruber (asiaconf.com) in edited excerpts from his original article* entitled The Markets’ Worst Kept Secret.
[The following article is presented by Lorimer Wilson, editor of www.munKNEE.com and the FREE Market Intelligence Report newsletter (sample here – register) and may have been edited ([ ]), abridged (…) and/or reformatted (some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. This paragraph must be included in any article re-posting to avoid copyright infringement.]
Gruber goes on to say in further edited (and in some place paraphrased) excerpts:
The Bank Of International Settlements (BIS) annual report outlines, in a clear and often confronting way, the realities of the world’s indebtedness and how current money printing and low interest policies won’t fix the problems emanating from 2008. The BIS has credibility as it was one of the very few institutions to warn of excesses in the lead up to the financial crisis. I can’t recommend the report highly enough.
The Extent of the World’s Debt Problem
First, the BIS details the extent of the world’s debt problem. It says total debt in large developed market and emerging market countries is now 20% higher as a percentage of GDP than in 2007 [and, as such,] the level of debt as clearly unsustainable...The primary reason given is that studies have repeatedly shown that once debt-to-GDP rises above 80%, it retards economic growth. Obviously, if money is being spent on servicing debt, then there’s less to spend on investment etc. Most developed market economies now have debt to GDP levels exceeding 100%.
The BIS [points out that] current long-term bond yields for major advanced economies are around 2% [as per the chart below], well below the average of the two decades leading up to the crisis of 6%, and that if yields were to rise just 300 basis points across the maturity spectrum (and still be below average), the losses would be enormous. Under this scenario, [as shown in the chart to the right below] holders of U.S. Treasury securities would lose more than US$1 trillion dollars, or almost 8% of U.S. GDP. The losses for holders of debt in France, Italy, Japan and the U.K. would range from 15% to 35% of GDP. Banks, being the primary holders of this debt, would be the biggest losers and ultimately such losses would pose risks for the entire financial system.
The BIS doesn’t let emerging countries off the hook either. It suggests that while debt may be lower in these countries, they’ve benefited from rising asset and commodity prices, which are unlikely to be sustainable and, therefore, caution is warranted here too.
The Policies of Developed Markets Central Banks
Now we get to the juicy bit where the BIS calls the extraordinary policies of developed market central banks into question. For a conservative institution such as the BIS, the language is nothing short of scathing:
“What central bank accommodation has done during the recovery is to borrow time –
- time for balance sheet repair,
- time for fiscal consolidation, and
- time for reforms to restore productivity growth.
The time has not been well used, however, as continued low interest rates and unconventional policies have made it –
- easy for the private sector to postpone de-leveraging,
- easy for the government to finance deficits, and
- easy for the authorities to delay needed reforms in the real economy and in the financial system.
After all, cheap money makes it –
- easier to borrow than to save,
- easier to spend than to tax,
- easier to remain the same than to change.”
Waiting Will Not Make Things Easier
The BIS report continues, saying:
“Governments hope that if they wait –
- the economy will grow, driving down the ratio of debt-to-GDP.
Politicians hope that if they wait –
- incomes and profits will start to grow again, making the reform of labour and product markets less urgent.
Waiting, however, will not make things any easier, particularly as public support and patience erode.”
The BIS recommends urgent, broad-based reforms which principally involve –
- cutting back on regulation to allow high-productivity sectors to flourish and for growth to return,
- further cuts by households to their debts,
- governments getting their balance sheets in order and
- regulators making sure banks have the capital to absorb any risk of potential losses of the type mentioned above.
The Math of Debt
It’s worth elaborating on why the current path appears unsustainable, as the BIS alludes too. Put simply, debt is a promise to deliver money. If debt rises faster than money and income, it can do this for a while but there comes a cut-off point when you can’t service the debt. When that happens, you have to cut back on the debt, or de-leverage in economic parlance.
There are four ways to de-leverage:
You can transfer money (Germany transfers money to Cyprus)
You can write down the debt. Note though, that one country’s debt is another’s asset.
You can cut back on the debt. These days, that’s looked down upon and consequently called austerity.
You can print money to cover the debt.
Since 2008, we have seen countries employ all four of these methods but the real key is to make sure that interest rates remain below GDP [growth] rates. If that happens, debt-to-GDP levels will gradually fall. If not, they’ll inevitably rise…[If, for example,] bond yields rise to the post-war average of 6% in the U.S., and interest rates increase to comparative levels, nominal GDP would have to be above 6% for debt-to-GDP levels to decline. If you understand this, then you’ll realise that talk of “tapering” in the U.S. is likely a load of baloney.
Real U.S. GDP growth is expected to be close to 1% in the second quarter, with inflation at around 1.1%, resulting in nominal GDP growth of 2.1%. Many expect this nominal GDP to rise to +3% over the next 12 months but, even at those levels, bond yields can’t be allowed to rise much further (with 10-year yields at close to 2.5%). Otherwise, debt-to-GDP ratios will rise, impeding future growth and making budget cuts, tax rises and more money printing inevitable.
If the U.S. does taper and bond yields there rise, this would put upward pressure on bond yields in Europe. With GDP growth near zero and still exorbitant debt levels, higher bond yields would quickly crush the Euro zone.
The above is why central banks can’t allow higher bond yields and interest rates. Of course, central banks don’t control long-term bond yields; markets do. If central banks want low bond yields, markets will comply until they don’t, that is, until they don’t trust that the current strategies of central banks are working. Given that investors are still enamoured with the every word and hint of Ben Bernanke and his ilk, it would seem that the time when bond markets do turn ugly is still a way off.
The BIS points out that reform is also critical to better economic growth for the developed world and lower debt burdens but on this front, however, it’s amazing how little restructuring has actually occurred in the U.S. and Europe. In the U.S., for instance, can you name one piece of significant reform which has reduced regulation and led to growth in new prospective sectors? I can’t, but maybe I’ve missed something.
[The fact is that] U.S. banks have killed [any efforts of reform] and the trend of the U.S. results season seems to bear this out…It’s hardly surprising that current policies are benefiting banks at the expense of the real economy. After all, not only did banks get massive bailouts in 2008 but they’ve been given almost free money from the Federal Reserve via QE ever since. The banking sector is not back to 2007 levels but it’s gradually getting there. Who would have thought this would happen just 6 years after the biggest debt bust in more than 70 years? It’s somewhat ironic that instead of the U.S. or Europe, it’s Asia which may be about to lead the way on the reform front…
Risk of Another Debt Bust?
It’s hard to see the U.S, Europe, Japan and other developed world countries implementing reform in time to prevent their debts from rising further and possibly imploding. In other words, many of the fears of the BIS may well come true.
The above may sound pessimistic and, to some, melodramatic, but the reality is that little has been done in the past six years to restructure economies and cut debt i.e. learning the lessons of 2008. Because we’ve partially recovered from that traumatic period, that’s led to complacency. All the while, the debt that caused the bust in the first place has compounded and threatens to undo the world again. Let’s hope it doesn’t come to that.
[Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.]
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