27 Jul 2010 11:54:07
Returning GDP to the private sector is the only way to avoid the looming debt trap
A cluster of sovereign defaults by small nations should pose few problems. The default of a major nation would be another matter.
Globalization added three billion new producers, consumers and savers to the world economy in a period of relative stability, particularly in inflation and unemployment. This created strong global growth until the collapse of debt fuelled asset booms initiated private sector credit liquidation. Huge fiscal deficits to offset the deflationary effects of the credit crunch, governments transferring bad private debt onto public balance sheets and guaranteeing bank liabilities plus aging populations have caused fiscal crises in several nations. As a result, investors have become aware of both sovereign risks and currency risks, so governments are finding unlimited borrowing power is no longer a given. A pessimistic outlook for sovereign debt contrasts with a rather upbeat outlook for the private sector. Can private sector growth avoid the risks of significant sovereign default?
In the past, excessive government spending and debt have usually been war related and many nations have grown and/or inflated their way out of such debt. Cutting war-related spending enabled tax cuts that returned GDP to the private sector. This was an essential part of stimulating growth, but reducing the government share of GDP will be much harder in this cycle. Aging populations are both causing increased spending and impeding growth – while private sector debt deflation is frustrating the record-breaking efforts to raise inflation rates. In the past, massive government war-related borrowing had squeezed the private sector out of credit markets, making the private sector very liquid and able to fund big investments after the war. In this cycle, by contrast, overinvestment has created a lot of redundant capital. Will governments return enough GDP to the private sector in this cycle to escape from the looming sovereign debt traps?
Sovereign defaults have suddenly soared, often from very low levels, four times since 1800. The first three times were in the secondary depressions after wars – in 1837, 1873 and 1933. The fourth was in the early 1980s due to: (1) unwise borrowing and lending piling up too much debt – especially from foreign creditors; (2) weak revenues and poor credit history creating roll-over risk and (3) soaring debt costs due to short-term borrowing and rising interest rates. Rapidly rising defaults in all four cases indicates the causative factors don’t accrue linearly. Instead, empirical evidence shows their effect accumulates below the surface until they cause a tipping point and yet another ‘unforecastable’ financial tsunami rolls in. Unwise borrowing, over indebtedness, and weak revenues affect a large number of countries. Rising interest rates could easily create a tipping point that causes a rash of defaults among nations with poor credit histories in the foreseeable future.
Banking crises are far more common than sovereign debt defaults, especially by big nations, which have had a much better credit history recently than small nations. A cluster of defaults in small nations didn’t affect the global economy or major financial markets greatly in the early 1980s and probably wouldn’t now. However, the fiscal crisis already in Europe threatens to spread to major nations, including the US, Japan and the UK, because the budget adjustments they have to make to stabilize their debt to GDP ratios at acceptable levels are as great as or greater than those required by smaller nations – but they’re papering over that threat. For example, the US Congressional Budget Office has made improbable predictions to show a stabilized debt to GDP ratio.
This budget predicts GDP will grow faster in the next decade as in the last one, even though credit liquidation and the aging population threaten lower growth. It also predicts federal revenues will grow 2.6 times as fast as in the last decade up to 2008 (thereafter they fell significantly) while spending growth will fall by almost half. However, assuming revenues grow at the predicted GDP growth rate (probably too high because the baked in tax increases will slow GDP growth significantly), would raise the deficit in 2020 to $ 1.9 trillion and the total deficit for the decade by 40%. America will ultimately have to cut spending. Its fiscal excesses are reducing its relative strength. Its hegemony is breaking down because it doesn’t create enough wealth to maintain the necessary military power. The US deserves to lose its AAA rating, but current talk of an absolute decline and of defaulting on its debt in the foreseeable future is thoughtless.
A major default is more likely to be in Japan, the UK or Europe. Japan’s internal financing and deflation have allowed it to lower the average interest rate on its government debt to an ultra low 1.4%. However, very low growth and bad demographics cast doubt on its ability to keep funding its rising debt load internally. External financing would probably double the average interest rate on new debt so, spread over ever fewer people with static to falling incomes, its bloated debt would ultimately become unaffordable. Rhetoric in the UK suggests it will return GDP to the private sector, but talk has exceeded action so far. In addition, borrowing to start a new business is harder in the UK than elsewhere and the way bank liabilities are reported changed as of January, lessening the clarity current trends. However, the rise of almost £ 300 billion in foreign liabilities and the drop of over £ 200 billion in sterling liabilities since January suggests UK banks are again depending on foreign wholesale funding, a business model that brought grief in the last liquidity crisis.
Even so, the danger of sovereign default is probably more imminent in the Euro Area because its low growth and misplaced faith in the efficiency of government rules out returning GDP to the private sector. In addition, excluding the sovereign debt banks intend to hold to maturity from the recent stress tests casts doubt on its convoluted system of sovereign guarantees. Banks hold sovereign debt to provide emergency liquidity and will fail if that debt is not liquid or if selling it in times of stress generates big losses. Governments must borrow the funds required to implement their guarantees, so the sovereign guarantee system may not survive a big bank failure. Policies may change and the stress may never occur but, if it does, caveat emptor!
Leigh.skene@lombardstreetresearch.com
The views expressed in these articles are those of the writer. They may not necessarily be those of Lombard Street Research Ltd (LSR) and other LSR economists may from time to time hold different views
