Authors: John Maudlin and Jon Tepper
The title of the book is self-explanatory. The authors say that we are at the end of the debt super cycle and then talk about ways of unwinding the global credit binge. They also look at the possible paths that different countries may take to undergo the process.
The book implicitly assumes that we are at the end of the credit binge. I, with little that I know, wonder if declaration of debt cycle peak is premature. Japan has been considered a sovereign debt basket case for almost a decade, and its sovereign bonds still yield close to 1%. I agree that the situation is unsustainable, but what is there to say that the problem won’t continue on for another two or five years. Same goes for U.S. debt. The recent hoopla managed to cut $1T over 10 years for a country with GDP north of $15T–less than 1% of aggregate GDP over 10 years. In recent weeks, as investors have shed risky assets, they have rushed into U.S. and Japanese debt. 2-yr Treasuries hit their historic lows. Clearly, the bond market, James Carville’s first choice for reincarnation, is not twisting arms of these offenders. Why will they change their minds in the next few years, at least for countries that control their own monetary and fiscal policies? But, I simply may jumping a step ahead. One need not assume that the credit cycle is at its final peak, and can think that of it as an inevitable designation. Everyone can agree that this debt super cycle has to end. If you set aside questions about when it will happen, the book is a great read, despite some poor editing. The editors force a conversational style in parts of the book, perhaps in an attempt to make the topic more accessible; I found it a little distracting, Also, be ready to be called a ‘gentle reader’. But, it’s a small price to pay for the goods inside.
Why do we have to watch this train-wreck, and why is no one throwing the switch?
It can be a little bizarre to see academicians talking about the disaster that will unfold if we continue on this path, and the market continuing to follow the path. There are two reasons, I think. First, professional investors can’t simply hand back the cash to clients and go home; they have to be in the play. Second, sovereign debt at this level requires a generational political debate, and more than a mere matter of fiscal or monetary policy, as is obvious to anyone who has followed markets over the last year. This leads to a drawn-out process.
The authors say that this can continue because the system collapses are sudden and give no warning, thus forcing no deadline on the participants–investors, politicians or the traders. They say: “When things are unstable, it isn’t the last grain of sand that causes the pile to collapse or the slight breeze that causes the ruler on your fingertip to fall. Those are the proximate causes. They’re the closest reasons at hand for the collapse. The real reason, though, is the remote cause, the farthest reason. The farthest reason is the underlying instability of the system itself.”
What will this endgame mean for equity markets?
Equity volatility follows the credit cycle. If you push commercial and industrial (C&I) loans forward two years, it predicts increases in the Market Volatility Index (VIX) almost down to the month. The authors also talk about the Minsky journey where investments goes from a hedge unit (investment can pay for itself) to a speculative unit (investment only pays for the interest) to a Ponzi unit (where the only way to repay debt is for the investment value to rise). At the Minsky moment, we have to confront extreme volatility. They say that we can look forward to very volatile markets for the next few years.
Introduction: Three Simple Equations
- GDP = Consumption + Investment + Govt. Spending + Net Exports
- Playing with the first equation leads us to-
Savings = Investment + Government Debt Financing
This means that unless government prints money, fiscal debt financing begins crowding out private investment, which is the backbone of job-creation.
- Domestic Pvt. Sector Balance + Govt. Fiscal Balance – Trade Surplus = 0
This means that if both private and public sectors de-leverage by paying debt, running positive balances, the trade surplus must be positive. This is the most important equation, as it says that countries where both individuals and governments need to de-leverage, they must start exporting to make up for the difference. But, this is a common problem across several countries, and not every country can run a trade surplus.
For more discussion on these equations, see
No quick fixes
A study by McKinsey shows that periods of over leveraging are often followed by 6-7 years of de-leveraging.
Is inflation on the the way?
Yes. Not because that’s a byproduct, but because that’s the plan. A little inflation, along with decreasing deficits, will result in a weaker currency and therefore (hopefully) more exports. This is the policy that the U.K. is following.
Is hyperinflation on the the way?
For U.S., it appears that hyperinflation is not imminent. Bernholz examined 12 of the 29 hyperinflationary episodes where significant data exist, and found that hyperinflations are always caused by public budget deficits which are largely financed by money creation. He concluded that deficits amounting to 40 percent or more of expenditures cannot be maintained, irrespective of how large the deficit is with rest respect to GDP. The United States has a government deficit of 10 percent of GDP, but is over 30 percent of all government spending. But, it is also important to know that who is financing the deficit. If it is financed by money creation, and not sold to public (through institutional investors), then hyperinflation is much more likely. In U.S., only 13% of government expenditure is financed by the Fed. Rest is held by China, India, Indonesia, Gulf countries and others. Thus, hyperinflation is unlikely for now.
A little more detail on what it means to finance deficit with money creation: Treasury must pay down its liabilities with currency already in circulation or else finance deficits by issuing new bonds and selling them to the public or to their central bank to acquire the necessary money. An open market purchase is done. Now, if the central bank purchases the debt, it monetizes that debt. This is what the Fed did with QE2. This is dangerous territory. A less independent Fed may collude with the Treasury, and end up monetizing too much debt, driving the country into hyperinflation.
Is inflation nirvana for countries that have their own currency?
No. One, investors would recognize even a stealth inflation policy and quickly push up yields. Second, many governments around the world have tied pensions and salaries to inflation measures, so increases in government spending would rise with inflation. Nearly half of federal outlays are linked to inflation, so higher inflation means higher deficits. Social Security, which represents about 25 percent of federal spending outlays, is officially indexed, and Medicare and Medicaid are unofficially indexed. Indeed, over the period 2009 to 2020, the Congressional Budget Office (CBO) estimates that these three programs will account for 72 percent of the growth in total federal outlays and about the same share of the growth in debt.
How can we identify countries that are likely to run into deficit crisis?
- Debt levels and coupon rates matter. But, don’t tell that to Cheney.
- Structure of B/S matters. If the debt is inverted (value of liabilities and servicing cost decline in good times and rise in bad times), such as foreign currency or short-term borrowing, the shocks are magnified.
- Economy’s underlying volatility, esp. its correlation with its ability to finance itself plays its part. This even more troublesome for countries dependent on commodities.
- Financial instruments such as delta hedging (which force investors to buy when prices rise and sell when prices fall) can add more trouble
- Default is a political decision, so if the investor base does not vote, they’re easy to default on.
- Average maturity matters. Now only one needs to go to the market less often, but inflation helps if maturities are higher. U.K. has the highest maturities among major sovereign debt.
The Japan Question
U.S. has a Debt/GDP ratio of less than 100%. Japan’s ratio is 220%.
Why has Japan not imploded then? Because most of the Japanese debt buyers are domestic. The buyers are investing their saving for use when they stop working. Japanese age imbalance is no news. As more people get old, they will start spending that money to pay for their life expenses and will stop buying Japanese bonds. This means that Japanese government will have to come to international markets for wholesale re-issuance and rollover. When Germany is paying 2.5%, why will the market pay 1% for Japanese debt? It won’t. This means that Japan will try to monetize debt through the two-step process that we discussed earlier. Yen will fall, interest rates will rise, bonds will sell off. This is not the end.
Imagine the ripple effects across the world. With a falling Yen, Japan will become more competitive with other countries who export similar items. What will Korea do? What about Germany? Japanese companies that would have invested in fixed cost right before this time will be suddenly VERY competitive. This change will have a host of implications for many countries and a broad range of equities.
Other Interesting tidbits
- Sovereign crises tend to cluster
- Eurozone problems are akin to countries that faced deflation on gold standard–they couldn’t simply print money.
- Watch Hungary and Latvia. These countries went to default before everyone else and will give us an idea of how other countries will recover.
- Excess liquidity follows the path of least resistance, flowing quickly in equities, bonds, and commodities–large liquid markets.
This book covered a lot of ground, and it would be impossible to summarize in a paragraph, but it wouldn’t be hyperbole to say that we will see financial history created within the next decade. The world in 2021 will be a lot different from what we see in 2011; the change from 2011-21 will be much more bigger than the change that we saw between 2001-11 or 1991-2001. Social contracts will be re-written, and economies will be re-tooled. I personally expect to see partial or complete defaults, and countries turning inward in face of blatant trade war. World is a non-linear place, and it may force this construct on globalization, which has gone in only one direction since China joined WTO, and cheap oil made it possible to ship bulk manufactured goods halfway across the world at a profit. We will live in interesting times.