Posts Tagged ‘Debt/GDP’
Default or experience austerity then default

There is something inevitable about feckless politicians being unwilling to tell the truth to their people. Perhaps even to confess it to themselves. No matter how much we may dislike reality, running from it is futile. Reality always wins, normally on the battle field.

Some problems become bigger if not addressed. No one likes being cut open, irradiated and injected with noxious substances. Yet many have opted for exactly that. As a consequence they have lived for many years more than they would otherwise.  Cancers tend to get worse over time if left untreated. Debt problems do as well. In an overly indebted society shifting excessive debt from one component of society to another does not solve the problem. The absolute magnitude is the problem. Shifting the debt around may mask the problem, and can delay the inevitable. But it does so at the cost of making the inevitable adjustment worse.

Interest accumulates on debt. New debt creates interest obligations. The principle has to be repaid. If the country has too much debt then shifting it around is akin to rearranging the deck chairs on the Titanic. Overly indebted consumers cut back on consumption. Overly indebted producers cut back on investment Overly indebted governments cut back on essential services and suck the life out of the other sectors of the economy. You do not want to become overly indebted as an individual or society. When you are there are no pleasant options. Politicians may seek to defer the pain, but it comes at the cost of the debt cancer growing and metastasizing or an inflationary destruction of price signals.

The optimal solution for a nation is not to become overly indebted.  A nation like an individual needs to keep an eye on the rate of growth of total debt to GDP. Having become overly indebted, the sooner one accepts the fact and sheds the excess debt the better. This means restructuring and defaulting, not borrowing more. Strangling consumption, investment and essential services to service the unserviceable simply puts off the default. It also devastates society and tries the patience of the people. In a democracy it greatly increases the chance of later slipping into anarchy or depression.

So what countries are overly indebted? In examining the following table of debt/GDP remember that with their level of debt, Greece defaulted:

Greek total debt/GDP was below the median. They defaulted before others because a high proportion of their debt is government debt and they have a cultural bias against paying taxes. Greece also do not have control of their currency and consequently can not just print money. Given the levels of total debt/GDP across the developed world as illustrated in the BIS table above, does anyone doubt others will follow?

There are historical precedents suggesting that sovereign defaults tend to be associated with many years of poor performance:

Having much of the Western world simultaneously in crisis can be expected to increase the effects compared to when problems are less widespread. The historical precedents could well be best case estimates given the extent of over indebtedness this time. The same applies to past great stagnations:

Decreases in absolute terms such as can be expected during depressions require proportionally greater increases to make good the loss:

The mathematics of loss followed by gain explains why it could be decades before we are as wealthy as we recently thought we were. Sadly much of the Western world has been living in the bezzle for years.

Our countries have been through experiences that are worse than an economic downturn. Our system need not lose legitimacy if it behaves in a legitimate way, even in a depression. But if the costs of the bust are put onto those who benefited least from the bubbles there could well be disorder. Defaulting on debt at the correct point, rather than when it has all been taken on by the government helps maintain the legitimacy of our system. Allowing vested interests to pass the losses onto government while keeping their gains undermines legitimacy, increasing the propensity to violent revolution.

Governments need to explain reality to their people, that they can’t meet their commitments, that they have been lied to. In effect eh Western social welfare state is a ponzi scheme and it is running out of new money. Printing money just disguises the problem for awhile at the cost of making it worse. But governments seem unable to explain reality to the people and implement sustainable policies:

Oops, German austerity fail: There’s an interesting article in Der Spiegel on Tuesday about how Germany has failed to reach its own austerity goals in 2011…

“SPIEGEL reports this week that the German government didn’t reach even half of its planned savings in the federal budget. Only 42 percent of the spending cuts named by Merkel’s coalition government, comprised of the conservative Christian Democrats and the business-friendly Free Democratic Party, were actually not implemented.”

Even the  Germans are having trouble implementing austerity. How do you think the likes of Spain and Italy will go? Governments should have been prepping their people and hording their treasure to assist those in real need during the times ahead. As for trying to avoid the issue through printing or borrowing more money, this needs to stop. Politicians need to start living the serenity prayer:

God, grant me the serenity to accept the things I cannot change, Courage to change the things I can, And wisdom to know the difference.

 

 
Raise interest rates

The Reserve Bank of Australia (RBA) reduced its cash rate to 4.5 per cent from 4.75 per cent. While it is good that Australia still has positive interest rates, this is a bad move.

When an economy has total debts (household, corporate and government) of 235% of GDP it should be reducing debt, not increase it. Australia’s 235% Debt/GDP ratio in 2010 is in the same territory as Greece at 262%. While different compositions of the debt and cultural attitudes to tax affect the likelihood of it being paid back, private as well as public debt affects growth.  Money used to service debt, particularly if foreign sourced, is money not spent on other things. Australia now has some of the highest levels of household debt in the world.

The Bank of International Settlements (BIS) produced table copied below shows just how indebted Australia and the rest of the developed world are.

The RBA is acting as if we still operate in a relatively debt-unconstrained world. That by tweaking interest rates it can painlessly boost the economy or constrain inflation. If such a world ever really existed, it certainly does not now. Yes the RBA can kill the economy by cranking up interest rates, but it does not necessarily follow that it can make it grow by reducing them.

Things change. The developed world has an aging population. There are lots of retired people and people saving for their retirement. Reductions in interest rates hits their hip pocket. This will constrain their consumption. Despite the bleating of assorted officials that all is well, many people know it is not. They are trying to reduce their debt. A decrease in interest rates will supply welcome relief, but will not necessarily drive them to the shops in an orgy of GDP boosting wanton consumerism. Some will reduce their rate of debt accumulation or even reduce their total debt.

Then there is the currency effect. The Australian dollar has been very strong. This has made imports, including fuel cheap. If lower interest rates result in a lower dollar, this will increase the price of imports. Increased import process, particularly of fuel, suck the life out of an economy. It is worse than a tax. At least governments tend to spend much of their tax take domestically. Even if the government expenditure is largely wasted it will still provides some benefit, at least for a while. But putting more money into some oil Sheiks pocket does not. It particularly does not if that money is then used to propagate Wahhabist ideology around the world. Who says Saudi Arabia exports nothing but oil?

A falling currency is a mechanism for reducing domestic production costs compared to those elsewhere. But it is not a painless panacea. The flip side of a falling currency is a relatively poorer nation. Although if internal markets, such as that for labour, are relatively inflexible then it can help. But devaluation is a very blunt instrument.

Rising import prices cause pain, but the source of the pain is hidden. Politicians tend to like that, making it a feasible policy choice. Of course, not all countries can devalue at once. Devaluation is a relative game, if some currencies are falling then others must be rising relative to them. That all, or even many might try and devalue at once is what keeps the gold bugs warm at night. In nominal terms, under such a scenario the price of real things will rise. This is not a prediction for immediate inflation. There is a high chance of falling prices as money and valuations are destroyed in a cyclone of credit defaults and forced sales. Although what happens after that is another story.

The Australian economy is in a perilous state. Outside mining related areas and the public service things are dire. But for the good of the nation as whole people need to reduce their consumption and increase their savings. The savings then have to be used to fund productive investments, not just speculation. This move in interests rates will encourage the opposite. It increases the chance of Australia following the US and UK path. It may delay the inevitable housing market correction, but at the cost of making things worse when we do eventually experience our correction. Australia has approved covered bonds, so crony capitalism is alive and well down under.

The Keynesian influenced mindset driving policy does not adequately take into account the starting point. Accumulation debt may have beneficial effects, but too much of it is an economy killer. Much of the developed world is past that point.

Given the level of indebtedness of the developed world there almost certainly will be:

Sovereign defaults. Debt holders do not get repaid in full and on time.

Great stagnations. Prolonged periods of low growth.

Financial repression. Low nominal interest rates help reduce debt servicing costs while a high incidence of negative real interest rates liquidates or erodes the real value of government debt.

There is a non trivial chance of a Great Depression, perhaps the Greatest Depression. The developed world is overdue for one. Our authorities also seems to be taking steps to guarantee that it will be big. Hopefully while the decline may be greater than that experienced in the 1930’s, it will still end at a much higher levels of absolute wealth. We live in hope.

We must also hope that aspects of the 1940’s are not repeated. National and international socialism have always and everywhere been bloody phenomena. But this will be the subject of another post.