Presenting The (Only) Four Outcomes To The Global Public Debt Crisis

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A global public debt crisis, in which private sector deleveraging is offset by public debt, to the point where Reinhart and Rogoff say "no more" (and often times beyond) has only four possible outcomes. These are: 1) a debt trap; 2) hyperinflation; 3) austerity but in conjunction with actual economic growth and 4) default. Currently in the developed world, the only two outcomes actively pursued, are (1), the debt trap, best seen in the US, where the only solution to debt is "more debt", and half of (3), austerity, although not coupled by the critical "growth" component, but merely more strikes, more economic deterioration, and more austerity in a closed loop to the bottom as a disenchanted population decides to let it all burn down in the process of losing its entitlements safet net. And with 3) so far a failure in every iteration (the closest it is to an actual empirical outcome is in the UK, where it has so far produced nothing but stagflation), what happens next will be, as UBS' senior economic advisor George Magnus says, "or else."

First a look at the the sad reality of what is happening in the developed world in the context of 2012 financing needs as a percentage of GDP: between Germany (arguably the strongest of all developed economies) and Japan, in the next year alone, the countries in the chart below will have to raise anywhere between 10% and 50% of their GDP in the form of new debt! That's right: everyone, from Germany, to the UK, to Ireland, to Spain, to Belgium, Italy, the US, and most certainly Greece and Japan, will have to hope there is an external demand for its debt, even as all of these countries are net sources of debt. How the math works out that any of these countries, intertwined in a massive ponzi loop, can purchase others' debt while also selling its own, in the absence of outright central bank monetization, has yet to be figured out by men far smarter than us.

So going back to the original story, here is UBS explanation on the 4 only possible outcomes from the current terminal economic dead end which absent a massive surge in political will to change a broken system, will likely have just one, very unpleasant, conclusion.

Public debt crises can only have 4 outcomes. First, in the absence of economic growth and economic reforms, and if faced with high funding costs and rising interest expense as a share of revenues, you end up in a debt trap, with huge political and social upheaval and probable abrogation of debt. Japan is in a debt trap, though as stated above, because it’s a creditor, and social and  political consensus hasn’t fractured, it has been able to sustain close to zero interest rates and 1%+ JGB yields.

If any country were at risk nowadays most people would probably concur it was Greece. But it is not necessarily the only candidate. In fact, once a country looks as though it is on an unsustainable debt path, the difference between a debt trap and some form of debt restructuring or rescheduling is basically the difference between a disorderly and orderly form of debt management and resolution.

Second, a lapse into Weimar or Zimbabwe-type inflation (and social breakdown) - an extreme form of nominal GDP creation - is an alternate means of bringing down the debt burden. But while this is often referred in blogs and casual observation, the examples of hyperinflation as solutions to debt crises are quite far and few between. We never say ‘never’, of course, but, let’s  discuss this again if we see the simultaneous emergence of dictatorships or broken political systems in one or more developed markets, and the crushing of central bank independence and credibility. In any event, the process of deleveraging and of protracted balance sheet repairs, and degrees of dysfunction in the credit system (which depress money multipliers and velocity) suggest strongly that the inflation option in a contemporary US and European setting isn’t even really an option.

Third, the debt to GDP ratio can fall slowly through the combination of sustained fiscal austerity in the context of some sustained rise in GDP – but not austerity alone. Clearly, that’s where countries want to be. And the ‘how to do this’ bit clearly occupies the minds of policymakers and financial markets in all the Western debtor countries.

It is the basis for the suggestions made by some that the US, for example, should make serious and detailed deficit cuts from, say, 2013-2025, but be prepared to use budgetary policy, if needs be, to sustain growth and strengthen the private sector in the interim. Indeed, US deficit paranoids should note that, according to the IMF latest Fiscal Monitor, the general government’s cyclically adjusted deficit is now projected to fall from 7.2% GDP in 2011 to 5.8% in 2012. Not a good state of affairs, but not a disaster either. The issue for the US is less about immediate debt management as about sustainability. The debt ceiling should, of course, be raised almost regardless, and the bipartisan agreement to achieve some $4 trillion of savings over the coming decade needs to have some bipartisan flesh put on those bones. The search for agreement continues….

It’s the basis for believing that the UK fiscal strategy might work, provided the cumulative minor incentives to make the private sector work better…work. It’s also the basis for asserting that the current thinking in the Eurozone is leading us to a dark outcome – reversible, but dark.

As the Greece saga rolls on, we think it abundantly clear that austerity alone isn’t the answer. It isn’t the answer to making the debt burden sustainable for the simple maths associated with the weak denominator in the debt/GDP identity. And it isn’t the answer to getting Greek citizens on board either. A little turbulence may be good to spur a debate about change and reform. A rebellion, tax revolts and non-compliance and so on are a bridge too far.

Alas, if all else fails, there is the 4th, and final, outcome:

Fourth, some form of default is inevitable if you:

  1. can’t create or sustain political consensus at home, and or
  2. lack the ability or imagination to pursue growth- and employment generative economic policies over time, and or
  3. have a pegged currency, so that an unacceptable internal devaluation is required, and or
  4. have creditors, who are uncooperative and weak, lacking the political clout or willingness to implement timely debt management strategies

Default, when it is managed in an orderly fashion, is simply a harsh way of describing the more acceptable terms of debt restructuring or rescheduling. This can also lower the debt burden for a while, but in and of itself is no cure. It has to be accompanied by outcome 3 and reversals of the conditions in option 4  which caused the default in the first place.

The UK is pursuing option 3 with pre-emptive policies designed to stabilise and reverse the surge in the public debt to GDP ratio by the end of the current parliament in 2015. The Achilles’ heel in the UK strategy - as for all other debtors - will be the degree to which the coalition government can sustain social support and consensus, and keep growth going. This challenge will intensify in the coming year or two as the public spending cuts cumulate, and the gauntlet of key reforms, for example to public pensions, is thrown down.

Ditto the US, but the country’s more complicated politics mean that it is at risk of instability from fiscal policy inertia on the one hand, and overkill on the other. The upcoming debt ceiling deadline in August will be a minor test of the ability to steer a path between the two, while the bigger issues of fiscal, healthcare financing and economic reform can’t be ducked forever.

The Eurozone faces a complex debt management problem in Greece and in the periphery, and an existential issue since it lacks the political and institutional mechanisms to ‘solve’ the Eurozone debt problem. To address the former, some form of debt restructuring, including debt forgiveness, now looks a most likely scenario, in our view. To address the latter, Europe must make a great leap forward to integrate further politically (European Treasury to preside over some sort of fiscal union, European Banking Authority, a common Euro bond and so on) or else a dangerous step back towards some degree of disintegration seems equally inevitable. Unless or until this is resolved, the periphery countries appear destined to pursue the austerity in option 3, while suffering in varying degrees from some or all of the conditions in option 4. This saga is likely to be with us for a while yet.

Magnus' less than optimistic conclusion:

We believe the sovereign debt problem will be addressed successfully only if political willingness and leadership are up to the task. The consequences of the financial crisis, the synchronised nature of the sovereign crisis across much of the developed world, and the existential nature of the crisis in the Eurozone make the politics of resolution even more demanding. Japan is the only developed market among 31 that have run up against the need for large-scale fiscal adjustment programmes since the early 1980s not to have subsequently stabilised or reversed its public debt burden. Whether this state of affairs can continue as Japan marches on into its demographic transition in the next 5 years is a moot point.

The prospects for the developed world nowadays are more certain: there is a small window of time during which to fix the politics of effective debt management and economic reform, and in the case of Greece and the Eurozone, the window is closing quickly. Assuming the Greek parliament passes the austerity package at the end of June, Europe has just a few days in July to transfer funds enabling Greece to pay its bills and roll over maturing bills – and Greece will have reached the end of the road as far as austerity goes. After that, it will be up to the Eurozone’s politicians and sovereign creditors to take that leap forward to manage the immediate debt crisis, take steps towards fiscal union including E-bonds, and create new institutions to undertake  pre-emptive debt restructuring, including for other periphery countries…..or else.

The "or else" part may come as early as this week unless the Greek government manages to suppress the popular expression of anger yet again, and vote the massively unpopular austerity measures which will do nothing to boost Greek economic recovery chances, everything to help bankers kick the can down the road for another bonus season, and certainly lead to even more paralyzing general strikes, and more, hopefully non-violent, expressions of what is now outright public desperation with a government that is no longer responding to the general interest of the people it "represents."