Sunday, January 24, 2010

The Fate of Debtors

Late last year I wrote a commentary titled "Eight Centuries of Financial Crises" about the book This Time Is Different—Eight Centuries of Financial Folly by Carmen M. Reinhart and Kenneth Rogoff. I felt that this book would be of particular value to today’s investors because it analyzes the differences and similarities of over 250 financial crises in 66 countries over the past eight centuries. Today I would like to discuss lessons that other observers have drawn from that book and the application of those lessons to the current financial crisis. The findings are especially timely as the Fed appears headed toward an exit from quantitative easing, and as the US, Japan and Europe face the prospect of funding extremely heavy debt loads in the coming year.


These thoughts appeared in The Big Picture blog, in the weekly commentary of John Mauldin titled "Thoughts on the End Game". The majority of the post reproduced the fourth quarter 2009 review and outlook written by of two of Mauldin’s colleagues, Van Hoisington and Dr. Lacy Hunt.

Based on the book This Time Is Different, all of these commentators conclude that the outcome of the present process of deleveraging will be an era of deflation, continued low interest rates, and outperformance of US Treasury securities compared to alternative investments. Now, this is not a point of view that I necessarily subscribe to, but we should take a look at the evidence and the arguments.

Five Lessons

Hoisington and Hunt abstracted five lessons from This Time Is Different concerning today’s financial predicament. I’ve quote these five lessons in bold and added my own comments:

First, financial imbalances occur when aggregate domestic debt is excessive relative to income, regardless of whether the government or private sector is accumulating the debt. Once debt becomes excessive, countries do not grow their way out of the problem; they must go through the time consuming and often painful processes of debt repayment and increased saving.

Ever since the 1970s, I’ve heard politicians justify their pet programs and dismiss complaints of rising Federal debt, saying that critics “don’t understand” how government finance works. After all, they said, “we owe the debt to ourselves” and it all balances out in the end. What liars! Domestic debt does matter, no matter who the creditor is. If you are crushed by debt, you cannot obtain the credit needed to grow your business or support your family. You have to cut spending and pay down your debts, even if you don’t enjoy your reduced standard of living. Unfortunately, our collective debts are getting more unsupportable. That’s where we are now as a nation.

Second, whether the domestic debt is externally or internally owed is not as critical as the excessiveness of the debt.

So, politicians were lying when they said that it didn’t matter that we owe our debts to ourselves. Domestic debt does matter, and the size of the debt is the critical parameter.

Third, government actions, even involving sizeable sums of money, are far less helpful than they appear. As the book states, “Infusions of cash can make a government look like it is providing greater growth to its economy than it really is.”

Rather than “reigniting” the economy, government stimulus will have only temporary effects. The underlying debts will remain and they will continue to act as a drag on the economy. The “green shoots” will wither once stimulus runs out, and we will face years of high unemployment, constrained spending, and recessionary economic conditions.

Fourth, Reinhart and Rogoff cover countries in debt crisis with a host of different conditions, such as growth and age of population, political regimes, technology status, education, and other idiosyncratic features. Nevertheless, economic damage as a result of extreme over-leverage has remarkably similar results, whether the barometer of performance is economic output, the labor markets, or asset prices.

It isn’t different this time. Debt crisis ends badly.

Fifth, further increasing leverage to solve the problem only leads to greater systemic risk and general economic underperformance.

Systemic risk is what precipitated this crisis. It is totally self-defeating to try to kick start economic activity by prompting banks to lend and consumers to borrow, because high debt levels brought down the system in the first place. The Federal government is only exacerbating the problem by running up astronomical debts trying to solve the crisis, and placing our financial system at even greater risk. Low interest rates help people finance their debt loads and speculate in the financial markets, but low interest rates will end someday, at a time when the bubble is even larger.

The Deflationary Outcome

There is much widespread debate today as to whether the current crisis will end up in inflation or deflation. In their book, Reinhart and Rogoff presented evidence that major debt crises have deflationary outcomes. In their quarterly commentary, Hoisington and Hunt extrapolated to conclude that interest rates will remain low for an extended period and say: “We are buyers and holders of long term U.S. Treasury debt.”


This is a sobering conclusion, but we must be cautious when interpreting historical cases. There are still important questions to answer, of which only a few are: Wouldn’t outcomes be different when countries lacked a well developed domestic credit system, such as banks and bond markets? Doesn’t a transition to fractional reserve banking confer enough flexibility to make a difference? What about the introduction of central banks? What about the effects of markets for securitized mortgages, consumer credit, accounts receivable, and credit default risk?

For example, colonial Spain defaulted on its debts numerous times, but that was when Spain depended for financing on marketing its plentiful supply of New World silver rather than a domestic system of commercial credit, as was developing in other parts of west Europe. Germany had budget problems after the Great War but didn’t experience hyperinflation until the victors forced the payment of reparations and limited the country’s options to printing the money.

The overall pattern of crises may appear similar over a long period of history, yet occurrences and outcomes may differ in essential details that matter critically. Details do matter, and we must exercise some caution in our interpretations. I can only advise reading the book, at a minimum. Fortunately, Reinhart and Rogoff go into more detail in This Time is Different than I can do justice to in this space.

As I said earlier, I don’t necessarily agree with all of this, but I also believe that historical precedents should be included in our deliberations when analyzing something as complex as the world financial and economic system.