Saturday, February 20, 2010

Inevitable Collapse

Jean Antoine Watteau, Gilles, 1718.

Today I would like to comment on recent reports issued by Societe General's Albert Edwards, a former colleague of Jean Marie Eveillard and James Montier, other value-minded strategists who have moved on to other organizations.  Because Edwards seems to be perpetually on the extremely pessimistic side, his reports should perhaps be received with a degree of critical caution.  After all, we should be examining every side of the debate over global indebtedness, and not dwell exclusively on pessimistic views.

On the other hand, Edwards is of interest precisely because he is extreme.  He cites debt-to-GDP statistics as pointing toward extreme market events.  Others have cited similar statistics and suggest that debt growth cannot continue, and some have been quite blunt, albeit without being quite as direct about the consequences as Edwards is.  When you strip away some of Edwards's alarming language, you find that, lurking underneath, there remains a worrying and deteriorating situation for the world's advanced nations.

Competitive Devaluation Looms

Lacking the Societe Generale reports themselves, we will have to rely on quotes from two articles by Tyler Durden in the Zero Hedge blog.  The first of these is pretty well summed up in its title: Timing The Exit As Competitve Devaluation Looms; Is The Euro 25% Overvalued? More Thoughts From Albert Edwards

As for current conditions, Edwards intreprets leading indicators as signaling that China and other emerging markets have topped out, and that the U.S. and other advanced economies are soon to follow.  He does not follow the interpretation of many others, that rises in economic indicators signal more positive surprises. 

He thinks that the Euro is too strong and inflation too low given the prospect an impending European slowdown, and the the dollar/Euro exchange rate should fall by 25%.  "The end game for the Ice Age was always competitive devaluation and the US and UK have embraced this strategy to revive growth and export their own domestically generated deflationary impulses."  Now it's the Euro that needs to devalue.  At least he doesn't see the U.S. as being prone to longer-term stagnation to the extent that demographically-challenged Japan is, given that "the US demographic outlook shows a continued expansion of the working age population through this century."

The Breakup of the Eurozone

Edwards's view of the ultimate outcome of the debt situation is summed up in the title of a related post:  Albert Edwards: At 500% Net Liabilities To GDP, It Is Too Late To Prevent The Collapse Of The G-7; Greece Is Irrelevant, We Are All Now Insolvent.  Starting with Europe, he believes that the debt problems of Portugal, Ireland, Greece, and Spain (the PIGS) will bring about "the inevitable break-up of the eurozone."   This is because "the root problem for the PIGS is lack of competitiveness within the eurozone," brought on by "years of inappropriately low interest rates."  The resultant inflation, double digit current acount deficits, and weak growth mean that "the PIGS public sector deficit will inevitably remain large."

Ivan Aivazovsky, The Shipwreck, 1871

Pressure to reduce these budget deficits by tightening fiscal policy "will not be tolerated by the electorates in these countries. Unlike Japan or the US, Europe has an unfortunate tendency towards civil unrest when subjected to extreme economic pain."   The breakup of the eurozone will then follow from "another of Europe's unfortunate tendencies -- the emergence of small extreme parties to take advantage of any unrest."

No Way Out But Default

As we know by now, the U.S. and U.K. also face the prospect of especially stern fiscal policies to reign in their budget deficits, which Edwards quantifies as "structural (cyclically adjusted) general government deficits of almost 10% of GDP (according to the OECD)."   He becomes particularly pessimistic when he looks at government debt including unfunded liabilities, for which "most governments are already insolvent with debt to GDP ratios closer to 500% of GDP instead of around 100% for most G7 countries . It is too late."  Moving on to individual countries, "Greek total net liabilities (on and off balance sheet) to GDP are 800%! EU: at 470%, the US, at over 500%. There is no way out but default."

Is It Really This Severe?

This range of liabilities-to-GDP sounds severe, but how severe is it really?  We have to consider differences between "official" debt accounts (on balance sheet) and total net liabilities, which include unfunded liabilities (off balance sheet).  We are of course familiar with the problems that private firms have encountered when suddenly faced with the unexpected need to pay for unfunded off balance sheet liabilities, such as those hidden in special vehicles or counterparty liabilities. 

However, in this case we are talking about government liabilities.  We are also talking about future liabilities, generally those owed to citizens, on the basis of promises and expectations about entitlements.  Such entitlements include, of course, promises like Medicare, Medicaid, and Social Security.  We do not know how such promises may be amended in the future, nor the ability of the taxpayers or the willingness of creditors to fund those promises.  We do not know how much the citizenry may amend its expectations, nor the political will of the leadership to enforce fiscal discipline. Such future unfunded liabilities are therefore uncertain in magnitude and, to some extent, fungible.

Equally important, we don't know how well the U.S. and other nations will be able to grow their economies.  Growth seems scarce in the developed world, and growth is necessary to raise government revenue.

Other Statistics, Other Opinions

This blog has recently discussed a number of viewpoints about the debt situation and has cited the supporting statistics such as debt-to-GDP ratios.  For example, Bill Gross includes the U.S. in the "Ring of Fire", his name for the set of advanced countries that are at risk of exceeding a 90% ratio of public debt to GDP.  That is the point at which he considers a country at risk of suffering a 1% decrement in its economic growth rate.  Gross does not say in his public statements what he thinks the chances are that the process will lead to a U.S. default or runaway inflation, but he does think that the situation bodes poorly for U.S. fixed income.

A different metric is the ability to make interest payments on debt.  Former U.S. Comptroller General David Walker recently said:  "Within 12 years…the largest item in the federal budget will be interest payments on the national debt."  As interest payments squeeze out other budget items, something will have to give, and at some point in the next few years a choice will be made between default and fiscal austerity.  Speaking at the same forum on fiscal reform, Federal Reserve Bank of Kansas City president Thomas Hoenig said that having the Fed print more money to purchase the mounting debt would lead to an inflation-induced financial crisis.

How Will It Play Out Politically?

In the case of Greece, we are now seeing an immediate reaction and the potential of confrontation over the need for fiscal discipline.  Who knows?  Perhaps Edwards has a point about the potential for extreme political reactions and fissures appearing with the EU. 

Scene from Nosferatu (F. W. Murnau, 1922)

In the U.S., however, the outcome is far, far from obvious.  Some want to continue stimulus, and others demand immediate fiscal discipline to avoid eventual insolvency and default.  The debate is vociferous and, unfortunately, there is every appearance of a stalemate persisting in Congress.

Edwards has no such uncertainties about the political process:  "The trouble is that, as the private sector debt unwinds, there is no political appetite to allow GDP to decline to its "correct" level as this would involve a depression. So burgeoning public sector deficits and Quantitative Easing are required to maintain the fig-leaf of continued prosperity."

Edwards also has no such uncertainties about the outcome.  According to him, "there really is no way out that does not trigger a major market-moving upheaval."

Payback Time

I agree with Edwards about what has happened to get us here:  "Ultimately economic prosperity over the past decade has been a sham: a totally unsustainable Ponzi scheme built on a mountain of private sector debt. GDP has simply been brought forward from the future and now it's payback time. "

But I just don't have his one-sided conviction about the future.  He sees the inevitability of collapse.  I believe that there are too many uncertainties to say.  Maybe the U.S. will just cut back on entitlements, people will suffer, and the country will muddle through and emerge a shell of its former self.  There is no way to know the outcome more precisely.  Not at present.

However, as governments run into budget problems, it does seem likely that people will run from one asset to another as their perceptions of safety change over time.  In the very near future, it seems likely that people will continue to flee to the dollar.  At some point another alternative may appear, and maybe that event is what we need to watch for.

Prediction is a perilous business, and Edwards mentions that his former colleague, James Montier, derides the notion of investing on the basis of forecasts as they inevitably prove so inaccurate.  Agreeing that prediction of markets and economies goes beyond prudence, I will avoid agreeing with anyone how the debt crisis will play out.

But something extreme is going to happen.  At a recent forum on budget reform, Former director of the Congressional Budget Office, Rudolph Penner warned:  "The American people today are not remotely prepared for the changes that are necessary."  This is something that I can agree with.  If political stalemate continues, and the debt situation deteriorates, Americans may be stunned by the magnitude of the changes about to take place.

Thure de Thulstrup, The anarchist riot in Chicago : a dynamite bomb exploding among the police. From: Harper's weekly. Vol. 30 , no. 1534 (May 15, 1886)