The Sovereign Debt Supercycle Will Keep Getting Worse Until Something Breaks

John Mauldin
Business Insider
July 19, 2010

I have been writing about The End Game for some time now. And writing a book of the same title. Consequently, I have been thinking a lot about how the credit crisis evolved into the sovereign debt crisis, and how it all ends. Today we explore a few musings I have had of late, while we look at some very interesting research. What will a world look like as a variety of nations have to deal with the end of their Debt Supercycle. We’ll jump right in with no “but first’s” this week.

Part of this week’s writing is colored by my next conference. Next week I go to Vancouver to speak at the Agora Investment Symposium. I have a number of very good friends who will be there, both speaking and attending. This is generally a “hard money,” gold-bug-type crowd (and a very large conference). Some (but not all) of the speakers believe that all fiat currencies, including the US dollar, will default in one way or another, either outright or through inflation, as mounting debts and out-of-control entitlement obligations force large-scale monetization, leading to high inflation if not hyperinflation.

(Bonus: The Complete History Of People Freaking Out About The National Debt –>)

There are a couple of panels and debates that I presume I will be involved in, and I have been meditating on how the panels will go. Bill Bonner, founder of Agora and a book-writing machine, has a steel-trap mind with an ability to turn a phrase that is way beyond that of your humble analyst. The preponderance of the panel members will likely be in the soft-depression camp, and most of us will card-carrying members of the Often Wrong but Seldom in Doubt school of economics and investing (the Latin for which, I am told, is “Saepe mendosus, nunquam dubius.”) And yet, I am not quite there with most of that thinking, so the debates will be lively.

Understand, I started in the newsletter business back in 1981 or so, working with Dr. Gary North (also known as “Scary Gary”). Gary is an Austrian, and although I took a lot of economics courses at Rice, I had never read anything even remotely close to the Austrian school. I caught up rather quickly, and in the mid-1980s even wrote my own gold-stock newsletter (although I must admit I know next to nothing of the current gold-stock world). I was mostly limited to books, newsletters, and journals for reading material.

Then came the mid ’90s and the internet, and the world opened up. I became incurably addicted to information and read widely and deeply. At some point the small lens of Austrian thought became difficult to continue to peer through, as I looked for perspectives on the larger world. I now worship at a number of economic altars, in the ongoing effort to understand what is happening in the real world, not just in the world of theory or the world of what we would like to be. So, with that background, let’s look at The End Game.

• A d v e r t i s e m e n t

The Debt Supercycle

When I mention The End Game, you’ll immediately want to know what is ending. What I think is ending for a significant number of countries in the “developed” world is the Debt Supercycle. The concept of the Debt Supercycle was originally developed by the Bank Credit Analyst. It was Hamilton Bolton, the BCA founder, who used the word supercycle, and he was referring generally to a lot of things, including money velocity, bank liquidity, and interest rates.  Tony Boeckh changed the concept to the more simple “Debt Supercycle” back in the early 1970s, as he believed the problem was spiraling private-sector debt. The current editor of the BCA (and Maine fishing buddy) Martin Barnes has greatly expanded on the concept.

Essentially, the Debt Supercycle is the decades-long growth of debt from small and easily-dealt-with levels, to a point where bond markets rebel and the debt has to be restructured or reduced or a program of austerity must be undertaken to bring the debt back to manageable proportions.

As Bank Credit Analyst wrote back in 2007:

“The history of the U.S. is characterized by a long-run increase in indebtedness, punctuated by occasional financial crises and subsequent policy reflation. The subprime blow-up is the latest installment in this ongoing Debt Supercycle story. During each crisis, there are always fears that conventional reflation will no longer work, implying the economy and markets face a catastrophic debt unwinding. Such fears have always proved unfounded, and the current episode is no exception.

“A combination of Fed rate cuts, fiscal easing (aimed at relieving subprime distress), and a lower dollar will eventually trigger another upleg in the Debt Supercycle, and a new round of leverage and financial excesses. The objects of speculation are likely to be global, particularly emerging markets and resource related assets. The Supercycle will end if foreign investors ever turn their back on U.S. assets, triggering capital flight out of the dollar and robbing U.S. authorities of any room for maneuver. This will not happen any time soon.”

I was talking with Martin a few months ago, and about the topic turned to the ending of the Debt Supercycle. Martin said we are nowhere near the end, as the government is stepping in where private debtors are cutting back. We have just shifted the focus of where the debt is coming from. And he is right, in that the Debt Supercycle in the US, Great Britain, Japan and other developed countries (yes, even Greece!) is still very much in play as governments explode their balance sheets. Total debt continues to grow.

Somewhere Over the Rainbow

And yet, and yet… While the Debt Supercycle may not yet have ended, I think we can begin to see a clear case that, like the sandwich-board-wearing cartoon prophet warning, “The End is Nigh!” Greece is the harbinger of fundamental change. Spain and Portugal are pointing to the same outcome, as their cost of debt keeps rising. And Ireland? The Baltics?

There is a limit to how much debt you can pile on. But as the work of Reinhart and Rogoff points out (This Time Is Different), there is not a fixed limit or some certain percentage of GNP. Rather, the limit is all about confidence, a theme I have written on many times. Everything goes along well, and then “Boom!” it doesn’t. That “Boom” has happened to Greece. Without massive assistance, Greek debt would be unmarketable. Default would be inevitable. (I still think it is!)

The limit is different for every nation. For Russia in the 1990s, it was a rather minor total debt-to-GDP ratio of around 12%. Japan will soon have a debt-to-GDP ratio of 230%! The difference? Local savers bought government debt in Japan and did not in Russia.

The end of the Debt Supercycle does not have to mean calamity for each country, depending on how far down the road they are. Yes, if you are Greece your choices are between very, very bad and disastrous. Japan is a bug in search of a windshield. Each country has its own dynamics.

Take the US. We are some ways off from the end. We have time to adjust. But let’s be under no illusions, we cannot run deficits of 10% of GDP forever. At some point the Fed will either have to monetize the debt or the bond market will simply demand an ever-higher interest rate. Why can’t we go the way of Japan? Because we do not have the level of savings they have traditionally had. But their savings levels are rapidly declining, which says that if they want to continue their deficit spending at 10% of GDP, they will have to go into the foreign markets to borrow money at a much higher cost, or their central bank will have to print money. Neither choice is good.

The Path to Profligacy

How did we get here? We simply kept borrowing ever greater amounts of money at an increasingly rapid pace. Look at the chart below. It is about six months old, but not much has changed.

In the beginning, each dollar of debt brought about a corresponding dollar of increase in GDP. But that early money was invested in houses and in the means of production, which helped grow the economy. As time went on, and especially after the ’80s, more and more of the debt was used for consumption (of which much has come to be from foreign sources) and not for the increase of productive capacity. Toward the end, it took $3 of debt to create a $1 rise in GDP in the US. And now, each $1 rise in debt is government debt, which some research (not neo-Keynesian Paul Krugman’s!) says has a slightly negative multiplier – it actually hurts GDP.

And it is not just the US. Take a look at the chart of G-7 debt (courtesy of GMO, more about which later). That is one ugly and unsustainable chart. In 1950 the G7 countries were recovering from very large war-time debts. Now we don’t have that excuse. Nor do we have the option of doing what they did. They cut military spending, inflated a little in nominal terms, and grew their way out of the problem.

Things That Cannot Be

Talk about unsustainable. The next chart is one of something that cannot be. The US cannot borrow $15 trillion in the next ten years. It’s just not there. Long before that, the bond market will simply rebel, rates will rise, and the aftermath will make the last crisis seem like a cakewalk.

For most countries with debt problems, The End Game is a binary-path-dependent future. Countries can elect to get their fiscal houses in order over time, getting the fiscal deficits below the growth of nominal GDP. That is not without consequence, as it will mean slower growth in the short term (less than one year), but cutting deficits year after year, even gradually, will mean a very slow-growth, Muddle Through economy for a sustained period.

Full article here

Comment Rules

Comments are closed.