The West faces death by debt

Although The Smartest Man in Europe is wealthy, material things don’t give him a high. He gets his thrills from identifying a problem and being right in determining its solution. In his ninth decade, he is an inspiration to me. In the wake of the Greek election results, I flew to meet him to discuss the world financial outlook and I left his office dazed and my optimism clearly diminished.

He began by saying: “you should title your essay ‘Dancing around the Fire of Hell’. I’ve always told you that the debt accumulation was the ending of the developed world and you’ve told me my views are extreme. You are an optimist and I am a realist. You think we face serious problems, but that policy makers will avoid disaster, and so far you’ve been right. Developed economies and markets have plodded along, neither making nor losing much investor money in spite of the challenges. Temporary measures to avoid financial catastrophe have been insufficient so far. It won’t happen tomorrow but dire events are falling into place.

“The main problem is incremental investor thought: not looking at the whole picture and how we got here and where we might end up. People in democracies want the government to do more, without the tax implications to them. Politicians get elected by promising benefits, not by raising revenue to avoid increasing debt. Real growth in developed economies should equal population increase plus productivity. For Europe and the US that’s 2 per cent, but people there want higher economic growth, so the government provides the stimulus to create faster growth, taking on the debt to do it. Everything is fine as long ten-year debt cost doesn’t exceed the nominal growth rate. When it does, the cost of debt servicing becomes unsustainable, as in Spain and Italy. The US isn’t quite there yet.

“Governments in trouble recognise that they can’t produce growth through fiscal stimulus — it would only increase the debt problem. They can’t risk a recession that might clean out the legacy debt obligations. This would prevent future borrowing. So they print money. The Federal Reserve did this in 2008, with $1 trillion while the ECB did this in 2011, with €1 trillion.

“This may go on for a while, but can’t go on forever. Germany will stop backing monetary expansion in Europe and the Fed will also get uneasy. Inflation has remained tame thus far, because house prices and wages have largely remained in Europe and the US, but it will become a factor.

“We’re currently witnessing a convergence. Developed world standard of living is declining while it increases in the developing world. Developed world Debt to Gross Domestic Product (GDP) ratios are about 100 per cent, leading to modest growth. In the developing world debt to GDP is about 35 per cent: these countries have a long way to go.

“China, the world’s second largest economy, and a major manufacturer, has come from nowhere in the 1970s. With so many places producing much and at relatively low cost relative to 30 years ago, is it any wonder that a lot of people in higher labour cost areas like Europe and the US face higher unemployment? The US today is primarily a service economy with a trade deficit. Germany is a manufacturing economy with a trade surplus. Do you have to ask why one is doing well and the other isn’t?

“There are two ways to solve the problems of the weaker countries: austerity, meaning a 10 per cent GDP contraction (Greece is doing worse than that) or default; as Russia and Argentina did.

“Before widespread defaults, authorities will pull every trick to prevent catastrophe, believing that the EU was a good idea. What they need is more cooperation through a coordinated banking system to prevent a run on the banks. Deposit insurance won’t suffice. A political union is too much to ask for now but a banking union could prevent the European banking system collapse.

“Central banks world-wide will keep printing money, bringing higher inflation. World leaders will agree that growth should be their objective and inflation will be the price paid. This may result in some currency instability. Before this happens there will have to be more suffering. Spain and Greece will default but outright financial disaster will be averted as banks will have sold most of their troubled sovereign debt to the ECB by then. The crisis may turn out to be a good thing because the pain of what we are going to go through will prevent recurrence.

“In the short term interest rates should keep rising because debt is increasing faster than GDP. This should be true in the US also, but capital is moving there for perceived safety reasons. After the defaults, there will be slow growth and a banking crisis will occur, resulting in a World Economic Conference agreement on an objective of 7 per cent nominal growth: 2 per cent real and 5 per cent inflation.

“Banks need more capital than they did in the 2008 financial crisis. Their loans are being written down. Their government bond holdings are declining in value. On top of this, Basel III is imposing additional capital requirements. Capital in Europe will continue to flee to Germany, Finland and the Netherlands.

“So what am I doing with my money? Preserving capital is my focus now, not making money. It is hard to hide in stocks. In November, markets will either drop or temporarily rally, depending on the election outcome for Obama or Romney respectively.”

It is clear that world leaders are going to do everything to avert financial catastrophe. They have the resources to accomplish that goal. The developed world has to resign itself to a prolonged period of slow growth.

(Byron Wien, Vice-Chairman, Blackstone Advisory Group)