By Wilfred Hahn, Chairman & co-CIO
Debt, huh, yeah; What is it good for? Absolutely nothing, uh-huh, uh-huh.
Incomprehensible economic theory? Actually, we are borrowing a lyric from the 1970s popular protest song by Edwin Starr. Its title was “War.” We substituted the word “war” with “debt.” Seen from a global monetary perspective, war and debt have some strong parallels and connections. We’ll show that link in our conclusion. And, actually, when it comes to debt, “absolutely nothing” has a positive implication. We’ll explain.
The topic is global debt. And, recently, there have been a number of weighty research reports issued focusing on this topic. McKinsey Global Institute (MGI) released an update of its 2010 and 2012 reports on global debt trends, titled Debt and (Not Much) Deleveraging. It presents some crucial findings. Also, the Bank of International Settlements issued a number of Working Papers on the topic of debt, the most relevant of these (to us) titled Secular Stagnations, Debt Overhang and Other Rationales for Sluggish Growth Six Years on.
First to the McKinsey’s report. It confirms some rather disappointing facts, though not without several bright spots. Now, 7 years after the start of the Global Financial Crisis, debt continues to rise around the world in aggregate. Deleveraging as a whole has technically not yet occurred … overall. Debt continues to rise around the globe and is predicted to continue to rise (measured as a ratio to GDP).
Quoting McKinsey, “From 2007 through to the second quarter of 2014, global debt grew by $57 trillion (USD), raising the ratio of global debt to GDP by 17 percentage points”. However, inside of that broad aggregate, there has been deleveraging in some countries. For example, this has occurred in the U.S. household sector uppermost, also the UK, and the shadow banking sector globally. The broad trend of increasing indebtedness does not apply to all countries.
Next, to the mentioned B.I.S. report: It argues that large debt overhangs (external, private and public) have been a major reason why economic recoveries have been so sluggish to date. This institution points out that, given the role of leverage in a financial crisis, an important marker for the completion of a crisis is a significant unwinding of debt. Darkly, they conclude that “[…] figures indicate that high leverage remains a headwind some 6 years after the initial crisis.”
So there we have it. Debt (and leverage) is still increasing overall according to MGI and the B.I.S. says that this is opposite of what is required to signal an end to sluggish economic growth and crisis.
How to get around this apparent impasse? There is a classical view and a new post-post-modern one.
First, let’s review the classical perspective.
Since time immemorial, an increase in productive debt has contributed to economic growth. However, once overall debt gets too high, increasing debt has less and less traction on economic growth. This is the exact problem being faced presently. To date, (by and large) post-crisis debt increases have not greatly spurred economic growth rates. While debt expansion has slowed relative to the previous 7 years of the period reviewed, it is that new debt per dollar of new GDP growth has also soared. In other words, each new dollar of debt has not been as efficacious in producing new economic growth. So, despite the huge increases in debt, world economic growth remains mired and sluggish. Another critical aspect of this condition is that it is the flipside to rising wealth inequality. This also is not a positive factor for general demand (GDP growth).
Therefore, with these observations and given that the pre-existing high debt levels were themselves a major contributor to financial crisis, the classicist asks: “Just how can more debt be part of the solution?”
Over to the post-post-modernist “new economic thinking.” They have seductive answers.
Firstly, there is a growing consensus that even more government debt should be encouraged in order to fund and spur new demand. Radical political changes are taking place in many countries around the world as populaces become despondent with low income growth, unemployment and austerian financial policies. Out with austerity and loosen the purse strings on public debt, is the chant. Let government debt continue to rise.
How then to circumvent the classicist’s debt trap?
Well for one, there is growing argument that one should only focus on net government debt. Specifically, one should only focus on government debt netted out for central bank bond holdings. To illustrate, McKinsey points out that overall government debt levels in the U.S. would fall to 67% of GDP as opposed to a gross total of 89% of GDP. Voila. Thus, this debt virtually disappears to “absolutely nothing.” After all, the interest income received on these bond holdings get paid back to U.S. Treasury in any case.
This could be a free lunch, according to the “new economic thinkers.” Reflecting a growing openness to such measures, says the widely-respected economist, Barry Eichengreen, in a recent article posted at Project Syndicate (Central Banks and the Bottom Line) “[…] should central banks really worry so much about balance-sheet profits and losses? The answer, to put it bluntly, is no.”
So, the message is this: Cast off your old tired conventions. Central banks can continue to buy government bonds (whether in secondary or primary markets) and not worry about any holes in their balance sheets. It doesn’t matter for an institution that can create money. In this way, then, rising gross debt levels will be seen to be benign — actually, highly stimulative — while not raising net government debt.
Consider the transformation of Japan’s debt levels when viewed net of central bank holdings: Net government debt falls an equivalent of 141% of GDP! The big question is whether central banks could cancel their government debt holdings without legal complications. However, the bigger any crisis, the more likely roadblocks will be creatively cleared.
Of course, this is smoke and mirrors and provides no free lunch. Nevertheless, as investors, we must anticipate new consensus. Therefore, we do believe, that eventually (if not sooner) continuing economic disappointments will lead to strong bouts of “monetary finance” as illustrated. This type of “money finance” is fissionable material, we think. It indeed will finally unleash the spending “reactor.” New money that is used to finance government spending and/or household tax cuts will be sure to be spent. As such, new money will finally hit the “industrial circulation” boosting economic growth, and not just the “financial circulation.”
When will that happen? Frankly, we can’t say specifically. Firstly, we think that more economic disappointments must first appear in order to galvanize the resolve of new and aggressive “money finance” policies.
On that score, another economic disappointment is again in the pipeline for the U.S. Though the consensus may believe that U.S. economic growth has lifted off, we think this is doubtable. For a start, economic statistics have remained mixed. Moreover, it is simply not possible for the U.S. economy to remain decoupled from global deflationary trends and demand deficiency. And, now, a large currency appreciation is adding biting headwinds.
This could set up another — perhaps the last? —bond market rally. Disappointing economic growth, in turn, generates the response of new stimulative economic and monetary policies. This could all play out before mid-year 2015.
We come back to our opening question: “What is the parallel between debt and war?” Firstly, it is interesting to note that the last time the balance sheets of the world’s major central banks (this according to 2014 paper co-authored by Niall Ferguson which tracked 12 major central banks over that period) were as distended as they are now was at the end of World War II.
At that time, a lot of wartime spending needed to be paid for by governments. Government bonds were issued and central banks complimentarily expanded their balanced sheets. War resulted in high debts … in fact, even higher than they are now relative to GDP in many of the original Allied Countries as well as others.
Today, a demand war is underway. This time around, the heightening debt is resulting in monetary wars. Salvos of new money and debt are being created by governments and bought by central banks. In conclusion, it remains a time of global economic war. Low rates could be here for a little while longer yet. But not much longer and likely becoming increasingly volatile.
We then expect this phase to give way to a global demand surge. This development will have a large upward impact on commodity prices and introduce some very violent volatility for fixed income markets. We may be getting ahead of ourselves. First to be expected is a disappointing economy.
All in all, significant “macro” strategy shifts will be necessary over the foreseeable future as these phases play out ahead. It remains the era of the “global macro” investor. As such, we will be on our toes.
Debt, what is it good for? Absolutely nothing … meaning here that central banks will cancel to nothing their government bond holdings. We may protest as did Edwin Starr. But, as we have explained, surprisingly there are a few more roles that debt will play in the quest to boost global demand growth. Uh huh, uh huh.
Categorised in: Blog
This post was written by mstockburn