The Cycle of Debt with Carmen Reinhart
This week I had the distinct pleasure of enjoying a breakfast with Carmen Reinhart, followed by a discussion on the exceptionally high levels of sovereign and private debt in the U.S. and the Eurozone and the likely economic consequences. The following is a summary of that discussion along with my own commentary, because let’s face it, I just can’t help myself!
Throughout history, countries have repeatedly experienced three major phases.
Phase 1: Financial Innovation – otherwise known as “We Rock!” During this phase there is an explosion of credit due to some innovative financial alchemy, (e.g. securitization of sub-prime mortgages in the U.S.). During this phase asset prices rise, private leverage expands and most people bask in their own brilliance.
Phase 2: Banking Crises – otherwise known as “Ooops!” The leverage from Phase 1 eventually collapses in one itself, causes a banking crisis which then morphs into a sovereign debt crisis as governments try to bailout their banking buddies. The line between private and public debt blurs. Think of the 2010 transfer of Fannie and Freddie from the private to public sector, which represented an increase in public debt to the tune of 25% of GDP. Ouch! This process is continuing in Europe. Ms. Reinhart believes it is likely that we will have another round of bank bailouts in the U.S. due to the unresolved mortgage debt problems.
Phase 3 – Financial Repression and Liquidation of Public Debt – otherwise known as “I need a beer!” During this phase there are continued low interest rates, with real interest rates often negative, as the government struggles to handle its over-bloated balance sheet combined with a sluggish economy.
So how does a society get out of phase 3? There are only three ways.
1. Economic Growth. This is extremely rare, with growth typically only contributing peripherally to debt reduction. Ireland in the 1980s is one of the few examples of a pure growth resolution.
2. Austerity. The short-term effects are incontrovertibly painful, causing economic contraction, but are necessary. Refusing to accept austerity is a bit like telling one’s doctor, “Yes, I realize that I need to lose weight and improve my fitness, but exercise just doesn’t appeal to me and I’m not giving up my donuts and Big Macs.” (Personally it’ll be a cold day in hell before I can give up my secret lovers, Ben and Jerry.) In the years following WWII, the U.S. ran many years with balanced budgets, despite significant deficits in prior years.
3. Restructuring. According to an article in the Financial Times on October 21st, the deterioration of Greece’s economy over the past three months is likely to force even more severe cuts on Greek bondholders than was contemplated during the summer, with the possible haircut increasing from 21% to near 60%. To give you a historical perspective on the ouzo lovers, from 1829-2009, Greece has been in external default 48.1% of the time! (What kind of FICO score do you think that would warrant?) Ms. Reinhart believes that the debt of Greece, Ireland and Portugal will have to be restructured, putting enormous strain on European banks, in addition to significant austerity measures. She also believes it is unlikely that Spain and Italy will need restructuring, but they are right on the edge, so that could change.
What does life look like during this process?
Unfortunately, not much fun. I’m expecting to keep Ben and Jerry close by. During this period the private sector goes through significant deleveraging, growth is decidedly sub-par and the unemployment rates remains on average 5% above the norm from the previous decade. This period is also marked by significant financial repression, meaning it is very hard to generate returns without taking on a good bit of risk. For a historical perspective, between 1945 and 1980, real interest rates on Treasuries were negative 49% of the time. From 1980 to 2008, that number dropped to less than 10%. From 2008 to present, it is up to 52% of the time.
In summary, the world has not experienced a widespread crisis like this since the 1930s. In the post war period, currency devaluation helped accelerate growth, a tailwind that is improbable this time around. The struggling nations are also unlikely to receive support from external stimulus, the way global expansion during the 1980s and 1990s helped Ireland growth out of its debt. The good news is U.S. corporate balance sheets have never been healthier and a crisis of this magnitude can often lead to much needed changes in society and government. As my mother would often say during my childhood, much to my annoyance I might add, “That which does not kill us makes us stronger.” Now where is that pint of Chunky Monkey?
