Government Debt Defaults and Inflation Are the Norm, Not the Exception
Interest-Rates / Global Debt Crisis Sep 01, 2010 - 12:20 PM GMTThe past 15 years have certainly been exciting for investors. During the second half of the 1990s we experienced one of the largest stock market bubbles of all times … and its bursting. Then, only a few years later, one of the biggest real estate bubbles … and its bursting.
In the aftermath of these events the world stumbled into the most severe economic downturn since the Great Depression of the 1930s. And the banking system came to the brink of a total collapse.
Unprecedented government interventions in the U.S., the UK, and continental Europe were implemented to prevent the breakdown of the financial system. Naturally these interventions came with a price: Ballooning budget deficits.
Now we’re witnessing a veritable debt explosion in the developed world …
Never before, aside from times of major war efforts, have governments amassed as much debt as during the past years. And this debt binge comes atop a decades-long trend of ever higher indebtedness.
Then, seemingly out of the blue, interest rates for Greek government bonds started to rise drastically. Suddenly the Greek state was at the brink of default, and other European countries like Spain, Ireland, Portugal, and Italy were also in jeopardy.
Stronger European countries and the International Monetary Fund (IMF) stepped in with a $1 trillion rescue package to prevent this crisis from running its natural course — that is massive government defaults.
Historically, Greece’s De Facto Bankruptcy Is All too Common
When examining the current predicament, you could easily conclude that we’re living in extraordinary times. But looking through a historical lens immediately shows that what seems to be extraordinary is in effect somewhat normal …
Sovereign debt defaults and sovereign debt crises are nothing new at all, but as old as the government bond market. Financial history is fraught with examples of government bond investors losing big time.
In their book, This Time Is Different, Carmen M. Reinhart and Kenneth S. Rogoff give dozens and dozens of examples from 1802 Austria-Hungary until 2002 Indonesia, including countries like France, Germany, Argentina, Russia, Turkey, Sweden, Mexico, China, India, and Japan.
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Now our leaders have set us up for the same fall by accumulating a debt problem so large …
There Is No Easy Way Out!
In theory there are six ways out of government debt:
Option #1— Stimulate economic growth
A growth miracle is highly unlikely here. If anything, history tells us to expect subdued growth in the aftermath of a burst housing bubble.
Option #2— Cut interest rates
Declining interest rates are already behind us. The Fed is done, interest rates are just about as low as they get.
Option #3— Bailouts by other governments
Bailouts by other governments are not an option for major economies, and totally impossible for the world’s largest economy and the world’s largest debtor, the U.S.
Since the above three options, let’s call them the easy ones, are not available for the U.S., government officials are left with the remaining three. All of them come with lots of pain …
Option #4— Implement austerity policies
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Austerity policies mean tax hikes and spending cuts. Greece can be seen as a test of this agenda. And its citizens have responded with strikes and social unrest.
Option #5— Crank up the printing presses
Although time lags are long, money printing is probably the most alluring path for politicians. And there’s always the hope to get away with offering scapegoats, because the mechanics of inflation are difficult to understand.
The Bernanke Fed has often made clear that it strongly prefers an inflationary policy to cope with the effects of the burst bubble and the Great Recession.
That is, however, a very risky undertaking …
In fact, history shows inflation can easily get out of hand and destroy the very fabric of a society. The most prominent example was Germany in 1923 when one U.S. dollar was worth 4 trillion German marks.
And the most recent case was Zimbabwe a few years ago when at one point inflation was estimated at 6.5 quindecillion novemdecillion percent (65 followed by 107 zeros). The country has even issued the world’s first 100-trillion dollar note.
Option #6— Default
Outright default is what happens if our leaders keep doing what they’ve been doing for the past several years. And for now, they seem determined to continue the very policies that got us into the current mess in the first place.
There are many names or euphemisms for default: Restructuring, rescheduling, repudiation, or moratorium to name just a few. But they all mean the same sad thing: Breaching the terms of debt contracts, such as bonds.
Which One Will They Choose?
So what will it be? Which way will our leaders choose to dig us out of this mountain of debt?
I think we’ll see all three in the coming years: Austerity policies, money printing, and default. It may very well differ from country to country, and it may even come as a succession.
For instance, like was done in Greece, they might first try some tax hikes and spending cuts …
But as soon as the public outcry becomes too loud to bear, politicians will quickly retreat and start money printing instead. Then the bond market could rebel forcing a return to austerity, and so on. Until, in the end, either hyperinflation or outright default terminates the whole cycle.
What Can You Do to Protect Your Wealth?
Unfortunately there is no easy answer. In my mind, though, one thing is certain: You must be as flexible as never before to act early on initial signs of important policy shifts.
Right now, my cyclical model is giving clear signals of a coming recession or another down leg in a running depression. The right thing to consider doing in this phase of the cycle is avoiding risk, especially stocks and junk bonds.
Best wishes,
Claus
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