How to Escape the Global Debt Trap and Make a Fortune
Economics / Global Debt Crisis Dec 15, 2010 - 01:06 PM GMTBy: Claus_Vogt
We have just released our new book, The Global Debt Trap: How to Escape the Danger and Build a Fortune, which we think is timed perfectly for the events now swirling around us.
And as our way of thanking you for your interest as reader, we are giving you the first sections right here in this issue …
The Dangers Now Coming to a Head
Nearly every advanced industrial nation on the planet is ensnared in the greatest debt trap of all time. The debt trap is not a far-off danger that we can worry about some other day. Nor is it merely a concern for armchair theorists.
Quite the contrary, the debts are so large, so widespread, and so deeply entrenched around the world that virtually every policy decision by our leaders, every strategic move by investors, and every financial choice by billions of citizens is influenced, constrained, or driven by the need to compensate for, or the desire to escape from, the great trap that these debts have created.
The most recent 15-year sequence of events provides the best historical evidence:
First came the tech boom and bust.
In the mid-1990s, mostly thanks to aggressive money easing by U.S. Fed chairman Alan Greenspan, U.S. technology stocks enjoyed a massive bubble that culminated in an equally massive bust in the year 2000.
In the wake of the bust, the Fed chairman, vividly aware of the debt trap, feared the market decline would set off a deflationary debt collapse.
So he eased money even further, engineering America’s lowest interest rates since World War II.
Second, we saw the housing boom and bust.
By overreacting to the tech stock bust, Greenspan helped create another, even larger bubble — this time in U.S. real estate.
And when that bubble also burst, his successor at the Fed, Ben Bernanke, confronted an even greater problem. This time, not only did U.S. authorities harbor the fear of a debt collapse, they faced an actual, real — time collapse that threatened the entire global financial system.
Third was the Great Recession.
The world stumbled into the most severe economic downturn since the Great Depression of the 1930s. The banking system did not only come to the brink of a total collapse, but actually fell over the brink.
In a concerted effort to prevent a global collapse, the United States, Western Europe, and others embarked on the most expensive program of financial bailouts, economic stimulus, and money printing in the history of mankind.
In the United States, the Special Inspector General for the Toxic Asset Relief Program (SIGTARP) — the government agency responsible for tracking the $700 billion bank rescue package of 2008, reported to Congress that, by mid-year 2010, the U.S. government had spent $3.7 trillion in financial bailouts and bond-buying operations.
If you add other measures taken to stem the debt crisis — such as U.S. government guarantees of bank deposits, credit markets, and other institutions — the total bill and liability is over $14 trillion. And if you consider parallel rescue efforts in Europe, it easily exceeds $20 trillion.
But none of these great rescues came without a cost. Quite the contrary, to save the banking system and financial markets from the global debt trap, the sovereign governments of the United States and Europe have gutted their own finances, instantly creating the largest peacetime deficits of all time.
Fourth, the sovereign debt crisis struck.
Given this sequence of events, it should have come as no surprise. Global investors rebelled, dumping the bonds of sovereign governments, targeting first the weakest among them.
Suddenly, Greek government bonds plunged in price as their interest rates soared from as low as 2 percent to 18 percent. Suddenly the Greek state was at the brink of default, and other European countries like Spain, Ireland, Portugal, and Italy were also in jeopardy.
Suddenly, the acronym PIIGS — Portugal, Italy, Ireland, Greece, and Spain — largely unknown to the public, became a household word, denoting countries buried in the muddy world of the sovereign debt crisis.
The European Union was initially very reluctant to intervene with yet another major financial rescue. But ultimately, the threat was deemed so great that European leaders were forced to do what many swore never to do — join with the International Monetary Fund (IMF) to bail out their weaker members with a massive $1 trillion rescue package.
The Global Debt Trap Is Now Clearly Driving Policy
Thus, it should be clear that monetary and fiscal policy are no longer driven by reason — let alone by any semblance of sounder principles established in earlier decades. Clearly, it is driven almost entirely by the global debt trap and the fear of its inevitable consequences — a global depression.
The global debt trap has driven monetary and fiscal policy makers to take ever more desperate measures to escape its fangs. But alas, the only solutions they have been able to come with so far have merely added more debts, created bigger speculative bubbles and ensnared them into a deeper trap, raising the specter of even harsher long — term consequences for billions of their citizens.
The Bank of International Settlements (BIS), the world’s “central bank of central banks,” helps give us a clear vision regarding what some those consequences might be. In its most recent annual report, it first gives us a snapshot of the massive, global deterioration in government finances, summarized in Table I.1.
This table itself is devastating in its implications. It shows that:
• We have witnessed an increase in government debt that is both dramatic and ubiquitous. Not one country listed by the BIS escaped the trend. Not one took effective measures to stop it.
• The government debts of two pivotal countries in the global financial system — the United States and the United Kingdom — are no less threatening than those of two countries that have already been victims of the sovereign debt crisis — Portugal and Spain. Indeed, for 2011, the BIS estimated that the government debts of Portugal and Spain to be 99 and 78 percent of GDP, respectively.
For the same year, the BIS estimated that the government debts of the United States and the United Kingdom to be 91 and 95 percent of GDP, respectively. The debt burdens of these two larger countries are similar — or larger — than those of the two PIIGS countries.
• Japan has the biggest government debt problem of all. So some apologists for large U.S. government debts use Japan as an argument for how much debt is possible without risking a bigger disaster. But Japan, unlike the United States, has been able to finance its debts almost exclusively with the savings of its own citizens, while the United States relies on foreign lenders for most of its financing. Moreover, any implication that Japan’s economy has not been severely hurt by its debt burden ignores Japan’s two lost decades of chronic, on-again-off- again recession and deflation.
• The changes in the fiscal balance of every one of these countries is shown in the second group of columns. And they show that the fiscal balance has clearly deteriorated sharply, especially in the past two to three years.
• Moreover, the BIS numbers show that the pace of deterioration in fiscal balance has actually been much faster in the United States and the United Kingdom than in four of the PIIGS countries — Italy, Portugal, Spain, and even Greece. This directly refutes anyone who might deny the possibility that the United Kingdom and the United States could be the next victims of the sovereign debt crisis.
But if you think this snapshot of the current global debt trap is shocking, wait till you see what the BIS projects for the future, as illustrated in Figure I.1.
Figure I.1 Gross Public Debt Projections (as a Percentage of GDP)
Here you can see that for each country, the BIS estimates three scenarios:
In the first scenario, deficits continue to grow at the current pace with little or no efforts to change course. In this case, the resulting global debt trap would be many times worse than we have today. Not only would it be entirely intolerable, creating a burden so massive it would sink every economy . . . it is also entirely unthinkable, threatening an end to governments as we know them and a twenty-first century of Dark Ages.
Therefore, the BIS assumes that governments must and will take steps to change course. The only questions are: How, how much, and when?
The big dilemma: Even if the United States, Japan, and the United Kingdom can cut deficits by 1 percent of GDP per year for the next 10 years, the BIS projects that their accumulated debt burden will still increase. They will still be incurring new debts and those will still be larger than the old ones they pay off. Plus, to accomplish that unsatisfactory result will be, in itself, a major challenge.
The only way the United States can reduce its debt burden in the BIS scenario is to not only cut its deficits but also to freeze age-related spending, such as Social Security payments, at current levels — in other words, austerity measures that most Americans would consider draconian.
In the United Kingdom and Japan, the challenge is actually greater. Even with the 1 percent annual decrease and the freezing of age-related expenditures, the burden of government debt continues to rise over the years, albeit at a much slower pace than it’s rising currently.
Again, the question arises: Are these future prospects better or worse than those of PIIGS countries that were considered directly vulnerable to the sovereign debt crisis? The answer: Compared to two of the PIIGS countries — Spain and Ireland — the prospects of the United Kingdom, the United States, and Japan are actually far worse.
Remember: Even if the United Kingdom, the United States, and Japan can impose austerity in the years ahead, their government debt burdens could still increase. But Spain and Ireland (plus France) are better off in this scenario. If they do pursue austerity measures, their government debt burdens will ease markedly, according to the BIS.
Another big dilemma: All three of the BIS scenarios assume healthy growth in the global economy. If the expected economic growth fails to materialize, or worse, if the global economy suffers another contraction, the explosion in growth in government deficits will be greater. At the same time, any tangible results from austerity programs will, at best, be delayed for many years.
Certainly the “healthy growth scenario” is far from guaranteed. Quite to the contrary, as we put the finishing touches on this English-language edition of our book, our forecasting model, which correctly warned of the 2001-2003 and of 2007-2009 declines, is again showing a very high risk of another recession. Hence, if anything, the BIS scenarios may be too optimistic.
So again we ask: When global bond investors pick their next sovereign governments for dumping sovereign bonds, which ones will they pick? Will they target the ones that have taken — or have the ability to take — measures to counter these trends? Or will they target those that have neither the political will nor the financial flexibility to do so?
And again, we say emphatically: Anyone who thinks the United States and the United Kingdom — or Japan — are invulnerable to a sovereign debt crisis such as the one that has struck Greece must awaken from their slumber and look carefully at these hard facts.
This is why the United Kingdom has already embarked on a shock-and-awe austerity program that far exceeds what most observers might have expected. And it is why political pressure is likely to build for the United States and Japan to do the same. Whether it will be possible to pursue austerity, however, seems doubtful. And how monetary authorities will react to the resulting economic shocks is equally uncertain.
No matter what the outcome, the only conclusion that can be drawn from the BIS study is a future of turmoil and economic pain.
What Will Actually Happen?
In theory, there are six ways to resolve the global debt trap — six escape hatches. So as a preview of the arguments we make in this book, let’s briefly review each one:
Escape hatch 1: An economic growth miracle.
It’s highly unlikely that the developed world will stage a growth miracle during the coming years. Even the most optimistic economists don’t dare forecast such an event. The debt burdens themselves are massive obstacles to growth.
Nor have any of the highly indebted countries made the investments in infrastructure or technology that would be needed to generate rapid growth. It would indeed be a miracle, and it’s so unlikely that it merits no further discussion.
Escape hatch 2: Major interest rate cuts.
Also not possible!
Interest rates have already been falling dramatically since 1981, with short-term official rates near zero. They cannot fall below zero. And there is virtually no more room for additional substantial declines in long-term rates.
In short, all developed countries have already played this card. They can’t play it again.
Escape hatch 3: Bailouts by other governments.
This was apparently possible — at least temporarily — for PIIGS countries, all of which are a part of the euro zone. But it would be far more difficult to justify for countries outside the euro zone.
Moreover, what country or entity is large enough to bail out the United Kingdom or Japan. And who could possibly bail out the United States itself? Certainly not smaller countries. Even if it were willing, China is not big enough, either. And a bailout from the IMF, whose funding comes mostly from the United States, would also not be possible.
Obviously these first three escape hatches from the global debt trap are not available — especially for the United States, the United Kingdom, and Japan. They must choose from one of the other three escapes, none of which is painless.
Escape hatch 4: Outright default.
This may be possible for smaller nations that can subsist under dictatorships that isolate them from the global economy. But it is not possible for the United States, which depends on its credit with foreign lenders, to survive.
Even if the United States is willing to give up its status as the world’s economic leader, an outright default on its government debts would be a disaster and blunder of such obvious and great magnitude that it is highly unlikely it would ever be seriously considered — let alone pursued as an escape hatch.
Escape hatch 5: Austerity.
Austerity policies include tax hikes and massive spending cuts — both with dramatic political consequences and painful economic impacts.
So far, virtually the whole world has responded to the Great Recession with the largest government stimulus program in peacetime, and still the results have been very disappointing.
Thus, it doesn’t take a PhD in economics to imagine what might happen if those same governments did precisely the opposite — instead of pouring money into the economy, pulling money back out. The result would be a vicious cycle of government cutbacks, falling income, shortfalls in income taxes, even larger deficits, and still more cutbacks needed. In sum — a depression.
This scenario is possible. But we don’t see it as the most probable, at least not until the final alternative is pushed to the limit.
Escape hatch 6: Money printing.
Governments can and do default on their debts in a more subtle and sly manner — through inflation. Central banks can monetize government debt and seek to inflate the debt away.
And it is this escape hatch that is typically the most appealing to most politicians.
In their minds, the major byproduct — inflation — is distributed through the society. And more importantly, the inevitability of that byproduct is not fully understood by large segments of the public, giving politicians the opportunity to inflate their country’s currency and let their successors or other scapegoats take the blame.
It is this escape hatch from the global debt that we deem to be the most probable. But it comes with a high risk. It may soon careen out of control and usher in a period of hyperinflation. Unfortunately, financial history holds many examples of this very sad outcome.
In the balance of this book, we explain why. We show you how we arrived at this unfortunate predicament, how our leaders have failed us, how they are likely to continue to do so, and most important, what YOU can do about it.
No matter what, the coming years promise to be both frightening and exciting. Both as an investor and as a citizen, you need to be as flexible as ever before to circumvent the many pitfalls. But always remember: The bigger the crisis, the greater the opportunity for those who can prudently prepare ahead of time. In the chapters that follow, we will show you how.
Best wishes,
Claus Vogt and Roland Leuschel
P.S. For the complete foreword of The Global Debt Trap by Martin D. Weiss, click here. For more on the authors, click here.
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