ATLANTA— The brief market collapse last Thursday might well have been a canary in the coal mine. It was caused principally by a sudden concern over the credit-worthiness of certain peripheral European countries: namely Ireland, Portugal and Spain. When coupled with the precarious finances of Greece, these countries’ spiraling deficits and out-of-control debt raise the specter of a significant default- and perhaps the onslaught of a second great credit crunch. Those of us who were previously looking at commercial real estate as the second shoe to drop might want to start turning our attention to the prospect of sovereign defaults. They would be much worse than commercial real estate, and could make Lehman look like a walk in the park.
I am finally making my way towards the end of the book, This Time is Different, by authors Carmen M. Reinhart and Kenneth S. Rogoff. The final 4 chapters describe the current economic recession and put it into a broader economic context. The authors refer to this recession as the Second Great Contraction, and make a rather compelling case based on historical evidence that this truly is the worst global recession since the Great Depression.
In building up to this point in the book, the authors have analyzed over 800 years of global financial data (to the extent such data is available), including a very thorough database of data going back to the beginning of the nineteenth century. There are some very interesting trends that emerge from this dataset.
The one trend most pertinent to this moment is that a sharp increase in sovereign defaults almost always comes after a regional or global financial crisis. The reason is that, on average, a country facing a domestic banking crisis winds up doubling their national debt within three years of the crisis occurring. This is because banking crises are particularly devastating to economic growth, which then drains public tax revenues. Tack bail-out costs and fiscal stimulus measures on top of that, and debt gallops forward (as we are witnessing in the United States). While the United States is still a AAA-rated borrower and will probably survive this recent spat in the medium-term (for better or for worse), many countries are ill-equipped to handle this type of debt-load and are at risk of default.
Given the pervasive, global nature of the financial crisis we have endured, there are dozens of countries the world over that have incurred massive amounts of debt in the last several years. And consider the debt-loads of developed economies: the United States currently has total debt of 84 percent of GDP; The United Kingdom, 71 percent; Japan, 190 percent. Given a trend towards more short-term sovereign borrowing in the last ten years (spurred by historically low interest rates), governments are needing to roll-over their sovereign debt much more quickly than before. As an example, national governments need to raise $4.5 trillion from the global capital markets in 2010 alone, which is triple the annual average over the previous five years.
Should defaults start to proliferate (which can come in many forms, including reschedulings, currency debasements, etc.), we might see bank lending start to cramp up again, as banks seek to cover their losses and further limit their exposure to troubled countries or regions. Borrowing costs for governments in general would start to rocket up and all of this would blow back through the broader economy in a very detrimental way. If emerging regions begin to default, we could witness regional credit crunches and massive losses on foreign equities. If any of the developed countries misses a payment, or shows signs of wanting to inflate away their obligations, the consequences would be much more vast and far-reaching. A mild double-dip recession could quickly become a precipitous collapse, and potentially a full-on depression.
In all honesty, it is unlikely that the The International Monetary Fund (IMF) or other bodies would let this occur, without giving assistance. It is highly probable, for instance, that the European Union (EU) will step in to help Portugal, Ireland, Spain and Greece. Even though these countries have long been breaking their treaty agreements with the EU, which require them to hold annual deficits to within 3 percent of GDP, the EU would be forced to step in to support them, to prevent a run on the Euro and a destabilization of the whole region. Economically, this would be absolutely necessary. Politically? Well, that will be a completely different animal altogether, as any bail-out would certainly be coupled with a further loss of sovereignty for these countries.
But even if quick fixes and IMF bail-outs are used in the coming months to paper over burgeoning government deficits for the short-term, the longer term looks pretty awful. This Time is Different makes the compelling case that historically, IMF bail-outs have resulted in repeat offenders. Historically, it isn’t until a country is allowed to suffer the full consequences of default (which typically include rapid currency collapse and hyper-inflation) that they change their long-term behavior for the better.
I have a feeling this coming decade is going to be a decade of real turbulence. Resolving the global, sovereign debt crisis, both in on-balance-sheet and off-balance-sheet liabilities is going to be paramount. We need serious political leaders to take on this task, not ideologues who pander to special interest and teeny-bopper, left-wing ideals with one trillion-dollar federal program after another.
As to how to invest in this environment? I’m still waiting to hear what a good play would be…
TennesseePaul
Stephen VanNuys
Brooklyn Daniel
The Freedom Thinker
You speak my heart in mentioning the danger of a default chain recation! In and of itself a Greek bankruptcy or bond default should -in theory- not affect the Euro as such very much, Greece being maybe 3% of the total. However, just as a Californian bankruptcy would reflect badly on the “state of the Union” as a whole so would the default of on EU country, coupled with the rising interest rates and thus further destabilisation of the remaining over-leveraged member states, make investors wonder when sovereign default across the board is likely. Thus they wouldn’t commit themseves to bonds of longer maturity and that’s the beginning of the end.
Crisismaven- I think you have this nailed. A Greek default in and of itself wouldn’t be as big a deal. But history shows that banks and other buyers of government obligations tend to look at the region as a whole and not the individual countries. Once one goes down and there are others at risk, they historically have cut off the spigots to the entire region. That happened during the Latin American debt crises of the 1980′s and was part of what happened in the Asian contagion of the 1990′s. Banks and lenders create the effect of spreading the crisis, causing a ripple effect through the entire system as access to capital is severely restricted. This could get ugly. My guess is that the IMF/EU won’t let it happen – at least not this time (for better or for worse).
Those of us who were previously looking at commercial real estate as the second shoe to drop might want to start turning our attention to the prospect of sovereign defaults.
You don’t say…
Historically, it isn’t until a [company] is allowed to suffer the full consequences of default … that they change their long-term behavior for the better.
Sometimes you have to let those who play with fire get burned before they truly learn their lesson…
“Countries” and “companies” are two vastly different things, in my mind. You can let a company fail, and its employees can find work elsewhere. But let a country fail, and things get much, much nastier. Then truly a bunch of people who may have had nothing to do with the root causes of the crisis and may have repeatedly voted against their leftist leaders are left to shoulder the burden of high inflation and economic destabilization. I’m a little more open minded to assisting countries over companies, albeit with tons and tons of strings attached. We’ll see. I haven’t fully formed my views here.
Wouldn’t disagree there, but the principle of deterring bad behavior is similar. You wrote as much yourself… it isn’t until they do go under that the bad behavior is changed for the better. Basically when you subsidize the behavior you get more of what you subsidize.
At this point the EU hasn’t been able to control their those countries. How do you enforce economic strings between country contracts? Do you sue the country for breech of contract? They just default then after one spent the money.
Countries fail all the time and it will always be the responsibility of a select group to shoulder the burden but that always exists just make sure the group that shoulders the burden is protected from the masses in the form as a Republican (in the truest sense).
You bring up an interesting point on EU- that they haven’t been able to control their countries spending habits.
It’s funny. The EU blasts our conservative views on liberalizing the financial markets and how those liberalized financial markets have destabilized the world economy.
But now the EU can’t control the socialist over-spending of its many constituents. And that over-spending (which is what all conservatives fear from big government) is threatening to destabilize the world economy.
Irony of ironies…
Commercial real estate is holding on by it’s teeth. We’ll see what the travel season brings…
As for letting those countries get burned that deserve to this probably won’t happen. Just like in the U.S. and our bailouts the EU and probably the U.S. (in the guise of the IMF) won’t let those countries collapse.
It’s the very thing those countries need – completely meltdown and economic retooling. This will of course affect the EURO which the EU want’s to try to stabilize. Just like America didn’t need it’s financial systems propped up but it was done anyways. This way people, companies, and government can go on living in debt.
As for the investment play, to me this is again China. If the IMF and EU deny what needs to happen then they are only delaying the problem to the benefit of Chinese debt and yuan strength. We’ll again be revisiting the issue a few years down the road. Just like we will be revisiting the issue here in the U.S. down the road. We may have survived the splash into the sea of insolvency but the sea is large and deep. Just as those European nations are beginning to take their plunge.
If you’re wrong and the IMF and EU don’t intervene and Greece, Portugal, Spain, and Ireland default creating economic strife in those countries then your investment play is in those countries with whatever entities survive the initial crash. The Athens Exchange as I remember is pretty open I actually researched strategies for an IPO on the exchange for a company raising venture capital funds once a long time ago…
I think if the EU/IMF didn’t do anything, then my immediate first play would be to move all money to US treasuries, as US treasuries clearly are still seen as the “safe” investment in such environments. I think we’d see a Lehman-like surge in the prices of treasuries. Then, you are probably correct- go back into these countries and see what you can pick off at dirt cheap prices.
Ah… but that’s for dreamers. I really don’t have those kinds of assets to put at risk. Interesting to theorize nonetheless.
As to China, I keep reading the perpetual bull sentiment out there, but I’m just not convinced. I think their biggest single weakness is their repressive political system and central command-and-control economy. Even though I admire their growth and their moves towards more economic freedom over the previous 20 – 30 years, I don’t think they have moved far enough. I really think they are going to royally screw up (and are in process of doing so already).
Chinese banking crisis. Next 5 years. Inflation, high unemployment on the mainland. It will be ugly politically.
But if they get more political freedom there, then watch out. I’m with you at that point.
It’ll be interesting to see what economy pops first. I think the U.S. economy crashes again before the Chinese economy.
http://www.marketwatch.com/story/how-to-invest-for-the-debt-bomb-explosion-2010-02-09?pagenumber=2
Interesting read, probably not to far fetched. China will get some good deals on U.S. companies and land in such a situation. It’ll be interesting how quickly we sell off to China in such an anarchy.
Yeah – I talked to a guy at my firm who knows wealthy people who are doing just this- buying guns and building bunkers, anticipating total economci collapse and anarchy by the year 2012. For some reason, 2012 is the focal year for a lot of these folks.
That is absolutely the worst case scenario. I’m optimistic we can fix things short of total economic collapse. Still, we need the impetus to make hard choices.
For some reason, 2012 is the focal year for a lot of these folks.
Didn’t you see that movie?
Hahaha…
Missed that movie…
Great work Stephen.
You hit the nail on the head given the EU’s recent announcement. Also understand they will be providing some austerity regulatons for Greece.
Yep – we’ll see how this plays out. Sounds like tomorrow there is a big meeting over this in Europe- curious what announcements will be made out of that.
And the good news is, this is just the first lil’ piggy. At least three more will be running to the trough very soon.
BTW, do you think China will treat us as good as Germany will treat Greece?
Great question!
No.
Of course, they are stuck with us. Any big depreciation in the value of the dollar or collapse in treasury prices (which tend to go hand in hand) will cause them to loose big-time on all their fabled foreign currency reserves. They’ve put themselves in a bind, buying so much of our debt.
http://www.bloomberg.com/apps/news?pid=20601039&sid=a_l2qpfPWwAQ
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