MBMG International Ltd.
Nominated for the Lorenzo Natali Prize
For those of us from a Judeo-Christian heritage, it is sometimes possible to
believe that suffering is worthwhile; a way of paying for past sins. In this
light, the age of austerity in which we supposedly live has a sort of
redemptive quality. Grit our teeth, and we will come out the other side,
purified and ready for robust economic recovery.
However, the prayer that policy makers have been uttering is that of St
Augustine: make me virtuous, but not yet. After five years, we are in a
worse place than when we started.
One would have thought that the recent deleveraging should have caused debt
ratios to collapse. Yet, after the financial maelstrom of the last five
years, debt ballooned to a weighted average of 417 percent of GDP from 381
percent in June 2007 in the eleven economies most under the market
microscope. Strikingly, in each of Canada, Germany, Greece, France, Ireland,
Italy, Japan, Spain, Portugal, the UK and the US, the ratio of total debt to
GDP is now higher than it was in 2007.
There are variations, and it is notable that debt in the US has increased
the least, from 332 percent of GDP five years ago to 340 percent today
(Goldman Sachs, Federal Reserve Z1 Report) - although we should not draw too
much consolation from that, as the statistics do not include social
entitlements such as Medicare or Social Security. Add in these ‘off-balance
sheet’ items, and the ratios would look a great deal worse.
As can be seen from the chart on this page, deleveraging is proving
impossible to execute. The world is still staggering under a mountain of
debt, the costs of which extinguish the ‘animal spirits’ which ought, by
now, to be coming to the rescue.
Based on this analysis, we can make five predictions. First, as deleveraging
has not even started yet, the real crisis of the world economy has not begun
either. All the perceived unpleasantness of the past few years is merely a
warm-up act for the greater crisis still to come. The requirement to get
debt levels down is as pronounced as ever in the euro-zone, particularly in
southern Europe, but also in the US and Japan.
Second, it will take a minimum of 15 years or so for the economy to reach
escape velocity and attain a level consistent with healthy growth scenarios.
This is because debt levels need to come down by at least 150 percent of GDP
in most countries. History suggests you cannot reduce debt by more than ten
percentage points a year, without unleashing major social and political
Third, when we do finally start cutting our debt, the economic impact will
be massive. Countries like Japan and the US need to increase their primary
balance by more than 10 points of GDP, in order to stabilise the ratio of
public debt to GDP to 2007 levels. Considering negative feedback loops
between deficit cuts and growth, each stands to lose more than 20 percent of
GDP against trend. And this does not account for the required private
The precise level of economic devastation is a function of the so-called
multiplier, which measures the impact of spending reduction on economic
growth. In a recent World Economic Outlook, the International Monetary Fund
(IMF) calculated recently that under current circumstances the multiplier
can be as high as two: every dollar cut from the deficit will lead to a two
dollar reduction in GDP. The multiplier is as much as four times higher than
in pre-2008 conditions.
Fourth, risky assets are set to perform badly for a long period of time.
Levels of corporate profits are highly correlated with changes in leverage:
reduce debt to meaningful levels and profitability will fall. Current levels
of valuation in equity markets are therefore unsustainable over the medium
term. Besides, the equity risk premium on major indices, such as the S&P
500, is at historically low levels. This needs to rise dramatically in order
to compensate investors for multiple market risks, ranging from sovereign
default to inflation, deflation and geopolitics.
The fifth and final point is that there is no magic bullet. In the past,
policy makers had various instruments to cushion the impact of measures
taken to stabilise debt levels. For example, they could cut interest rates
or allow their exchange rates to fall, leading to export-driven recovery.
But in an era of low or zero interest rates, with most countries competing
to devalue their currencies, such policy tools have lost effectiveness,
hence the high multiplier. Even inflation, long touted as a back door
solution to debt reduction, will not help. The onset of inflation would send
bond yields sky high, compounding the costs of servicing debt and killing
off any recovery. And ‘off-balance sheet’ entitlements, the biggest item
that needs trimming, are inflation adjusted.
How do asset classes rank on the totem pole if this scenario plays out?
Bonds of solvent governments and corporates should do well in a deflationary
environment where rates are kept lower for longer; stocks should revert to
new lows; and currencies of highly leveraged, growth-sensitive markets
should be sold. The possibility of making money on property is now much more
reliant on where in the world it is. As for alternative investments, such as
commodities, it depends on what you have gone for and where it is in its own
In the words of an old Austrian adage, the situation is hopeless, but not
serious. It is not serious, as politicians simply fail to acknowledge the
elephant in the room, namely leverage, introducing instead a succession of
policy gimmicks. It is hopeless, in that virtue is not likely to be rewarded
for a generation. But money can still be made - just remain liquid!
The above data and
research was compiled from sources believed to be reliable.
However, neither MBMG International Ltd nor its officers can
accept any liability for any errors or omissions in the above
article nor bear any responsibility for any losses achieved as a
result of any actions taken or not taken as a consequence of
reading the above article. For more information please contact
Graham Macdonald on [email protected]