What is Causing the Worldwide Government Debt Crisis?

Mohamed El-Erian, the Chief Executive Officer of PIMCO, writes this morning that “It is now commonly accepted that Greece’s predicament is due to two inter-related problems: the economy is unable to grow, and the debt burden is enormous. (http://blogs.ft.com/the-a-list/2011/06/17/only-a-totally-new-greek-approach-can-save-europe-now/)

Yet, El-Erian states, neither of these issues are being addressed in the discussions going on concerning the resolution of the debt crisis in Greece.

The reasons for this are complicated although they very often boil down to the priority to handle short-run problems immediately and postpone the long-run problems to another day.  Of course, the famous quote of John Maynard Keynes comes to mind: “In the long-run we are all dead!”

A good listing of the complicated entanglement of the politics of the Eurozone is present in the Wall Street Journal article “Europe’s Greek Stress Test” by John Cochrane and Anil Kashyap. (http://professional.wsj.com/article/SB10001424052702304186404576389542793496526.html?mod=ITP_opinion_0&mg=reno-wsj) The authors list four key facts:

“First, the Greek government has borrowed more than it can plausibly afford to pay and certainly more than it will choose to pay. It now owes more than one and a half years' economic output.”

“Second, European banks are holding the bag.”

“Third, the European Central Bank (ECB) is now involved as well.

“Fourth, in the end this is all about Ireland, Portugal, Spain and Italy.”

In other words, by ignoring the basic underlying causes of the problem, the sickness has spread and now envelopes nor only Europe…but the world.

In other words, the old economic paradigm is dead, and the political leaders of the western world have only made things worse by trying to keep the old paradigm alive. 

As a consequence, the options available to these leaders are shrinking and those options that are left are becoming less and less desirable.

And, even if the bailouts continue and postpone the resolution of the crisis until another day, the two basic issues mentioned by El-Erian are not being addressed.  These are the issues pertaining to the reasons for slow economic growth and the reduction of the massive debt levels that are outstanding. 

The solution…increase economic growth and lower debt levels.

The problem…over the past fifty years or so the political leaders of most western nations worked with an economic paradigm that resulted in an increase in debt levels to increase economic growth.  That is, credit inflation, whether in the economy as a whole, or in a particular sector like housing, would buy politicians additional votes by keeping economic growth high and unemployment low. 

“The solution” reverses almost 100 years of the economic and political thought of western intellectuals.  It also contradicts the perception of many voters in western countries. 

Keeping a lid on debt exposure is an old-fashioned idea and one that collides with the modern day concept of what governments should do and of the excesses of the consumer society. 

An emphasis on education and training also is an old-fashioned idea although it was the basis of economic productivity and inventions in the nineteenth and early twentieth centuries in the United States.  And, this particular emphasis is one that collides with the modern-day approach to “certification” and the building up of “self-esteem” where everyone passes or everyone gets A’s.

The current sovereign debt crisis is not going to go away with “doing more of the same.”   Yet, changing the economic paradigm is going to be difficult.  We see this on the streets of Greece…and Spain…and Vancouver…oops, sorry…

The focus is on Greece right now and rightfully so.  But, the lessons need to be learned by others…but this will not make it any easier.  Long-run solutions are never “easy”.

There was an interesting article in the Saturday Wall Street Journal titled, “What Kind of Game is China Playing?” (http://professional.wsj.com/article/SB10001424052702304259304576374013537436924.html?mod=ITP_review_0&mg=reno-wsj) The answer is that American leaders need to learn how to play the game of “Go”, an ancient Chinese board game.  The game of “Go”, “emphasizes long-term planning over quick tactical advantage, and games can take hours. In Chinese, its name, wei qi (roughly pronounced "way-chee"), means the "encirclement game."

The economic paradigm of the past fifty years emphasizes “tactical advantage”, the short-run.  Why this approach became so popular was that the political leaders of the western world saw it as the means of gaining their goals…getting elected and then getting re-elected.

What El-Erian and others are arguing for is more emphasis by these political leaders on the “strategic” and not the “tactical.”  The “strategic” aims to achieve “sustainable” results.  The “tactical” way of dealing with a problem always contains the caveat that the other problems will be dealt with when they become the major issue.

Well, the other problems have now become the major issue.

And, this is the lesson for the countries included within the definition of the western world. 

Politicians are going to have to learn how to think “strategically.”  The question is, “Can politicians be allowed to think strategically in a democracy in which winning the next election is the most important thing on their agenda?”

Greece, in my mind, is going to have to restructure its debt in one way or another.  So is Ireland…and so is Portugal…and so in Spain…and so on and so on.  How many more countries will find themselves facing a restructuring of their debt is, of course, unknown. 

It is painful when you find out you have been working with a model that is not correct.  Creating more spending and more debt is not the solution to every problem.  Yet, we have lived by this model for a long time.  And, now the bill seems to be coming due.

To me, this is what is causing the worldwide government debt crisis. 

Why Debt Is Going To Continue To Be A Problem In The United States

Officials at the Federal Reserve and in many other leadership positions around the world believe that liquidity is the solution to our current woes. And, if the amount of liquidity that is in the anking and financial markets is not enough to resolve our problems then more liquidity is certainly the answer.

This is behind QE2, and this is behind most of the effort to resolve the sovereign debt crisis in Europe.

What does liquidity allow you to do? It allows you to sell assets into the marketplace.

However, selling assets into the marketplace does not solve your problems if the price at which you sell the assets is substantially below the accounting value of the assets on your balance sheet. In such cases, having liquid markets in which to sell assets may allow you to more than wipe out your equity and leave you unable to pay off your debts.

There are two ways to counter this problem. The first is to inflate prices so that the real value of the debt declines which reduces the amount of leverage you have on your books. The second is to create income and wealth so that equity increases relative to the debt outstanding thereby reducing leverage.

The people advocating the injection of more liquidity into the financial system hope to spur bank lending and thereby stimulate economic growth. Those that are concerned with the creation of more and more liquidity argue that this first group of people really just want to create inflation and reduce the real value of the debt.

The problem I see unfolding is that the economy is expanding and will continue to expand in 2011, but it will not expand in such a way as to stimulate sufficient income growth and wealth creation so as to lower the debt loan many people are bearing. As a consequence, the further liquefying of the banking and financial markets will just benefit those who are not too highly leveraged…generally the financially better off in society…and continue to depress those who are highly leveraged.

In terms of economic growth, the economy is expanding. However, by historical standards, the year-over-year rate of growth of real Gross Domestic Product is substantially below the general recovery pattern. In the year-over-year rates of growth in 2010 were 2.4%, 3.0%, and 3.4% in the first, second and third quarters, respectively. Historically, at this stage of the recovery, the growth rates are usually much greater.

The problems come when we observe some very basic facts with respect to economic performance. First, although Industrial Production has recovered from the lows reached during the recession it has not come close to reaching the peak it attained before the recession set in. Second, the capacity utilization of our manufacturing has recovered, yet it still lies well below its previous peak (which is the lowest peak achieved since the statistical series was begun in the 1960s). Finally, even though unemployment dropped last month, under-employment continues to be extremely high as I estimate that one out of every four or one out of every five individuals of employment age are either unemployed, working part time but would like to work full time, or have dropped out of the work force. This phenomena is captured in the data on the Civilian Participation rate. Note, that this rate is substantially below the level it was before the Great Recession began in December 2007 and is also even further below the level reached before the 2001 recession. Under-employment in the United States has been growing, almost steadily, since the latter part of the 1960s.

Even though corporate profits are rising dramatically, even though many large corporations are acquiring other corporations at a very rapid pace, even though commodity prices are going through the ceiling, even though the big banks are doing very well, thank you, there seems to be a real structural problem in the United States. Liquidity is helping a lot of people but it is not the people we are talking about in this

The "Next Greece" Again

The New York Times business section carries the headline, “Traders Turn Attention to the Next Greece”: http://www.nytimes.com/2010/03/04/business/global/04bets.html?ref=business.

“Is Spain the next Greece? Or Italy? Or Portugal?”

Sounds vaguely similar to another article on the topic, my post of March 1, “Where is the Next Greece?”: http://seekingalpha.com/article/191242-where-is-the-next-greece. But, the subject is in the air these days.

The New York Times article wades into the issue of whether or not the “banks and hedge funds” should be doing what they are doing.

“Indeed, some banks and hedge funds have already begun to turn their attention to other indebted nations, particularly Portugal, Spain, Italy and, to a lesser degree, Ireland.” Aha, the PIIGS, of course without the G.

“The role of such traders has become increasingly controversial in Europe and the United States. The Justice Department’s antitrust division is now examining whether at least four hedge funds colluded on a bet against the euro last month.”

The same concern has been expressed over short sales.

Little concern was expressed about the debt policy of nations, states, municipalities, businesses and consumers when they were piling on massive amounts of debt to their balance sheets.

Of course, nations, and others, have good reasons for loading up with debt. It stimulates the economy and everyone wants prosperity and full employment. Well, don’t they?

Everyone wants businesses to prosper. Everyone wants everyone else to own their own home.

All good reasons for piling on debt.

But, when do “good intentions” spill over into “foolish behavior”?

And, in an environment where excessive amounts of credit are being pumped into the economy (thank you again Federal Reserve)n to spur on housing or some other “good”, shouldn’t it be expected that “extra-legal” means will be used to “get the credit out”.

But, when does serving “societal goals” become fraudulent and hurtful?

The problem in both cases is that there is a very blurry line between the “good” and the “bad”. On the upside, of course, emphasis is placed on the “good” being done, and the “bad” is alluded to but quickly dismissed. A common theme in such periods is that “Things are different now!”

On the other side, however, great pain takes place. One can certainly sympathize with those who live in Ireland, and Spain, and these other countries.

This, however, is just where “moral hazard” raises its ugly head. There is a downside to the excessive behavior of nations, states, and so on! There is pain on the other side of the pinnacle.
And, eventually the pain must be paid for. Bailing out those that used excessive amounts of debt just postpones the situation and usually leads people to behave just the way they did before the crisis. That is, the lesson learned is the one can behave badly and, if there is the threat of sufficient societal pain, little or no cost will be carried forward because of the previous un-disciplined behavior.

The problem is that those in power get mad at the bankers and the hedge funds and try to prohibit them in some way from moving against those private or public organizations that are financially weak. But, in doing so they are taking away a tool that can be used to enforce discipline on those who have lived excessively. The same applies to short selling.

We have seen behavior like that exhibited by the “banks and hedge funds” in the past. The last time these predators were called “shadowy international bankers”, many of whom were pictured as living in Switzerland. In that time the “ bankers” attacked the currencies of profligate nations. France, under the leadership of François Mitterrand, is perhaps the best known example of such a situation. Mitterrand, the socialist, had to pull back from his grand plans and became a believer in fiscal discipline and an independent central bank. Similar cases are on record.

It is disconcerting to see the increased efforts to reduce or eliminate financial tools that help to bring discipline to the market place. If these investment vehicles get punished or face harsh controls and regulations then the world is so much the worse for it.

Yes, I agree, at this stage it looks like the strong are kicking the weak member of the party. But, in these cases we forget that many benefitted greatly on the upside, particularly the politicians that promoted goals and objectives that were underwritten by the undisciplined use of debt. And, the central banks were prodigal in underwriting this credit inflation.

And, now the piper is calling in the debt.

It is a rule of life: those in power that create a given situation are often the most vocal opponents of those that respond to the consequences of what the powerful have created. If you create an inflationary environment fueled by excessive credit expansion then, sooner or later, the price must be paid.
Greece, Spain, Italy, Ireland, Portugal, England, and others are now facing the downside of so many years of “good intentions.” Let’s not just blame, or punish, the “bankers and hedge funds” for creating the situation we now face