A Measured View of the Debt Crisis

Edward Chancellor, the financial historian now working for Jeremy Grantham's fund management company, has done more than anyone to illuminate the imminence and consequences of the global debt crisis. In his most recent White Paper on the subject, he picks a measured path through the thickets of what soveriegn debt problems mean for economies and for investors. Among the key points I picked out from his eight page study are these:


1. Rapid increases in sovereign debt don't have to lead to default or high inflation, although more often than not they do. One classic example is Britain after the Napoleonic wars. More recent examples, we know, include Sweden, Finland, and Canada in the 1990s. Swedish gross government debt fell from a peak of 84% of Swedish GDP to below 45% within three years.

2. Inflation and/or currency debasement is however more often than not the way out. It is politically more convenient and generally the easier option. Sometimes, when things have really deteriorated, it is the only option. Because repaying debt rewards the wealthy at the expense of the poor, devaluing the currency is, to borrow a phrase from Keynes, “the line of least resistance… it is, so to speak, nature’s remedy, which comes into silent operation when the body politic has shrunk from curing itself.”

3. The biggest problem today is that many countries today have very large structural budget deficits that cannot be fixed as readily as Britain was able to solve its Napoleonic war debt. The largest structural deficits, according to the Bank for International Settlements, are in the UK (10% of GDP), US, Ireland and Japan. What is more, these calculations exclude both the growing burden of unfunded liabilities such as pension and healthcare costs, which as we all know are enormous, and the bank guarantees given during the recent crisis.

4. A further problem is that large proportions of the outstanding debt of the worst affected countries are held by foreign investors. For Ireland, the Netherlands, Spain and France, the figure is around 60%. In the case of the USA, it is nearly 50%. In the case of the UK, it is around a third. This matters because, if you are looking for comfort from historical experience, in those cases where excessive levels of debt have been successfully reduced to more normal levels, most of the debt has been held domestically, reducing the risk of destabilising capital outflows and/or currency collapses.

Chancellor makes the valid point that it is easy, but wrong, to extrapolate naively from the cases of Japan (since 1989) and the Club Med countries in Europe (today) to argue that a calamitous debt implosion is likely or imminent in every heavily indebted country. The Club Med countries, Spain, Greece and Portugal, for example have specific problems, such as a lack of competitiveness ( exacerbated by their membership of the eurozone), which put them in a different category to the UK and United States. Fiscal retrenchment is already underway in the UK and other countries and may yet, if combined with renewed economic growth, produce an acceptable outcome.

There are simply too many unknown variables to make a definitive forecast of how the sovereign debt crisis will play out possible. The risk of policy errors remains high. Nobodyknows whether the political will to make painful but necessary decisions will hold. In 19th century Britain, when both wealth and political power were concentrated in the hands of a small landed minority, the owners of the debt had fewer qualms about imposing rising unemployment and poverty on the majority to safeguard the value of their debt.

For investors, the important message from Chancellor's analysis is that owning bonds of indebted countries at current prices can only make sense if you are convinced that the worst outcome is where we are heading. In his words, "under only one condition – that the world follows Japan’s experience of prolonged deflation – do they offer any chance of a reasonable return. But this is not the only possible future. For other outcomes, long-dated government bonds offer a limited upside with a potentially uncapped downside. As investors, such asymmetric pay-off profiles don’t appeal to us".

To which I would only add: nor me. Until or unless it appears that the extreme deflationary case is coming to fruition, which is not impossible, but a low probability outcome, I would judge, the safer bet is still that inflation is coming our way. When it does happen, history suggests, it can happen very quickly. How much and how soon are the unknowns. A copy of the White Paper is attached. Recommended.