The dynamics of sovereign debt
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Edward Chancellor’s masterful 10-page essay on sovereign debt crises past and present should be required reading for anybody seriously interested in the “new normal” and the way that sovereign debt dynamics might play out over the medium-to-long term. The whole thing can be found here (warning: 12.2 MB PDF file), or it’s embedded below.
Chancellor does a great job of explaining in a single graph why the PIGS in particular are being singled out for trouble — although in this case the I is very much for Ireland rather than Italy.
What’s more, Chancellor has read his Rogoff and Reinhart thoroughly, and is unafraid to draw smart conclusions from their fantastic trove of data. The main one is that governments nearly always prefer inflation to default — unless and until most of their creditors are foreign, in which case default becomes more attractive. What’s more, the best predictor of future default is simply past default: credit ratios tell you almost nothing. The UK managed to get through debt-to-GDP levels of 240% without defaulting or even inflating the debt away in the early 19th Century, while Russia defaulted in 1998 with a debt-to-GDP ratio of just 12.5%.
More generally, sovereign defaults are by their nature unpredictable. At some point, a country hits a tipping point, and then it’s all over — but no one can tell where that point might be. Greece has already reached its tipping point, which is why it needed the EU bailout; Japan seems as though it might, but it’s not there yet. Notably, the interest rate it’s paying on its debt is lower today than when it was first downgraded in 1998 — despite the fact that the Japanese domestic savings rate has dropped from 9% to 3% over those years, making it harder for Japan to finance its enormous structural deficits.
Chancellor concludes powerfully:
Current yields on government bonds in most advanced economist are at very low levels. 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.
There are still trillions of dollars invested around the world on the implicit basis that sovereign debt is risk-free. It isn’t, and as those investors wake up to the new realities, they’re going to do unpredictable things with their money. Which is a good reason to prepare not only for volatility in sovereign debt going forwards, but also for volatility in just about all other asset classes as well. It’s going to be a bumpy, unpredictable ride.