Government debt’s Minsky-ish moment
If government debt is the new subprime, it may just turn out that Greece is a Florida condo while the United States is a single-family house in a nice mid-Western suburb, the kind of place that fell 15 rather than 50 percent.
In considering the Greek, or European, sovereign debt crisis, the common line of argument, which is true if incomplete, is that the U.S. is far more different than similar; it possesses its own currency, which just happens to be the world’s primary reserve unit, its economy is stronger and more flexible and its institutions better developed and more credible.
All true, but there is a funny feeling that investors, prompted by Greece but also having looked at better credits like the U.S., are doing a fundamental reevaluation of the risks of lending to governments. This may end at Greece, it may end at Portugal, it may end at Britain, but it is not over yet.
“The media may see the contagion to Portugal and Spain as attributable to ‘speculators’ taking on a new target, but in reality, it’s about creditor concerns about the value of their loans and the credit risk of their sovereign and financial counterparts as the European credit boom of the last decade collapses,” George Magnus and Andrew Cates of UBS wrote in a note to clients.
“And it’s about the desertion of confidence that governments are taking control of economic and financial events. It’s Minsky all over again, this time with sovereign debtors.”
Economist Hyman Minsky theorized that financial markets were prone to speculative bubbles, and that these culminate in a final Ponzi stage where borrowers cannot even meet the interest payments on loans and must rely on new borrowings or asset sales.
A “Minsky Moment,” a term coined by Paul McCulley of Pimco, happens at the latter stage of a bubble when some shock prompts lenders to come to their senses. They withdraw credit and a cascade of asset sales takes place as both Ponzi borrowers and the rest of us try to meet loan obligations with the wasting currency of a deflating asset of one type or another. In the end good and bad borrowers alike cannot get adequate credit and deep economic damage is done.
This is certainly a very good way of looking at the housing bubble; borrowing to speculate on assets eventually toppled the system in a Minsky Moment and, but for the intervention of big government, the wheels of the global economy would have seized up entirely.
CAUGHT IN A DEBT TRAP?
It is a less exact fit for the evolving sovereign lending crisis, though there are some interesting parallels.
It is surely the case that lenders to sovereigns, who for years kidded themselves and us that there was such a thing as a “risk-free” rate that could serve as a jumping off point for other, presumably juicier, investments, are now having, if not a Minsky moment, a bit of a Minsky flashback.
For countries such as Greece, it is obvious that without massive changes, repayment was not going to happen.
It is not just Greece; on current OECD forecasts, industrialized countries as a whole will have 2011 debt-to-GDP ratios approaching 100 percent, something unprecedented in time of peace. Japan will be well above 200 percent and the U.S., for all its differences, should hit 100 percent.
As Magnus and Cates point out, many are flirting with a debt trap. A debt trap happens if there is an ongoing primary budget deficit and, crucially, countries pay a higher real interest rate on government debt than their rate of GDP growth. Meet those criteria and debt just becomes harder and harder to manage.
For the U.S. the 2009 real average borrowing cost was just over 4 percent, while GDP growth in the first quarter of 2010 was 3.2 percent. Other industrialized countries are in considerably worse situations.
Now, plenty can change. Budgets can be brought into line, real interest rates can change, as can economic growth. Assuming that there will be the political will and ability to cut budgets throughout the industrialized world, there is a real question as to what that does to economic growth. European austerity will have a moderately large deflationary effect. If Britain joins in, as it seems that it will, that will be magnified.
With this in mind, it is hard to see real interest rates falling. Besides the fact that central banks will have trouble keeping up with the threat of deflation, investors are increasingly imposing additional risk penalties on sovereign borrowers. That can easily spread, even beyond where it is warranted.
As it was with the sober home-owners of Iowa and the speculative flippers of Florida, when the Minsky moment comes everyone suffers, and not always in proportion to their merits.