Deal or no deal, debt drama is not going away

By Mohamed El-Erian
August 1, 2011

Are you tired of all the stories on Europe’s financial crisis and American politicians’ endless bickering about debt and deficits? Are you tired of weekends of hectic negotiations as policymakers rush to cobble together some agreement before markets open? If you are, you are not the only one.

Millions of people, including stressed-out policymakers on both sides of the Atlantic, wish to put these issues behind them. Unfortunately, despite many announcements, they are unable to do so decisively, and for good reason.

So we better understand why, if we want to minimize the risk of collateral damage and unintended consequences.

To do so, you need only remember one rather clumsy phrase: “safe de-levering” (also known to some as “safe de-leveraging”), or the lack thereof. Consider please each word, starting with the second one.

De-levering refers to the rehabilitation of balance sheets that have gotten over-indebted to such an extent that they are unsustainable going forward. The contributing causes are usually numerous and many years in the making.

In Europe, three peripheral countries face immediate and significant de-levering pressures. Greece and Portugal are two of them. They had too many years of irresponsible government spending, inadequate taxation, weak public administration, and insufficient economic growth. The third, Ireland, was fiscally responsible but made the big mistake of using what was a relatively healthy public balance sheet to assume the massive losses of its irresponsible banks.

These three countries now face a buyers’ strike. Lenders have been resisting the renewal of their credit lines and, needless to say, have no appetite whatsoever to provide incremental funding. No wonder interest rates have soared and financing has dried up, other than official bailouts from neighboring countries, the European Central Banks and the International Monetary Fund.

The result is not just a liquidity crisis; but also a solvency one. With government gross debt burdens ranging from 100 percent of GDP in Portugal to 156 percent in Greece, these countries are now embarked on an unpleasant, forced de-levering process.

America’s case is different. Yes, it has a high budget deficit (over 10 percent of GDP) and has experienced a dramatic increase in its debt-to-GDP ratio since the global financial crisis. Yes, the fiscal outlook gets cloudier as a result of a structurally weak budget. But unlike peripheral Europe, it is nowhere near an immediate liquidity crisis.

America’s creditors are more than willing to fund the country at historically low interest rates. Rather, it is political squabbles that have dramatically brought forward medium-term fiscal challenges, and have done so through the use and misuse of the debt ceiling, an arcane but, as we have all found out, a rather lethal legislative weapon.

We should all accept that Europe and America — the former for fundamental reasons and the latter for self-inflicted ones — are now in a de-levering cycle whose consequences will be with us for many years.

The actual process of de-levering can play out rather quickly. Indeed, too fast a de-levering can be catastrophic in terms of its impact on growth, employment and poverty. So you can be sure that policymakers will do their utmost to deliver a safe, gradual process.

The best way to do so is through high economic growth. This maintains living standards and generates incremental income to pay off debt, thus providing an orderly path to medium-term debt sustainability. Unfortunately, this option is not available today to either Europe or the US as both are stuck in what PIMCO has been describing for over two years now as the bumpy journey to a new normal.

Other than some short bursts, Europe and America are unable to sustain the sort of economic recovery that would make a meaningful dent in their debt dynamics. They will remain in this regrettable situation until policymakers become more serious about a comprehensive and coordinated set of measures to remove structural impediments to sustained economic activity — including steps to improve the functioning of the housing and labor markets, better worker retooling and retraining, enhanced education systems, even more bank lending, improved productive infrastructure, etc.

If they are unable to grow out of their debt problems, countries have four other options. Two of these are also available to us as individuals: we can default, and let restructuring lower our debt burdens, albeit in a rather disorderly fashion; or we can implement austerity, spending less in order to generate cash to pay off our debt.

Because countries control the printing presses and write regulations — things that the rest of us do not have or cannot do — they have two additional alternatives. They can try to inflate their way out of the debt, or they can reduce it through years of “financial repression,” that is, paying millions of depositors and creditors much less than they deserve in order to divert funding to debt payments.

Judging from what we have seen so far, governments are opting for different mixes.

The three peripheral European governments are imposing harsh austerity on their populations — remember the riots in Greece? — and also benefiting from the willingness of their European neighbors to financially repress their citizens in order to provide additional official funding. At least one (Greece) is having to go further by also partially restructuring its debt.

America is talking about austerity, including this past weekend’s compromise fiscal framework, but using financial repression. So far, this has taken the form of the Federal Reserve maintaining interest rates at extremely low levels for an exceptionally long period of time — so much so that savers and creditors are paid interest rates that are below inflation, and in some cases, well below inflation.

This will not suffice. Look for America to intensify financial repression through regulations that forces banks and other regulated entities to hold low yielding government securities. Also, it will attempt to generate unanticipated inflation. Ultimately, it will be forced into more painful austerity involving both spending and tax measures.

The de-levering pressures will be with us for years, and governments will mix and match from the menu of options. Accordingly, periodic debt dramas and crises will not go away any time soon. Debt is simply too high and there isn’t enough economic growth to painlessly de-lever.  Each response that governments decide to adopt has different implications for us, as savers, investors, debtors, home owners, and business people (the topic of a future piece).

Unfortunately, none of us have the ability to fully insulate ourselves from the collateral damage and unintended consequences. The best we can do is to understand the process, including what governments will do. In this way, we can try to minimize, though never eliminate, the adverse impact of de-levering.

16 comments

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Wondering what a government will do in these difficulties? Just answer the question, “what would be the stupidest, most short-sighted thing to do, right now?” and you will have your answer.

Posted by Cranios | Report as abusive

If your analysis is right there is a good chance US has finally entered the age of fall and decline – like so many other’s before in history. What’s most disengenuous about Obama and his leadership is that he continues to trap himself in policy cul-de-sacs from which he’s unlikely to make the electorate satisfied…to re-elect him.

But the GOP opposition offers still less confidence to the public with their religious (sacred) cows of capitalism and free market- no taxes!

EU-17 however has lessons of civilization to focus on;
besides what’s in best interest of euro group – going forward. I don’t think even Ms Merkel(CDU) will flinch, inspite of domestic right wing opposition, of what might eventually emerge as a *transfer union* (eg. E Germany).

Thus history moves in waves – as we see now in emerging markets – and we’re perhaps at cross-roads of a global paradigm shift (Tea Party Bolsheviks notwithstanding).

Posted by hariknaidu | Report as abusive

Since confidence is fundamental to the success of any financial/economic system, it matters little what is undermining global confidence in the U.S. The author is correct about how the U.S. is different from Greece.

But the fact that American politics rather than fundamental financial integrity is primarily what is prompting America’s troubles is cold comfort. Confidence is collapsing, regardless of the cause. The author is also correct in saying this is a strategic problem.

When an old order gives way to a new one, things usually get pretty messy. The old order dominated by the developed economies is rapidly giving way to a new order dominated by the under-developed economies. This transformation has already tipped ‘past center’ and cannot now be stopped or reversed. It’s going to be quite messy for everyone, but profoundly more messy for the former dominators than for anyone else.

Posted by NukerDoggie | Report as abusive

People who blame this mess “on Obama” are essentially pulling a P.T. Barnum wiggle on the facts, and to deliberately deceive their readers if not themselves. Our troubles began long before Obama was elected, in spite of the rather silly picture of an inflation-free, balanced budget prior to 2008. If you don’t know that, go to the library and start reading news magazines from 2007, when our current depression began.

We spend over $3 billion per day on Israel. We borrow $4 billion per day for everything. This has been going on more more than a decade now. Fact. Any light bulbs turning on out there? Maybe a solution different from throwing our poor, elderly and disabled into the gutter and not patching potholes?

Posted by txgadfly | Report as abusive

txgadfly: Better check your numbers. Israel gets about $3 billion per YEAR, not per DAY. Big difference. Eliminating aid to Israel would not even make a dent in America’s debt problem.

Any light bulbs going on in your head?

Posted by NukerDoggie | Report as abusive

@Nukerdoggie: The old wheels will go turning again. This won’t be good for developed countries but even worse for emerging markets and BRIC countries. Just wait until all the money starts pulling back. Unfair, yes, but it will be so.

Posted by FBreughel1 | Report as abusive

@FBreughel1: When Treasury Paper goes toxic just like subprime mortgage paper did, then money will flow toward the under-developed economies and stay there.

The entire risk calculation is being rewritten – and not in favor of the U.S. The REAL risk of Treasuries is coming out into the open. Our domestic politics is poisoning our financial assets, turning them toxic. And there’s to be no end to such toxicity anytime soon.

Posted by NukerDoggie | Report as abusive

I suspect Mr. Bernanke understands exactly what needs to be done and is attempting a “soft landing” for our extremely leveraged indebtedness. Growth (consumer spending) is key, as it will reduce transfer payments and increase tax revenue. Yet consumers cannot be induced to spend more as they fear unemployment and impoverished retirement. Confidence in their future is waning, and we now struggle within a liquidity trap. Unfortunately, debt restructuring is likely the only solution, yet requires such political courage that it will not be done orderly. The fuse is lit.

Posted by johnvos | Report as abusive

US Aid to Israel is actually 114 Billion Dollars a year. I don’t know where you’re getting your facts from. Either way that’s not the big issue, but it is an issue nonetheless. However, there are more drastic things going on here. China will take over. The US Government will be hostage to China’s financial and economic power, notwithstanding its currently military build up. Therfore, it’s military power. To sum it up, in 10 years China and the US will have switched roles in the world. Well, The US will be in a lot worse shape than China is now. Can it be saved? Of course. With the correct policies and with the US’s debt to GDP ratio of only 10, the US can get out of this mess if the politicians found out a way to think clearly and come up with new stragies to tackle this unnecessary mess. It is true that Europe is in terribly bad shape, but if the US and China cooperate now, then I believe this whole global crisis issue on our hands can be saved and peacefully as well. Let’s just hope the “who has the bigger biceps?” childish story ends soon..

Thanks Mohamed, you are indeed a great thinker and an achiever in profession. You always illustrate things as they are; and simply too. All people have to do in the end to solve any possible problem on earth is to cooperate. Look how far we’ve reached thus far, this is hardly the greatest disaster humanity has ever faced. We are made to win every battle.

Posted by aelrayes | Report as abusive

Leaders of the developed world economies have to sit down and figure out how to handle competition with low-wage developing countries. Connect these dots and what do you have?

U.S. manufacturing employment has declined from 17 million in 2000 to 12 million today.

China’s share of global manufacturing has risen from 5% in 1996 to 12% in 2008.

The U.S. is running a $650B goods trade deficit, offset by $150 services surplus. This is 10-15 million jobs overseas making U.S. goods. Recall also that a trade deficit requires borrowing to fund it. In essence, the U.S. consumer borrows to fund the trade deficit.

Apple has 25,000 U.S. workers and 250,000 overseas workers. Dell has a similar 10X ratio, as Andy Grove (former Intel CEO) described in a great Business Week article.

If innovation in the U.S. means jobs in developing countries, its time to overhaul the incentive structure that is driving our business.

That is change you can believe in.

Posted by Farcaster | Report as abusive

If the U.S. can’t deleverage its financial liabilities, maybe it should consider selling some assets, such as California. Long ago the U.S. bought the great plains from France through The Louisiana Purchase and bought Alaska from Russia. The sales mechanism is time-tested, safe and part of the U.S. historical tradition.

Posted by 78wwy3Ht | Report as abusive

Our National debt (current) represents 25% of TOTAL world debt FYI and doesn’t include the 10s of Trillions of IOUs for unfunded entitlements, etc, ect etc! Our debt debate has just begun folks! Make the mental adjustment! Honesty is the best policy!

Posted by DrJJJJ | Report as abusive

Until sofar this view hasn’t prevented from U.S. bonds rising in demand. But I agree with you that in the long term there will be a loss one way or another for being in U.S. bonds. Wouldn’t go into Japanese stocks or bonds either.

Posted by FBreughel1 | Report as abusive

Of all the repected analysts out there PIMCO seems to be the one that make the most sense. I’m not an economist but a mathematician and occasionaly what the politicians, press and industry analysts say seem so stupid as to be beyond belief. Correct me if I’m wrong ( I probably am).
Obviously the reason that soveriegn bonds are reckoned to be good investements is that on trend growth, the debt/gdp ratio decreases. Fine. But given that they are fixed return instruments surely a soft default is possible, especially for foreign investors. If there is high inflation in a currency, plus the currency itself falls in value (perhaps two sides of the same coin)then effectively investors have taken a pretty big haircut, yet nobody makes a fuss. As you’ve probably guessed I’m talking about the UK, almost zero growth, rapid inflation and a highly iffy pound. This is not helped by the action of the Bank of England and the MPC, as despite what they are supposed to do they have not increased interest rates, which might have helped bond holders from losing loads’a'money. As I’ve said I’ve no financial background but I’d be interested to hear from someone out there who understands these things as to how much investors have lost in capital over the last two years in UK Govt. bonds.

OK I reckon the UK won’t officially default, but UK creditors are taking a pretty big hit and overseas creditors are hurting even more. Yet no one whinges, why ?

Posted by richiep40 | Report as abusive

And to think that we the people elected those jokers who created this mess.

Posted by rangerfan | Report as abusive

You could just try imposing a one-time wealth tax on those who did this to us all. There’s more than enough in their accounts to free us all of debt. And now I’m going to have to kill myself before anyone else gets the pleasure.

Posted by thisoldman | Report as abusive