Disclaimer. After nearly 40 years managing money for some of the largest life offices and investment managers in the world, I think I have something to offer. These days I'm retired, and I can't by law give you advice. While I do make mistakes, I try hard to do my analysis thoroughly, and to make sure my data are correct (old habits die hard!) Also, don't ask me why I called it "Volewica". It's too late, now.

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Monday, July 18, 2011

The Debt Doom-Loop

Let's suppose a country (Greece, for example) owes 150% of GDP.  Now let's suppose that it has been paying, say, 4% on 10 year money.  That means that the interest on government debt as a percentage of GDP is 6% (4%*150%).  If tax revenue is, say, 30% of GDP, interest alone will use  up 20% of tax revenue.   Put it another way:  if the government wishes to run a balanced budget, taxes as a percentage of GDP have to be 25% higher than they would have to be if there was no debt.

A moderately parlous situation, but the markets could live with this if they believed the government was going to "trade its way" out of the mess, by for example, running a balanced budget.   Over ten years, real growth of 2.5% and inflation of 2.5% will increase nominal GDP by two thirds.  This will reduce the ratio of debt to GDP to below 100% and the ratio of debt interest to revenue to below 4%.  You don't even need to run a surplus for this improvement to happen.

However, suppose the government goes on running deficits.  Let's suppose its deficit is a modest 5% of GDP.  Let's also assume that its outstanding debt has an average life of 10 years, so that one tenth comes up for refinancing each year.  In fact (bizarrely) most governments have debts with much shorter average lives, often as low as 6 or 7 years, with maturities skewed towards 3 or 4 year paper.  On our assumptions, the government would have to borrow 15% of GDP each year, 10% refinancing and 5% new money.  In practice the numbers would be much higher, because more of the debt would mature each year.

All well and good, as long as the markets trust the government.

What happened in Greece was that the previous (Conservative!) government lied about the level of debt and the size of the deficit (O tempora!  O mores!)  The new government trumpeted the sins of its predecessors to the market shortly after it came to office (instead of keeping quiet and moving as fast as it could to rectify the situation behind the scenes).  The market panicked and the yield on Greek debt started to soar.

At an 8% yield, say, the debt cost doubles as a percentage of GDP.  Not overnight, because only some of the debt is maturing.   On our very conservative assumptions, the Greek government would have to borrow/refinance 15% of GDP each year -- though in practice it could easily be as high as 30% of GDP because of the short profile of total oustanding debt.   That means that the deficit widens by at least 1.2% of GDP more each year that interest rates remain at 8% instead of 4%.  Remember that debt maturities were much shorter in Greece and the deficit much larger.  And that current yields are now 17%.   Suddenly the situation slips out of control. The markets sell more Greek bonds which pushes up bond yields even more, the deficit gets worse, the markets get more frightened ... and wham!  A massive doom loop emerges.

It becomes impossible for the government to "trade its way" out of the crisis.  Tax increases and spending cuts become inevitable.   But this reduces GDP growth, which makes the deficit worse and also makes the market more convinced that the government will in the end be unable or unwilling to honour its debts.  Yields rise again, the deficit gets bigger, another "package" is introduced, things get still worse, etc, etc.  That's where Greece is now.

And that's why most analysts reckon that a government shouldn't let its debt get above 100% of GDP.  At that point the risks of a self-feeding meltdown rise alarmingly.

Chart from http://www.usgovernmentspending.com/index.php
US government debt is perilously close to 100% of GDP.   The Tea Party crackpots want to cut expenditure (while not cutting Medicare, despite it being "socialized medicine").  The Democrats want to raise taxes (while not cutting entitlements).  Either remedy would slow growth, making the deficit worse.   Draconian tax increases and spending cuts now will push the US back into recession.  But reforms in the out years, cutting both spending and increasing taxes would convince the markets that the problem is only temporary.  Right now, it looks as if the US is going down the Greek path of pollies taking no action at all.  Greece is just 0.5% of the world economy.  The US is over 20%.  The risks are obvious.

[As usual, clicking on the chart will produce a bigger image]

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