A Look At Obstacles To Long-Term Recovery

Maybe one of the reasons that I like Ambrose Evans-Pritchard so much is that we tend to see the world through the same lens. That doesn’t mean it’s the right lens just that it’s a similar lens. His most recent column touches on several issues that I’ve also written about.

In his column this week he speaks to a looming capital shortage, the implications of demographics and the distinct possibility that this recession may profoundly alter the world.

The world is running out of capital. We cannot take it for granted that the global bond markets will prove deep enough to fund the $6 trillion or so needed for the Obama fiscal package, US-European bank bail-outs, and ballooning deficits almost everywhere.

Unless this capital is forthcoming, a clutch of countries will prove unable to roll over their debts at a bearable cost. Those that cannot print money to tide them through, either because they no longer have a national currency (Ireland, Club Med), or because they borrowed abroad (East Europe), run the biggest risk of default.

Traders already whisper that some governments are buying their own debt through proxies at bond auctions to keep up illusions – not to be confused with transparent buying by central banks under quantitative easing. This cannot continue for long.

Commerzbank said every European bond auction is turning into an “event risk”. Britain too finds itself some way down the AAA pecking order as it tries to sell £220bn of Gilts this year to irascible investors, astonished by 5pc deficits into the middle of the next decade.

US hedge fund Hayman Advisers is betting on the biggest wave of state bankruptcies and restructurings since 1934. The worst profiles are almost all in Europe – the epicentre of leverage, and denial. As the IMF said last week, Europe’s banks have written down 17pc of their losses – American banks have swallowed half.

“We have spent a good part of six months combing through the world’s sovereign balance sheets to understand how much leverage we are dealing with. The results are shocking,” said Hayman’s Kyle Bass.

Earlier this week John Jansen at Across The Curve described the treasury market like this, “The bond business is in tatters. There are fewer players and there is less balance sheet available for those who would counter these flows.” While the reasons for this state of affairs are varied, the fact is that the deepest fixed income market in the world is a shadow of its former self. It’s obvious what that implies for rest of the markets.

Evans-Pritchard then asks the question of where the $6 trillion in capital is going to come from and, more importantly, how is it going to be paid back.

The National Institute for Economic and Social Research (NIESR) said last week that since UK debt topped 200pc of GDP after the Second World War, we can comfortably manage the debt-load in this debacle (80pc to 100pc). Variants of this argument are often made for the rest of the OECD club.

But our world is nothing like the late 1940s, when large families were rearing the workforce that would master the debt. Today we face demographic retreat. West and East are both tipping into old-aged atrophy (though the US is in best shape, nota bene).

Japan’s $1.5 trillion state pension fund – the world’s biggest – dropped a bombshell this month. It will start selling holdings of Japanese state bonds this year to cover a $40bn shortfall on its books. So how is the Ministry of Finance going to fund a sovereign debt expected to reach 200pc of GDP by 2010 – also the world’s biggest – even assuming that Japan’s industry recovers from its 38pc crash?

Japan is the first country to face a shrinking workforce in absolute terms, crossing the dreaded line in 2005. Its army of pensioners is dipping into the collective coffers. Japan’s savings rate has fallen from 14pc of GDP to 2pc since 1990. Such a fate looms for Germany, Italy, Korea, Eastern Europe, and eventually China as well.

So where is the $6 trillion going to come from this year, and beyond? For now we must fall back on the Fed, the Bank of England, and fellow central banks, relying on QE (printing money) to pay for our schools, roads, and administration. It is necessary, alas, to stave off debt deflation. But it is also a slippery slope, as Fed hawks keep reminding their chairman Ben Bernanke.

Aging populations, shrinking economic output and soaring deficits do not make for a tenable economic environment. In fact, they almost ensure default in some form or manner. Mr. Evans-Pritchard throws into the equation of soaring public debt the very real possibility that governments everywhere also face the prospect of massive bank liabilities landing on their balance sheets. The problem is especially acute in Europe where banks have under reserved for whole loans and the bank’s balance sheets were allowed to grow to levels that dwarf the economies of their home countries.

The conclusion he reaches is pretty stark.

Great bankruptcies change the world. Spain’s defaults under Philip II ruined the Catholic banking dynasties of Italy and south Germany, shifting the locus of financial power to Amsterdam. Anglo-Dutch forces were able to halt the Counter-Reformation, free northern Europe from absolutism, and break into North America.

Who knows what revolution may come from this crisis if it ever reaches defaults. My hunch is that it would expose Europe’s deep fatigue – brutally so – reducing the Old World to a backwater. Whether US hegemony remains intact is an open question. I would bet on US-China condominium for a quarter century, or just G2 for short.

I would argue that Europe’s deep fatigue as well as the structural inadequacies of its economic construction have already been exposed. As for China, you may know that I am a skeptic. To my mind that country has significant structural problems yet to overcome and is in a race with its demographic time bomb (maybe the worst of any countries in the long run).

China’s reserves can see it through this crisis and maybe come out the other end as a junior partner to the U.S. Whether it goes beyond that will be determined by its willingness and success in conquering its internal issues.

As for the U.S., Evans-Pritchard is probably right about our demographic advantage. Additionally, working off of a $14 trillion GDP gives the country an enormous size advantage. The sheer momentum of the economy cures a lot of ills. The trick will be to move America back into to some sort of sustainable growth mode. If the world as a whole or even significant parts of it lag behind then that will be a tall order.

It’s not written anywhere in stone that sovereign defaults and slow or no growth are to be the order of the day. At the same time most countries will come out of this with enormous debt, crippled financial systems and still captive to their demographic fate. A tough set of circumstances.

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