Stag­na­tion, de­fault or de­val­u­a­tion

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

Last week’s Jack­son Hole meet­ing helped to high­light a sim­ple re­al­ity: un­like other parts of the world, the eu­ro­zone re­mains mired in a de­fla­tion­ary bust six years af­ter the 2008 fi­nan­cial cri­sis. The only of­fi­cial solutions to this bust seem to be a) to print more money and b) to ex­pand gov­ern­ment debt. Mean­while, Europe’s al­ready high (and ris­ing) gov­ern­ment debt lev­els and large bud­get deficits raise the ques­tion whether we should worry about ‘debt thresh­olds’, past which in­creas­ing deficits, and hence grow­ing sov­er­eign debt, no longer add to growth? Such a con­straint could come from one of at least two sources:

1) Once the debt level gets high enough, debt ser­vice costs (even at very low rates of in­ter­est) can eat up so much of the bud­get that it is im­pos­si­ble to spend new money on any­thing else. For­tu­nately, most Euro­pean coun­tries are not at that point. Take France as an ex­am­ple: at roughly ?45 bln (or 2.1% of GDP), debt ser­vic­ing costs are not out of line with its re­cent past.

2) Per­haps more in­sid­i­ously, if the sus­tain­abil­ity of the debt be­comes de­pen­dent on low rates - as in­creas­ingly it is in coun­tries like France - then the gov­ern­ment has a pow­er­ful in­cen­tive to do ev­ery­thing it can to keep rates low so it can pur­sue its ex­ist­ing poli­cies with­out fac­ing the threat of fas­tris­ing debt ser­vice costs. If the price of keep­ing rates low is low nom­i­nal GDP growth, then so be it. This is where Ja­pan has been for some years, and could be where France is now head­ing. Though, wor­ry­ingly for France, when it comes to the sus­tain­abil­ity of debt ac­cu­mu­la­tion, the sim­i­lar­i­ties with Ja­pan may end there.

When look­ing at an over-in­debted bor­rower the most im­por­tant ques­tions should always be ‘ Who owns the debt?’ and ‘Will the owner prove pa­tient or fickle?’ For ex­am­ple, a fam­ily in which a fa­ther lends money to his chil­dren, will, on a con­sol­i­dated ba­sis, have no debt. Ap­ply­ing this anal­ogy to Ja­pan, it seems that Ja­panese savers pre­fer to buy bonds rather than pay taxes (gov­ern­ment debt is noth­ing but de­ferred taxes). As a re­sult, 92% of out­stand­ing JGBs are owned by the Ja­panese them­selves. Thus, in a pinch, Ja­pan could choose to con­vert its re­payable debt into per­pet­ual bonds yield­ing, say, 1%. Even bet­ter, it could trans­form its debt into pieces of pa­per called ban­knotes, which are re­ally per­pet­ual debt yield­ing 0% (per­haps this is what Ja­pan is al­ready do­ing?). An­other op­tion would be for Ja­pan to im­pose in­her­i­tance taxes of 80%, and very quickly the gov­ern­ment debt would melt away…

Of course, such solutions are not con­se­quence free. Fi­nanc­ing gov­ern­ments through debt rather than a func­tion­ing tax sys­tem tends to be de­bil­i­tat­ing for economic growth. Over time it favours the ren­tier above the en­tre­pre­neur (since the only way to find buy­ers for the new debt is for its yield to be higher than the growth rate of cor­po­rate prof­its). As Knut Wick­sell con­clu­sively showed, this pushes the econ­omy into stag­na­tion. Still, Ja­pan has proved that such stag­na­tion is com­pat­i­ble with economic sta­bil­ity. But is the Ja­panese op­tion open to France?

The other al­ter­na­tive to grow­ing debt lev­els is the path trod­den by Ar­gentina, Rus­sia and Greece in re­cent decades. What unites th­ese bank­rupt is­suers is that a ma­jor­ity of their debt was owned by for­eign savers. In­deed, when a coun­try ac­cu­mu­lates too much debt and be­gins to find the roll-overs a grow­ing chal­lenge, it re­ally has just two op­tions: the first is a to­tal or par­tial de­fault; the sec­ond is a large cur­rency de­val­u­a­tion. The sec­ond choice begs the ques­tion ‘Who prints the cur­rency in which the debt is la­belled?’ When a cen­tral bank con­trols and in­de­pen­dently prints the cur­rency, then a de­fault is highly un­likely and de­val­u­a­tion a near cer­tainty (which is what is start­ing to oc­cur in Ja­pan). If the cen­tral bank does not con­trol the cur­rency in which the debt is la­belled, then the only so­lu­tion over time is a par­tial or to­tal de­fault, es­pe­cially if in­ter­est rates are above the nom­i­nal growth rate of the econ­omy (debt trap).

This brings us to Mr. Draghi’s speech at Jack­son Hole, in which the Euro­pean Cen­tral Bank head ar­gued for more fis­cal stim­u­lus and more struc­tural re­forms be­fore the ECB does more to help out Europe’s fail­ing economies. But, at this stage, more fis­cal stim­u­lus in coun­tries like France and Italy would likely mean much higher bud­get deficits and debt lev­els. Given the roll-over sched­ule of the next 18 months, those could prove chal­leng­ing for the bond mar­ket to swal­low, un­less, of course, the ECB is will­ing to em­bark on the same kind of ex­change pro­gram that the BoJ has em­braced in the past 18 months, namely trad­ing 0% in­ter­est rate bank notes for gov­ern­ment bonds. It is a kind of Catch 22: the ECB wants to see more re­form be­fore turn­ing on its print­ing press; how­ever, re­forms with­out growth are par­tic­u­larly tough to de­liver. In­ci­den­tally, this was the pat­tern in Ja­pan for 15 years or so: the Min­istry of Fi­nance pointed the fin­ger at the Bank of Ja­pan for not print­ing enough, and the BoJ pointed the fin­ger at the MoF for the slow pace of re­form in the Ja­panese econ­omy. Re­place MoF with Bercy, and BoJ with ECB and very lit­tle has been ‘lost in trans­la­tion’.

But as we know, there are key dif­fer­ences between Ja­pan and France; dif­fer­ences which bring us to the fol­low­ing con­clu­sions: · In­vestors who be­lieve that the ECB will always step in to pre­vent French spreads from blow­ing out should prob­a­bly con­clude that France is now head­ing down the Ja­panese path: that of an un­der­per­form­ing econ­omy whose tech­no­cratic elite has a grow­ing embed­ded in­ter­est in keep­ing in­ter­est rates low (and thus nom­i­nal growth low), lest a spike in rates trig­ger a fund­ing cri­sis. · In­vestors who be­lieve that the ECB will not always step in to pre­vent French spreads from blow­ing out will have to con­clude that a po­ten­tial debt re­struc­tur­ing lies in France’s future. How­ever, this re­struc­tur­ing is un­likely to hap­pen un­til the ECB de­cides to let France go. And the ECB won’t let France go un­til con­di­tions in Ger­many (most likely higher in­fla­tion) force the ECB’s hand. Hence, this sce­nario is not a near term con­cern.

Very clearly, with OAT yields at record lows, and the euro gap­ping down, the mar­ket is ac­knowl­edg­ing th­ese con­clu­sions. Noth­ing Mr. Draghi said in his Jack­son Hole speech changed this re­al­ity. At this stage, the path of least re­sis­tance is for the eu­ro­zone, and es­pe­cially France, to con­tinue dis­ap­point­ing eco­nom­i­cally, for the euro to weaken, and for Europe to re­main a source of, rather than a des­ti­na­tion for, in­ter­na­tional cap­i­tal.

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