To Deleverage or Default? That is the Question

If you get too cold, I’ll tax the heat
− Taxman, The Beatles (1966)

That’s all we have to say about the carbon tax. It’s a pretty minor risk to your wealth compared to other issues right now. Not that you shouldn’t kick up a fuss.

Dan Denning certainly is, over at his newsletter Australian Wealth Gameplan. Except it’s a good kind of fuss. That’s because Dan sees a certain energy industry taking off like a rocket, carbon tax or no, right here in Australia. His video on the matter has already been viewed by 34,719 investors.

And he’s picked the perfect time to spend a few days at a conference in Noosa, meeting the key players poised to take advantage of the vast opportunities. Just this week two major news stories hit the headlines, letting investors know that both ConocoPhillips and BHP Billiton have positioned themselves to profit from the industry that Dan is recommending to his subscribers.

If you haven’t seen it already – and you want to find out how to claim your stake in Australia’s new energy boom – click here.

Stock markets have turned bipolar ever since Bernanke uttered his hint that more money printing may be on the way. On the one hand, things must be pretty bad for him to say whatever he said. (We didn’t read any quotes, as we don’t speak central-bank speak.) On the other hand, more money printing may mean another stock rally.

But it’s a doomed policy as far as economics goes. That’s because the world is going through a stage where more debt is not going to provide more growth. It might merely delay the collapse for a while.

That’s a profound shock to economists. They thought they could manage economic growth by meddling with interest rates – the price of debt. If things look slow, simply lower the price of debt to encourage spending and borrowing. If inflation is too high, increase interest rates to discourage borrowing and encourage saving.

The world’s financial system is designed around this premise. But the central economic planners have stimulated their way to debt levels that cannot increase without costs outweighing benefits. Even with negative yields on US government debt, the economy isn’t being stimulated.

Just to make that clear, investors in one-month US Treasury bills (a type of bond) are effectively paying interest instead of receiving it! And this is happening at a time when the US government is nearing default because of the debt ceiling! For investors to be willing to sit in bonds that cost them money in nominal terms, let alone in real  terms (inflation adjusted), they must be pretty darn scared.

By the way, it’s unlikely the US government will default on bonds on the much hyped day in August when US debt reaches its statutory limit. The government will sooner reduce spending elsewhere than not pay creditors. Citizens are less important than lenders. We learned that from the bank bailouts. But poor Obama made a major gaffe when he admitted this. According to him, it will be Social Security payments that stop if the debt ceiling isn’t raised. This has kicked off a major controversy in the US, because he seems to have admitted that Social Security is nothing more than a taxpayer-funded redistribution system. That would be like finding out your Super has been paid out to your neighbour’s grandparents instead of accumulating in an account somewhere. You see, just like Super here in Australia, Social Security is supposed to have a bundle of assets to sell. So it should be the last government program that stops paying out claims.

The truth is the Social Security system invested in US government bonds, which are like claims on tax revenue. Tax revenue that is falling short in the current budget.

But the US government is not alone in its ridiculous debt schemes. All around the world, people, just like their governments, have simply maxed out on debt. So the choice for both is between defaulting and deleveraging. Do you go into bankruptcy or face austerity?

This is a global problem, so don’t think yourself immune. Just because Australia’s public debt is comparatively low, we don’t avoid the risks. Apart from our high private debt being a problem in itself, our prosperity is reliant on countries which have terrible balance sheets. Both in the private and public sector. They are Greeces and Irelands waiting to happen.

The end of the debt cycle will be very difficult to avoid on an individual level too. You may have very little debt personally, but your employer or business relies on credit-fuelled customers. Take that away and you will face difficulty too.

A third dimension is that many companies operate under significant leverage. Without debt their return on equity would be dramatically diminished. Many of these companies are not worth running without high leverage. In a world where debt has become a problem and companies are trying to raise capital, you might have to prepare for sub-par returns for some time to come.

Looking back at history, this point in the debt cycle appeared to have been reached several times.

British Prime Minister James Callaghan said in 1976:

We used to think that you could just spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you, in all candour, that that option no longer exists; and that insofar as it ever did exist, it only worked by injecting bigger doses of inflation into the economy followed by higher levels of unemployment as the next step.’

But the Keynesian game of stimulating, reacting to inflation, stimulating and so on continued regardless. UK Prime Minister Margaret Thatcher’s policies were only a small respite. And US President Ronald Reagan’s rhetoric proved hollow. Former Federal Reserve Chairman Paul Volcker, the man who slayed the inflation dragon of the 1970s, has lost his inflation-fighting spirit. Lord Maynard Keynes has been the comeback kid of the last 20 years in economic circles. Now, though, the authorities can’t even seem to manufacture the inflation that inspires a spurt of growth. At least not growth that translates into jobs. Their efforts to do so have been less and less successful for some time now. Recoveries in job markets have been growing slacker each time the central banks come to the rescue.

This time around, with QE3 in Bernanke’s sights, you can expect nothing but another short-lived equity rally. Which Aussie equity investors don’t get to take part in because the Aussie dollar absorbs all the gains. (As your editor writes this, his colleagues sitting opposite are unpacking online shopping deliveries from the US. Apparently a high Aussie dollar offers significant savings, much to Australian retailers’ demise.)

So, now that the old short-term solution of borrowing and printing money isn’t shaping up – and more of the same only makes the problem worse – this question becomes the key; default or deleverage?

Many Americans chose the default option when it came to crunch time on their mortgages. The repercussions of this are still unfolding. Just how slowly is an indication of how bad the problem is for banks. In Europe, austerity is being attempted by governments. That’s failing for the most part because the point of no return was passed many years ago. China managed to engineer a significant spurt of growth to avoid the financial crisis, but that looks like topping out too now. And debt levels are as horrendous as they are shrouded in mystery.

There is a third option to defaulting and deleveraging. Well, it’s sort of a combination of the two. By inflating away the value of money, debt becomes more manageable. But, as Prime Minister Callaghan pointed out in the quote a few moments ago, that leads to more problems down the road. Not to mention the danger of hyperinflation. Considering the pitiful effect of money-printing policies so far, the amount of monetary stimulus needed to kick off some serious inflation would be immense.

This is the first time the entire world has been on much the same footing. Countries are either overleveraged or tied to countries that are. That’s why the symptoms are so widespread. Many American states are facing bigger budget disasters than Greece.

The oddest thing about how the top of a debt cycle plays out is just how ironic the policy responses are. What caused the crisis? Interest rates too low for too long. What is their solution? Lower for longer. In countries like Greece, there is too much debt. The solution is to lend to Greece. Companies that are too big to fail have been merged with other companies. And debt that was explicitly not government guaranteed became government guaranteed.

Two academics who have studied the history of situations comparable to today, Rogoff and Rheinhart, recently wrote the following in an article on Bloomberg:

While we expect to see more than one member of the Organization for Economic Cooperation and Development default or restructure their debt before the European crisis is resolved, that isn’t the greatest threat to most advanced economies. The biggest risk is that debt will accumulate until the overhang weighs on growth.

Based on how poorly economic stimulus is performing, the bigger risk of incurring too much debt to grow out of has already been fulfilled. We are at the peak of a debt cycle. But why the focus on debt cycles? Look at it this way. Money may be created by governments, but it is multiplied by banks and their fractional reserve system. Each time a bank lends, it creates new money. Therefore, money is debt.

If you study money, you are studying debt. And, as money is half of (almost) every transaction and the government’s main policy tool (in a fiscal and monetary policy sense), a study of debt is very comprehensive. At least in terms of the state of an economy. And so, as debt goes down, so will the economy.

We promised to take on the political right in this weekend’s Daily Reckoning.   And readers tried to help out with what ‘the right’ actually is. After reading the comments, our confusion only grew.

Some helpful efforts included:

‘Right means correct.’

‘In the Parliament if you look down the isle at the Speaker in the Middle, those on your Left are the Right & those on your Right are the Left. Make sure you are facing the Speaker when doing this test.’

‘My definition of right is the same as for left. Both equal central planning/ infringement of civil liberty. Both result from the prime premise that “they know best” and the citizen is stupid. Western democracies are stuffed because we now are all driven by central planning twerps.’

‘Forget about Left or Right in politics – let us get rid of politicians altogether.  I strongly feel we would all be much better off without any government.  I’m sure there are entrepreneurs out there who would be happy to take on all the roles our government handles and do a much better job into the bargain.  And the competition would be so healthy. The question is – Do we really need a government?  I don’t think so.’

Until next week,

Nick Hubble
Markets and Money Australia Weekend

Nick Hubble
Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like.

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6 Comments on "To Deleverage or Default? That is the Question"

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A free market with no government or similar monopoly/central power would require every participant respecting one another’s property rights. A utopia.


“A free market with no government or similar monopoly/central power would require every participant respecting one another’s property rights. A utopia.”

Or maybe just respect one another’s right to bear arms.


Yes respect for all so called rights.

How long does it take in utopia before one individuals self proclaimed rights clash with those of another?
Since the world is not a utopia and human nature giving rise to the outcomes it does, the answer is, very quickly.
People coalesce looking for solutions…the seeds of central authority.

Q. if most goods are made in say china or india (yes?) then putting more and more money into US economy should just mean more money ultimately goes to china and india and so on etc. If the former leaders in making stuff like USA and Europe now send all their industries to china etc where does it really lead them? Cheaper toys, TVs and stuff for a few decades or more perhaps but then in this game of World Monopoly the Mayfairs and Park Lanes are ultimately those who make all the stuff and as far as I see… Read more »
Ned S

“How can our kids get jobs making TV’s ( figuratively speaking) when 10 ++ people in some other place can work on it for the same wage?”

By working for the same wage as them I would have thought?

Comment by Ned S on 18 July 2011: “How can our kids get jobs making TV’s ( figuratively speaking) when 10 ++ people in some other place can work on it for the same wage?” By working for the same wage as them I would have thought? With Australias’ high taxes, charges, red tape and on-costs to employers for having emplyees.. “They” would actually have to work for a lesser wage ;) On costs to employees actual wage can be as high as 40% $20 an hour wage $8 an hour costs to the business… $800pw wages actually cost the… Read more »
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