EurAnalysis

This week we read that Greece indeed wants private investors to agree to a 90% write-off. Soon it will be public bond holders like the ECB that will take haircuts.

No country starts borrowing money with the thought that they will keep on borrowing until there is an economic collapse. It all starts with good intentions. No bank lends money not expecting to have it returned. Then things change over time. Since there seemed to be no problem with the current level of debt (and spending), why can’t we increase it a little more?

There are countries that can keep their budgets and debt under control (like Switzerland and others). But politicians like to promise benefits today and pay for them with debt that future generations must incur (like the US and countries all over Europe). Or they try to spend their way to prosperity and growth (like Japan).

And of course they promise that “in the very near future” they will get the deficits under control. “We will grow our way out of the problem. We will limit the growth of spending next year, when the economy is better. We can always raise taxes on the rich. Or increase consumption taxes. Or create some taxes somewhere.” Whatever it takes to convince the bond market to keep on funding their spending.

And so the choices to provide this benefit and that program, each justified by some reason and desired by some group of voters, add up over time. Everything goes well until there is a recession. Then revenues go down and costs go up, because unemployment benefits rise. But because the natural business cycle leads to recovery and growth, things soon get better and the game continues.

But then the accumulated debt becomes too much to handle when the next recession comes along. And bond investors lose confidence and the Bang Moment has arrived. Cochrane shows that there is no magic number or formula, no way to know in advance when that moment will be. Unless a country chooses to deal with the pain of cutting spending and raising revenues, eventually there is a true crisis, resulting in massive dislocations and losses. Bond holders lose a large percentage (if not all) of their investments. That moment is often precipitated by a credit or banking crisis. And when the banking system freezes up, businesses lose access to capital, and the recession can turn into a depression if not dealt with aggressively. But that means pain.

Let’s jump ahead to an illustration we will refer to again later. In the late ’70s, inflation in the US rose to over 14%. I remember borrowing money at 18%. The stock market lost about 40% in just 18 months. Unemployment was high and rising.

CONCLUSION !!!

The Time for Hard Choices
Most nations in the “developed world” are coming to, or are already at, the end of their Debt Supercycle. They will soon lose their ability to borrow money at low rates, absent a demonstrated ability to control their budgets. An abilitythat almost none has shown. And when you look at the cost of the promises made to an aging population for healthcare and retirement benefits, the future costs are staggering. There is no way such promises can be kept. And one by one, with increasing frequency, countries will find their interest rates, the cost of servicing their debt, of getting people to buy their bonds, will rise to the point where, absent a central bank willing to print money in massive quantities, their budget and economy will collapse. Banks that have “invested” in huge amounts of sovereign debt will see their capital wiped out, seemingly overnight.

In Europe in the past few weeks, almost €500 billion has been deposited at the ECB for a return of 0.25%. The interbank market, when it functions, will pay 0.40%. Why would a bank take less money from the ECB? Because they can’t get other banks to lend them the money.

Banks no longer trust the ability of other banks to pay them back. UniCredit in Italy is raising money at a 40% discount to their already depressed stock price. They will not be the last to be forced into such choices. The credit markets are telling us there is a crisis in the making, on the scale of Bear Stearns or Lehman in 2008, except that now governments have less ability to step in and salvage the banks. Now, government debt is the problem.

Just as you can’t solve the problem of being drunk with more whiskey, you can’t solve a debt problem with more debt.

But that means hard choices. And the choice right now, is how long should this letter be?

I think we are at a good breaking point, so next week we will look at why the choice in Europe is between recession now or depression later. We will take a look at periods of deleveraging in the US in the 19th century, and see what happened. While there were indeed massive dislocations of the economy and huge investor losses, a few good lessons were learned and applied, until recently. We will look at what choices countries can make. Some, like theUS, still have a viable path to control their bond markets and avoid a depression or major recession; but there will be pain. Think Volcker. Others simply will get to choose between what type of depression they want: short and deep or long and exhausting.

Will the Greeks become debt slaves, working for an entire generation at reduced wages to pay their debt and remain in the eurozone, or will they leave and suffer very large currency losses and the loss of access to the credit markets? Not a very good set of choices, but that’s all they have, unless they can convince German taxpayers to fund their deficits and rising costs ad infinitum. Good luck on that one.

Link:

http://www.johnmauldin.com/images/up.../mwo010712.pdf

We are entering Unchartered Waters And Anything Is Possible...