“Greek banks have lots of Greek sovereign debt on their balance sheets (which is exacerbating their financial insolvency), so did other European banks in 2010 and prior. I am thinking that all the world’s banks (whose deposits are mostly guaranteed by their governments), as a matter of safety and soundness and because it is a serious conflict of interest, SHOULD BE PROHIBITED from owning their countries’ (or others in a group, like the Euro zone) sovereign debt on their balance sheets…

…It would also have the positive effect that the private banks would not be forced by government financial regulators to fund their countries debts/deficits at non-market terms. Think about it. Who in their right mind would be buying U.S. Treasury bonds today, given the market for them has been massively distorted by the Federal Reserve’s QE/monetary policies and their historically low yields (as a result), unless they were forced to do so by their government’s financial regulator? Don’t believe me? Read the article below.”, Mike Perry, former Chairman and CEO, IndyMac Bank

“That leaves one other tool: to reduce debt ratios. If central banks can keep real interest rates low, and even negative, then even debts over 200% of GDP can be sustained indefinitely. While this might raise inflation, that would actually be welcome, as inflation is currently too low and higher inflation would, by raising the dollar value of GDP, cut the debt ratio. Of course, savers must be persuaded to accept such paltry returns. After World War II, capital controls and other forms of “financial repression” gave savers little alternative. Nowadays, Ms. Reinhart has noted, this is more likely to come in the guise of prudential regulations that require banks and pension funds to hold more government debt.”, Greg Ip, “Greece’s Lessons for an Indebted World”, The Wall Street Journal, July 16, 2015

Economy

Greece’s Lessons for an Indebted World

To avoid default, countries with historically steep levels of debt will need growth, austerity, low interest rates

By Greg Ip

Sovereign defaults are like cockroaches: There’s seldom just one.

Greece’s debts are so high, its recession so deep and its economy so uncompetitive, it’s easy to play down the lessons it offers to the rest of the world.

But while Greece is exceptional, the entire world is suffering from an overhang of debt. Since 2007, public debt in advanced economies (including national, state and local governments) has risen by 35 percentage points of total economic output, according to the McKinsey Global Institute. In many countries it has risen by far more: 47 points in Italy, 50 in Britain, 63 in Japan, 83 in Portugal.

A country can shed such steep debt several ways: via austerity, economic growth and low real (that is, inflation-adjusted) interest rates. More common than appreciated, though, is the more radical step of restructuring debt by reducing interest, lengthening the maturity or slashing the amount owed.

“Will Greece be the last sovereign debt restructuring of this cycle? No,” says Susan Lund of McKinsey. “Look around the world and you can see other countries with very toxic combinations of high debt and low growth.”

In their 2009 history of financial crises, Harvard University economists Carmen Reinhart and Kenneth Rogoff observe that “country defaults tend to come in clusters.” In the 1930s, the Great Depression triggered defaults throughout Europe and Latin America. In the 1980s, plunging commodity prices triggered a wave of defaults by emerging economies that had borrowed heavily from Western banks.

Noteworthy defaults this time around have been rare: they include Greece, Cyprus and Argentina (the latter linked to its prior-decade restructuring). The quietude is unlikely to last. Ukraine is now seeking to restructure its debts to private investors, as is Puerto Rico (which, to be sure, is not a sovereign country). Opposition politicians in Ireland, Spain and Italy have in the past pressed to restructure some of those countries’ debts, which according to McKinsey stood last year at 115%, 132% and 139% of gross domestic product, respectively.

Mr. Rogoff cautions against assuming a wave of defaults is coming. Similar fears surrounding Argentina’s default in 2001 proved unfounded. The feared contagion from Greece has not occurred, he notes. Commodity-dependent emerging economies hit by China’s slowdown have been cushioned by flexible exchange rates.

And countries that have borrowed in their own currency, such as the U.S., Japan and Britain, need never default, since they can, if needed, print the money.

Nonetheless, these countries must still find some other way to whittle away their debts.

By far the least painful is via economic growth: An expanding economy automatically reduces the ratio of debt to the whole of the economy and generates tax revenue to shrink deficits. Economic growth has been key to deleveraging in the past, from the U.S. after World War II (when debts had reached 121% of GDP) to Sweden and Canada in the 1990s and 2000s.

Sweden and Canada were able to offset the pain of budget cuts by letting their currencies drop and exporting to other countries. That won’t work if every country is trying to offset the pain of deleveraging by exporting more at the same time.

In the 1950s and 1960s, the U.S.’s underlying “potential” growth was bolstered by brisk expansion in the labor force and productivity. By contrast, potential growth around the world is now slipping.

This has been an underappreciated contributor to the global debt problem. For example, one reason the International Monetary Fund is so pessimistic about Greece’s ability to repay its debts is that, given historically weak productivity and a shrinking working-age population, its potential growth is likely negative. A similarly toxic combination of shrinking GDP and budget deficits has pushed Puerto Rico to the breaking point. Italy’s economy is the same size as it was in 2000.

This week the Obama administration slashed projected U.S. growth for this year, and now sees the federal debt, which it once thought would fall steadily, stuck above 74% of GDP for the coming decade.

Declining long-term growth means more debt reduction will have to come from reduced spending or higher taxes. But too much austerity too soon can make matters worse by reducing GDP, and fuel a political backlash that kills the effort.

That leaves one other tool: to reduce debt ratios. If central banks can keep real interest rates low, and even negative, then even debts over 200% of GDP can be sustained indefinitely. While this might raise inflation, that would actually be welcome, as inflation is currently too low and higher inflation would, by raising the dollar value of GDP, cut the debt ratio.

Of course, savers must be persuaded to accept such paltry returns. After World War II, capital controls and other forms of “financial repression” gave savers little alternative. Nowadays, Ms. Reinhart has noted, this is more likely to come in the guise of prudential regulations that require banks and pension funds to hold more government debt.

The good news, then, is that there is a way out of today’s crushing debts other than default: It will take some combination of growth, austerity, and (for savers) punitively low interest rates. And, adds Ms. Lund: “It takes 40 years.”

Posted on July 21, 2015, in Postings. Bookmark the permalink. Leave a comment.

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