Don’t Head For The Hills…

Is it something they put in the US water, Matt?

I only have to mention debt default and you and your compatriots talk of heading for the hills, and stocking up on canned food and ammunition.

Our rulers have been reneging on their debts long before and long since Edward III of England refused to pay the bankers of Florence in 1345. They’ve been merrily walking away from their obligations, or sneakily reducing them by clipping coins, for centuries. The US government defaulted in 1933 (when the dollar’s gold clause was abrogated) and again in 1971 (when Nixon abandoned Bretton Woods). The UK government did it in 1932, when there was a forced conversion of War Loan bonds from a 5% instrument into a new bond paying 3½%, and that followed very similar defaults in 1749, 1822, 1834, and 1888/89.

And these are the so-called developed countries. If you look at emerging markets it’s a default a decade, give or take. Among the most likely candidates on my daily email from CMA is Ukraine, headed for a repeat performance of its 1998 default, and Argentina, on course for another one just seven years after the 2002 version.

Incidentally, there’s a great paper on the forgotten history of domestic debt by Carmen Reinhart and Kenneth Rogoff, Professors of Economics at the Universities of Maryland and Harvard, respectively. They show that defaults on debts denominated in the domestic currency have happened far more frequently than is generally known, particularly when associated with financial market crises.

So, adding together that historical knowledge and all the evidence that the 1982-2007 debt bubble was the biggest that we’ve ever seen, you’d be reckless not to anticipate a repeat performance by governments this time.

For the moment, judging by the equity markets’ continuing uptrend and the 2009 rise in commodity prices, it looks as though investors are banking on inflation returning and a reduction in the debt burden occurring that way.

I think it’s going to be very difficult to manage economies out of the credit crunch by the “controlled inflation” route. Bond yields have already risen sharply this year, and if investors really became convinced that inflation were returning we’d see them much higher, still. This is the last thing that governments need, since a rise in the interest burden on the existing stock of debt could easily make their finances unmanageable.

There have been some heavyweight entrants to the inflation camp over recent weeks, too, including Marc Faber and, today, Nassim Taleb, according to the FT. The press is also full of “investing for inflation” stories.

It may be that this theme continues for a few more weeks or months.  But the point of my blog comment on the GM bankruptcy was that substituting public debt for private is not addressing the real issue, which is the overall level of indebtedness. Add it all together, and there’s a whole lot of money owed on an ever-shrinking productive base, and supported (in the case of government bonds) by falling tax revenues. Something doesn’t add up, and I suspect that (early next decade?) we’re going to see massive debt write-downs.

 

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