Sovereign Debt: Waiting to blow

As the global economy completes is latest weak lap around the track, worries abound on different sides of the stands—on one, concerns focus on deflation; while the other side frets about inflation.

But the real worry may be that policymakers are treating a solvency problem like a liquidity problem. Liquidity means central banks are injecting money into the financial system, and the question among many economists is whether they’re providing the right amount: too little, and we go back to the Great Recession, or what has been called the iDepression, due to electronic unemployment payments and food stamps. Too much, and the gold bugs start stocking up on canned beans, small arms and mountain redoubts.

But what if the problem is solvency? Deflation certainly worsens debts, but inflation won’t cure them either. The debts are non-performing and bankruptcy is the solution.

That’s the argument made by Alex Jurshevski, founder of Recovery Partners and Beat Guldimann, founder of Tribeca Consulting Group. Both spoke at the Exchange Traded Forum in Toronto on Monday, an event organized by Radius Financial Education.

The debt track record Sovereign debt looms large for Jurshevski, who once served as an advisor to New Zealand’s government when it committed to austerity in the 1990s. He’s seen only two countries cull their debt significantly: New Zealand and Canada. That’s out of 140 or so attempts by various governments. “The track record isn’t necessarily very good,” he says.

And it isn’t likely to get better. Although G20 countries have pledged to halve their deficits by 2013 and stabilize their overall debt to GDP by 2016, three reasons make that unlikely according to Jurshevski.

First, most of the population doesn’t realize that the social contract is broken—expenditures are too high and tax revenue is too low. Second, the political elites themselves aren’t in agreement on the issue, playing what amounts to political football. Thirdly, no plan with explicit targets exists to measure the government’s progress, whoever the ruling party might be.

“You need a lot of time,” Jurshevski says. “They cut across electoral cycles… it’s very difficult for governments to sustain the political support they need to keep these austerity programs going.”

Government action is another issue. Devaluation of the currency leads to international competitiveness, providing everyone isn’t doing it at once. For Greece, which is bound to the euro, devaluation isn’t an option. “If you’ve got a lot of countries in the fiscal hole and they’re all trying to do that at the same time, someone’s going to wake up and say, jeez, we can’t all do this at once. It’s a zero-sum game.”

This is as true of the United States as it is of Iceland. “Reflation” isn’t going to help, Jurshevski says, as debt loads approach post-Second-World War levels. That’s because the growth drivers are different—and anemic. The developed world faces aging populations who will pay fewer taxes than in their working lives while drawing on more resources.

Do defaults loom? Because of this, sovereign defaults are possible in several countries, like Portugal, Ireland, Iceland, Greece and Spain. The U.S. is not likely to default on its debt, largely because its population and political class refuse to admit the enormity of the country’s problems.

“The U.S. is technically insolvent,” he says. Were one to add to the official debt all the off-balance-sheet debt, including Medicare and Social Security, then the U.S. debt-to-GDP ratio would be 540%.

Some European countries are in similar straits. But, while they no longer meet criteria for belonging to the euro, they probably won’t be kicked out, says Guldimann. Restive Germans, however, are looking fondly at the stability of the Mark.

Part of the problem, says Jurshevski, is that European Central Bank and International Monetary Fund decisions and arrangements that eased Greece’s debt blow protected the banks that lent to the country.

In the U.S., the banks are carrying “tremendous loan losses on their books,” says Jurshevski. To re-liquefy the economy, he thinks the U.S. first has to let those banks fail.

Otherwise, he suggests buying corporate bonds—at least there are tangible assets behind them.

“People have this illusion that sovereign debt is safe,” adds Guldimann, But, he argues, “corporations are probably safer than some governments.” So, perhaps, is gold.

But will the U.S. default? No. “You just start printing money [and] you just keep buying it from yourself.” The U.S. Treasury is selling bonds to the U.S. Fed to fund government operations. The U.S. Fed sells them on the open market, but under quantitative easing. Lately the Fed has been the marginal buyer, a situation Guldimann likens to a “state-sponsored Ponzi scheme.”

This program will continue until U.S. politicians take government debt seriously, establish a consensus and communicate that debt management policy to the public.

But Jurshevski doesn’t think that will go over well. Not with 100 million Americans—one-third of the population—dependent in some way on government. With numbers like that, political gridlock is the likely outcome.

Scot Blythe is a Toronto-based freelance financial journalist.

(10/27/10)