How Long, To The Point Of No Return?

Alea posted a paper, and The Big Picture a slideshow on sovereign debts, by the same author.  We have had a blessed period post-WWII, where there have been no defaults of major nations.  But that is not normal.  Nations default on their debts if they get too large, or they repudiate through inflation, or they raise taxes on a docile public.

The main point of the paper is that we are past the point of no return in most major nations, without significant changes that would diminish living standards for some time.  Add the implicit obligations to the explicit debt, and there is quite a mountain to climb.  Defaults are coming, the only question is what nations will default.

I often think that economists need to get out of the math ghetto, and study history.  Math is not capable of capturing nuances.  I write this as one who uses advanced statistical analyses regularly.  History is more robust than mathematical analyses.  Math occludes understanding in economics because it forces a numerical simplification of matters that have more dimensions than are admitted in the analysis.

Are there doubts about this?  Here are some simple tests: How well do macroeconomic models forecast, particularly at turning points?  On microeconomics, what kind of R-squared are they getting when they test the general equilibrium neoclassical model?  Are many of the testable hypotheses are not rejected?  When last I looked, R-squareds were in the percentage single digits, and most testable hypotheses were rejected.

So why do we think that developed nations could not default on their debts?  The book This Time is Different, should disabuse such notions.   Major nations have often defaulted on their debts.  It is regrettable, sinful, but normal.

Personally, I think that all of the developed nations as a group have gotten lazy, and also do not realize the degree to which they are interconnected, particularly through their banks.  This is not a call for governments to reach out and help one another, but a yellow flag to say, “Don’t bail out other nations.  Focus on the effects on your own country; if you must do bailouts at all, focus on your local financial institutions, and then create risk-based capital rules that penalize foreign lending, and encourage diversification in what foreign lending is done.  This is logical in a credit-based system, because you only regulate one side of the transaction.

I am not arguing for isolationism in investing, but there is a tendency in the bull phase of the credit cycle to assume that nations don’t default, and so lending to sovereign credits that are weak becomes the trade of the moment.  Good regulation of financials limits the ability of those regulated to be yield hogs, particularly in the bull phase of the credit cycle.

-==-=-=–=-=-=-==-=–=

Nations are mortal.  They don’t last forever, historically, if they last 200 years, that is significant.  Even with nations that last so long, they can repudiate debts multiple times in their lives, though there is a cost — being shut out of the bond market for a time, until lenders forget.

So, what is the calculus on national default?  It is an option, but what influences the choice?

  • Willingness of public to accept more taxes.
  • Willingness of the public to accept reductions in services.
  • Strength of the economy.
  • Willingness of foreign creditors to buy more debt.
  • Willingness of locals to save through buying national debt.

Default happens when a nation gives up; they conclude that there is no way that they can pay off the debts incurred.

Nations have not given up so far, but unless economic growth increases significantly, there will be defaults in many places eventually.

28 Comments

  • Kolya says:

    I wonder how many Americans would accept significantly lower living standards / less government services as a price for not defaulting either implicitly or explicitly.

    One fellow I talked to a while back said we should just print more money. How long will it be before some politician offers us that choice. As a nation we have no experience with hyperinflation unlike Germany – a lot of folk out there might think we could manage such a process without losing control.

  • i must weigh in because i’m kinda jealous that the MMT crowd has taken to commenting on my posts but not yours – they keep me up at night with hypotheticals.

    here’s the point: you wrote “Default happens when a nation gives up; they conclude that there is no way that they can pay off the debts incurred.”

    the MMT crowd RIGHTLY points out that this line of thinking is erroneous. Sovereign nations can always avoid default by simply printing (digitally or physically) new money. they don’t need revenues to pay off their debts.

    this is true – but obviously NOT without consequence. the logical conclusion (for me) is that printing money leads to either 1) inflation or 2 )moral hazard in a capitalist economy or 3) both. So, perhaps it’s semantics – you’re screwed even if you don’t technically default – but for different reasons.

  • Brent says:

    I look back to what happened to Canada in the 1994 time period where difficult decisions were made, but the economy restructured and the economy and government finances were set on a path that has had the economy doing well for the last 15 years. At the time, people questioned whether Canadians were willing to make the sacrifices and the government talked a lot but did not do a lot until the public really got behind the need to do this.

    The U.S. is at the point where the general public is starting to realize how serious the issues are. I believe you will see some of these difficult decisions made with public support over the next few years and the U.S. economy will adjust accordingly and get onto a new strong path.

  • Indy says:

    I wonder what the standard of living is going to look like in Greece in about four years time. Do we have enough courage even to save our own lives and avoid such a tragic fate?

    I also sometimes wonder if we don’t require a suicide-pact generation of politicians to do what needs to get done, make it difficult to undo, and accept the price of that success which is likely prompt ejection.

    Any volunteers, or are we all just coward complainers?

  • Greg says:

    Kid Dynamite: “the MMT crowd RIGHTLY points out that this line of thinking is erroneous. Sovereign nations can always avoid default by simply printing…”

    I’m not sure who the “MMT crowd” is, but I think their line of thinking is erroneous.

    Paying back debt with printed money is default by another name. This is obvious to most Germans — a few of whom lived through the Weimar Republic and are still alive; but anyone with German ancestry heard about the terrible costs from their grandparents.

    Other than silly legal semantics, there is no difference between “paying back” debt with printed money and “paying back” with seashells or grains of sand. Every lawyer can argue what the meaning of “is” is, and what exactly is a dollar, deutch mark, pound sterling, or euro. With fiat money, the definition is whatever the lawyers say it is.

    Economically, you borrowed someone else’s purchasing power. The reason for debt / investments is to shift consumption across time — the debtor needs consumption now, the lender wants to preserve consumption power for later.

    When you don’t return that purchasing power in full, you have defaulted.

    Whatever stupid argument the ambulance chaser crowd wants to make about the definition of “is” and “currency” is an argument beneath a person with any self worth.

    Your word is your bond — if you start re-interpreting what you meant when you gave your word, you are nothing

  • matt says:

    What terrifies me is that the United States still looks like the best of a bad lot, especially given the economic focus of most analysts (no one considers asset-liability management outside of insurance companies and pension funds).

    While the pillars collapse around the United States, the capital will seek refuge there and, I fear, will embolden U.S. leadership to continue with their recklessness. Of course, as the metaphor goes, the ceiling will be ready to crash down when all of the pillars are gone.

  • Davy says:

    If your debt is denominated in your currency (“you” = sovereign entity) then you can inflate your way out. But if Ruritania’s debts are in USD or Euros, it’s a bit trickier. I suppose the gov’t could engage in massive swaps and then deflate…

    in substance, I have to go with Greg…

    though pure default is not the only alternative. I.e. the creditor might be persuaded to take a downward revaluation if it reduces future credit risk…

  • Mike C says:

    the MMT crowd RIGHTLY points out that this line of thinking is erroneous. Sovereign nations can always avoid default by simply printing (digitally or physically) new money. they don’t need revenues to pay off their debts.

    I was just introduced to the MMT crowd via a blog post from Dash of Insight, and ended up spending about 1 1/2 hours there. I’m genuinely hoping that some intellectual heavyweights like David and others will address this. I’ve posted some questions on some blogs related to this, but have yet to receive any answers or responses. If the MMT guys are “right” then all this huffing and puffing over government debt is arguing over nothing.

  • Greg says:

    Stop writing “MMT Crowd” unless you say what it is

    MikeC — I didn’t see “MMT” anywhere on the Dash of Insight blog (I did a search on the page)

    What I did see was a whole pile of academics arguing that debt doesn’t matter, with some partisan nonsense that republicans only care because they lost power…

    First, having debt that you cannot pay off is not a partisan issue. The politicians (and pundits hoping to be politicians) bring this nonsense up because it is just TOO EASY to distract dim witted voters away from actual issues. Yell something about the other party and the hapless lemmings (whoops, voters) will spend the rest of the day arguing toe-MAY-toe toe-MAH-toe.

    Second, all the people claiming debt doesn’t matter (on that blog) are academics. The people who told us about CAPM, efficient markets, gaussian distributions, and other theories that are great on paper — but don’t hold true in the real world.

    If Harvard professors are so much smarter than everyone else, why did their endowment get clocked — just like everyone else? Answer: they put their pants on one leg at a time, just like a UAW auto worker

    The other thing to remember about academics is they live in academia. Where can you raise prices 2-3 times as fast as CPI — decade after decade after decade — and not have a customer revolt?

    Answer: government and academia. That’s it. No where else.

    Academic models are great for developing theories and learning how to think — but professors don’t live in the real world and are simply not equipped to comment. Lets see them manage their own “business model” correctly (without 10% per year tuition hikes and tax exemption) before we trust them to run the real world

  • greg – check this for MMT (modern markets theory):

    http://bilbo.economicoutlook.net/blog/

    warning – judging by your posts, i can tell you won’t like it.

    if you want a specific post to start with, try this one:

    http://bilbo.economicoutlook.net/blog/?p=7864

    note : i am NOT in this crowd!

  • najdorf says:

    Some might look at the academic model and say that people who know how to raise pricing 10%/year and achieve massive government spending and tax subsidies without eroding demand or generating significant public outcry actually know a great deal about how business is done in modern American capitalism.

  • carping demon says:

    Greg @ 1:39

    Nope, the Kid’s right. Like it or not, printed money is the only kind of money we have now. Gold is just another commodity; if you expect to get “repaid” by the US, you’re going to have to accept $US. The Weimar inflation resulted from the demands of the allies to be paid reparations in gold, not German Marks. Germany’s attempts to acquire gold and foreign currencies devalued the mark, and removed currency from within Germany. Weimar printed money for private consumption that was not backed by gold during the time when the gold standard was the basis of foreign exchange. This unbacked, printed, money, not surprisingly, was considered worthless. Weimar is irrelevant to the present.

    There is all the difference in the world between paying back debt with fiat money and paying back with seashells. You are almost right. The value of fiat currency is what the international community ["lawyers"] declares it to be; this is continually in flux.

    The world economy has progressed to the point where multilateral aggreements between nations as to value is the only money there is. I.e., THE AGREEMENTS ARE THE MONEY. Some nations are fortunate that they can borrow in terms of their
    own currency and default is unnecessary. Other nations have made different agreements, not necessarily by choice but agreed just the same, and default may appear to be the only possible path. The point is, we’re not all unilaterally making this up, saying our money is anything we want it to be at the moment. This is the current state of foreign exchange. It will continue to change, but only with the authority of sovereign governments aggreeing amongst themselves on the changes. That authority is all there is. We don’t get to go back to the Garden, and we don’t get to go back to a commodity standard.

  • Greg says:

    Some might bother to read a history book or two, instead of shooting their mouths off.

    Printing money isn’t a new idea — actually dozens of banana republics throughout Latin America and Africa already tried it. They collapsed, usually into brutal dictatorships.

    Germany tried printing money during the Weimar Republic — that collapsed and gave Adolf Hitler a launching pad.

    The French monarchy tried inflation after the West India ponzi scheme was exposed — that ended in guillotines and the streets running with blood.

    Italy and Greece (prior to the Euro) had to create new currencies every 15-20 years, as each version of the Lira/Drachma became worthless. The former site of Rome gave us Mussolini, while the Athens airport features armed soldiers to protect against rebels.

    Speaking of Rome, they tried shaving edges off their coins to inflate … they augmented that with a corrupt bureaucracy and high taxes like what is proposed today in the US. Rome collapsed.

    Lets all show the world just how stupid Americans can be… say it together now: “THIS TIME WILL BE DIFFERENT!!!”

  • carping demon says:

    Greg @ 1:39

    Nope, the Kid’s right. Like it or not, printed money is the only kind of money

    we have now. Gold is just another commodity; if you expect to get “repaid” by

    the US, you’re going to have to accept $US. The Weimar inflation resulted from

    the demands of the allies to be paid reparations in gold, not German Marks.

    Germany’s attempts to acquire gold and foreign exchange devalued the mark, and

    removed currency from inside Germany. Weimar printed money that was not backed

    by gold during the time when the gold standard was the basis of foreign

    exchange. This unbacked, printed, money, not surprisingly, was considered

    worthless. Weimar is irrelevant to the present.

    There is all the difference in the world between paying back debt with fiat

    money and paying back with seashells. You are almost right. The value of fiat

    currency is what the international community ["lawyers"] declares it to be, and

    this is continually in flux.

    The world economy has progressed to the point that multilateral aggreements

    between nations as to value is the only money there is. I.e., the AGREEMENTS

    ARE THE MONEY. Some nations are fortunate that they can borrow in terms of their

    own currency and default is unnecessary. Other nations have made different

    agreements, not necessarily happily, and default may appear to be the only

    possible path. The point is, we’re not all unilaterally making this up, saying

    our money is anything we want it to be at the moment. This is the current state

    of foreign exchange. It can, and will continue to change, but only with the

    authority of sovereign governments aggreeing amongst themselves on the changes.

    That authority is all there is. We don’t get to go back to the Garden, and we

    don’t get to go back to gold.

  • Matt Franko says:

    As long as a nations Primary Dealers can repo previously issued govt bonds at the central bank to gain reserves to purchase the new issue bonds at a Treasury auction, that nation can never default, no matter what the level of debt to GDP ratio is…

  • flow5 says:

    There will come a time (unpredictable) when it will be impossible for the government (federal) to collect enough in taxes to pay all of its expenses, including interest on the national debt. The Gov’t can of course borrow an indefinite amount through the Fed. (Concealed green backing) given a few changes in existing law. But that would lead to hyper inflation – i.e., a collapse in the credit of the Gov’t.

    So the easy way, is the way the French did it in 1960. Simply say that beginning Jan 1 (or any other date), new dollars will be issued, and that each new dollar is worth 100 old dollars. Then follow that up with a largely state controlled economy.

    In 1960, the French economist / mathematician Jacques Rueff, during Charles de Gaulle’s presidency, converted the old franc, to a nouveau franc, equal to 100 of the old franc. However, even with this substitution, inflation continued to erode the currency’s value, though at lower rates of change, in comparison to other countries. And this new franc equaled 20 cents to a U.S. dollar. The old rate was 5.00 to a dollar.

    In 1960, the French franc, which was one of the weakest currencies, overnight, became one of the strongest. Correcting policies included plans to 1) balance the budget, 2) stabilize the currency, and 3) eliminate currency controls.

    The gold content of the franc increased 100%, & 1) foreign exchange rates, and 2) France’s internal prices, reflected the conversion overnight. Internally, prices dropped about 90 per cent, and the foreign exchange value rose from about 0.238 cents per franc, to about 20.389 cents per franc.

    Domestically, France was on a managed paper standard; externally, on a modified gold bullion standard. With the new policies, France’s economy strengthened, and the franc became fully convertible @ approximately its gold par, into gold for foreign exchange and into foreign currencies.

    With the introduction of the Euro, the franc in Jan. 1, 1999, was worth less than 1/8 of its Jan. 1, 1960 value

  • flow5 says:

    “How well do macroeconomic models forecast, particularly at turning points?”

    The answer is that one is PERFECT. You have to guess at which statistics to apply (so that your answers are workable). Forecasting is simple. Higher mathmatics aren’t necessary.

    Case in point, I gave my time series to a Ph.D. in statistics. He tested GDP to my money flows (courtesy of Dr. Leland Pritchard, Ph.D economics, Chicago 1933, MS statistics, Syracuse).

    He came back to me and said there was no correlation. Therein it gets difficult. The correct answer depends upon applying the correct statistics.

    If you don’t believe it, you will never find it. Economic turning points are easy. Market turns are a little different.

    I know the greatest market timer of all time. He has called every turn in the DOW (on the exact same day) since 2000. But he was always on the wrong side of the market the previous 20 years.

    Why? Because he told his subscribers how he did it. So many subscribers and followers ended up using his methods, and they would anticipate his calls, rendering them invalid.

  • David C says:

    Unless a politician can be elected on a platform of cutting Medicare, Medicaid, Social Security and Defense, we are ultimately doomed.

  • Stevie b. says:

    flow5 “I know the greatest market timer of all time.”

    Please, tell us more.

  • buddha john says:

    “It is regrettable, sinful, but normal.” Ha! You are a great, articulate, yet down to earth, economist. And a terrible theologian! Usury (in a classical, not modern sense) is the sin.

    Cheers from Osaka,
    john

  • frank canneto says:

    David,

    I had a similar thought to yours it goes something like this.

    Governments have chosen a course of fiscal and monetary policies that they think works and most importantly does not cause or deepen a recession. The mindset of policy makers is to chose whatever option but it must be as pain free possible. They see that they are making bad choices but they feel the benefits outweigh the negatives.

    I seem to remember what historians said about WW I – that Governments and the people had forgot what great power war looked like and they were unaware of potential awesome killing power of the new military technology.

    Historians write that the world was shocked by the horror of how bloodly WW I became.

    Well, its somewhat similar, Governments have forgot how terrible the impacts can be from too much debt, because we haven’t seen or lived through a real sovereign collapse in the Western world in a long time.

    I think that also, Government Officials don’t realize exactly how much debt they are taking on, they are acting blindly and unaware fully of the consequences of their actions. I also don’t think they fully understand how complex and overgineered the financial world has become. Even after the crisis, people seem to think things are going back to normal, the 100 yr “black swan” event is over. I don’t.

    In the end if we see a painful outcome of sovereign debts with defaults, more recessions, civil unrest, and austerity budgets being suddenly imposed on unhappy citizens, I think we will look back and say we are not going to be bailing out every financial institution because its not fair to the rest of citizens.

    Frank C

  • jdmckay says:

    I find it interesting that through all the comments… to default or not to default, MMT and all the rest, there is no discussion whatsoever regarding underlying economy which currency represents.

    On US shores, there has been a dramatic shift in just that (what we do, and especially what we no longer do) here. For starters, especially in context of David’s post (eg: take a look a history!!!), any economy that has financial sector rise up to % of GDP US hit (+/- 40%) is, historically, in trouble.

    No amount of juggling currency… default, print more, whatever, is going to alter the dilapidation that’s happened in US underlying economy… eg. what we do here.

    And IMO, especially in view of David’s posts on our Cultural problems, I’d say that compounds the difficulty for a real recovery… eg. making/doing “stuff” that matters. We’ve go a generation who got rich on paper flipping houses, as their jobs/industry went “poof”, and thought they were geniuses. Really, housing bubble no more than a ponzi scheme.

    Now, values down and upside down, far fewer jobs and what jobs there are, on average, not even close to levels able to finance home purchase anywhere near bubble levels.

    Yet, whole parts of this “demographic” don’t want to give up their standard of living… their paper-profit, bubble-generated standard of living.

    There’s a gazillion things wrong here, just tons of stuff. Dishonesty (or outright professional deceivers), a lot of sloth, a lot of competing professions believing they are the most deserving, and IMO most infrequently mentioned: a comparatively (say, to top 20 planet GDP’s) very large portion of working age people w/serious health problems… we lead the world in diabetes per capita right now. More folks dependent on pills for this and that, overweight… all which means less productive generally (and less happy), not to mention don’t fell all that hot.

    And the thing about that is, most of the health issues are bad food related… in large part because food processing industry has hit public w/double whammy of massive advertising for junk, while bankrolling a lot of k-street politicians this decade to roll back labelling, food testing, and just about anything giving Joe Q. Public some insight into what they eat.

    And worse, most folks here don’t know this is an issue, and most wouldn’t know what to do about it if they did.

    Personally, I think unless somehow the US finds a way to take an honest appraisal of basic facts common to us as a nation, basically, whatever the finance/money guys come up w/really won’t matter.

  • Greg says:

    carpe demon — I was arguing that printing money to pay off debt is a technical default. And I was pointing out that this sort of technical default has almost always resulted in bloodshed throughout history.

    I am not arguing that the crowd in DC won’t do it anyways — only that this is a default. Instead of most people suffering a decline in living, a minority (but a large minority) will suffer the ultimate decline in living standards (death)

  • carping demon says:

    Greg–As long as $1US can be exchanged at the US Treasury for $1US, there can be no default. The only thing that stands behind the $US anywhere in the world is the USA’s guarantee that if you lend the USG $1US, you will get $1US(+i) back when the loan is due. The guarantee is not that the US will maintain PPP over time; no nation could do that. That guarantee of dollar-for-dollar was all that existed when the loan was made (bond was sold, whatever) and it’s all that exists now.

    Certainly, other nations can decide that they don’t want dollars at the current exchange rate, but a dollar created by a printing press, or a keystroke, or a pen scratch at the time the contract started does not differ from a dollar (printed, keyed or scratched) today. To have a default, you have to have something exogenous to the exchange agreements against which currencies can be valued. And there isn’t anything. The clowns in DC, or London, or Brussels or Hong Kong don’t have anything to do with it. Not that they know that. IMNSHO, bloodshed on account of exchange rates is a ways off, Rogoff and Reinhart notwithstanding.

  • carping demon says:

    That should be “the crowd”, not “the clowns”.

  • sg says:

    “Nations have not given up so far, but unless economic growth increases significantly, there will be defaults in many places eventually.”

    Demographically speaking, I can’t see any real way for economic growth to increase at all, much less significantly. Those counting on the de facto pyramid scheme of investment vehicles need to notice that there are not enough in the bottom of the pyramid. What happened in the 19th and 20th century was the opposite of what is happening now. Back then the diligent were increasing faster than the indolent. Currently we have the reverse. I would love to be wrong, but have seen no evidence otherwise.

  • vimothy says:

    Please find me an example of a sovereign default from a nation with a comparable monetary system to the US (fiat currency/floating FX/debt denominated in the domestic currency).

    Thanks.

  • vimothy — as with many other things in this crisis, predicting something that has not happened before is unusual. If we count high inflation as a type of default, we have the 70s and 80s.