The Real Effects of Debt

September 19, 2012

From the Bank of International Settlements, research that confirms what Ken Rogoff has been telling us all along. Here’s the abstract:

At moderate levels, debt improves welfare and enhances growth. But high levels can be damaging. When does debt go from good to bad? We address this question using a new dataset that includes the level of government, non-financial corporate and household debt in 18 OECD countries from 1980 to 2010. Our results support the view that, beyond a certain level, debt is a drag on growth. For government debt, the threshold is around 85% of GDP. The immediate implication is that countries with high debt must act quickly and decisively to address their fiscal problems. The longer-term lesson is that, to build the fiscal buffer required to address extraordinary events, governments should keep debt well below the estimated thresholds. Our examination of other types of debt yields similar conclusions. When corporate debt goes beyond 90% of GDP, it becomes a drag on growth. And for household debt, we report a threshold around 85% of GDP, although the impact is very imprecisely estimated.

You can read the whole paper here.

Households really aren’t any different. High levels of debt can impact their solvency also, and threats should be addressed quickly and decisively. Likewise, it’s a good idea to have a fiscal buffer for emergencies.

I’m not sure how quickly and decisively Congress is dealing with national fiscal issues, but you have control of your own response at the household level.

It’s pretty clear that there will be significant investment implications from high levels of debt, whether at the sovereign or corporate level. It’s not clear exactly what those implications will be. In fact, there is still a lot of disagreement about whether taking on more debt in QE3 will help the economy or hurt it. While we have a chance to see if Mr. Rogoff’s theory works in the real world, investors might do well to heed the message sent by relative strength. Theory is interesting, but it may be more profitable to see which asset classes get stronger as a result of continued easing.

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Beautiful Deleveraging

May 21, 2012

Ray Dalio of Bridgewater Associates is an interesting and pragmatic economic thinker. He had a recent interview with Barron’s, in which he described the deleveraging process in the US as “beautiful.” Here’s a snippet:

A beautiful deleveraging balances the three options. In other words, there is a certain amount of austerity, there is a certain amount of debt restructuring, and there is a certain amount of printing of money. When done in the right mix, it isn’t dramatic. It doesn’t produce too much deflation or too much depression. There is slow growth, but it is positive slow growth. At the same time, ratios of debt-to-incomes go down. That’s a beautiful deleveraging.

We’re in a phase now in the U.S. which is very much like the 1933-37 period, in which there is positive growth around a slow-growth trend. The Federal Reserve will do another quantitative easing if the economy turns down again, for the purpose of alleviating debt and putting money into the hands of people.

We will also need fiscal stimulation by the government, which of course, is very classic. Governments have to spend more when sales and tax revenue go down and as unemployment and other social benefits kick in and there is a redistribution of wealth. That’s why there is going to be more taxation on the wealthy and more social tension. A deleveraging is not an easy time. But when you are approaching balance again, that’s a good thing.

What makes all the difference between the ugly and the beautiful?

The key is to keep nominal interest rates below the nominal growth rate in the economy, without printing so much money that they cause an inflationary spiral. The way to do that is to be printing money at the same time there is austerity and debt restructurings going on.

It’s interesting that he seems pretty satisfied with the process the US has taken so far, in the sense that we may avoid significant inflation or deflation. The deleveraging process won’t be easy socially or economically, but it’s certainly preferable to a Japan-type scenario. His opinion is interesting to me because so many other commentators are falling into the doomsday camp, although half are expecting Japan-style deflation and the other half are counting on Weimar-style inflation.

I suppose it is human nature to worry about the worst thing that can happen, but Mr. Dalio suggests a middle path might be the most realistic.

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Beanbag Economics and Relative Strength

May 17, 2012

By now, it’s pretty apparent that the Euro is eventually going to be toast, just like the ERM imploded before it. (Perhaps it was never logical to assume that one currency and one central bank would be able to satisfy many different cultures and political regimes?) Of course there is a lot of hand-wringing going on about all of the bad things that will happen, but no one is talking about the offsetting good things that will happen.

We’ve written before about beanbag economics, the essence of which is that when you smush in one part of a beanbag, it just poofs out somewhere else. Relative strength is a simple and effective way to see where trends are underway.

Consider a typical bad news lead in this Reuters article:

Worries about a run on Greek banks has rattled Athens this week, after savers withdrew at least 700 million euros on Monday alone…

That sounds quite scary. However, buried deep in the article, at the very end, is the beanbag economics section:

Deposits shifted around Europe dramatically last year, analysis of data from more than 120 listed European banks show.

More than 120 billion euros was taken from two banks in Belgium alone, including an exodus of customer deposits from Dexia (DEXI.BR) which had to be bailed out and restructured. KBC (KBC.BR) also saw a big outflow.

Some 90 billion euros was taken from France’s banks, including around 30 billion each from Credit Agricole (CAGR.PA) and BNP Paribas (BNPP.PA). French banks were hit last year by their heavy exposure to Greece and concerns about their liquidity that forced them to accelerate plans to shrink.

Worries the euro zone crisis would spread also saw about 30 billion euros in deposits leave Italian banks, although inflows to BBVA (BBVA.MC) helped limit the net outflow from Spain.

Cash flooded into Britain; more than 140 billion euros was deposited in four big banks alone. The UK benefits from its position outside the euro zone and its Asia-focused banks HSBC (HSBA.L) and Standard Chartered (STAN.L) are seen as particular safe-havens.

Other banks to see big inflows included Barclays (BARC.L), Germany’s Deutsche Bank (DBKGn.DE), Switzerland’s Credit Suisse (CSGN.VX) and UBS (UBSN.VX) and Russia’s Sberbank (SBER.MM) and VTB (VTBR.MM).

Banks that were in trouble had deposits leave, but they didn’t vanish into thin air. Other banks saw massive inflows at their expense. And—think about it—the Greek and French banks had the money in the first place because depositors saw them as relatively more attractive than European stocks or their mattresses, or whatever, at the time. Times have now changed and the flow of money is being directed somewhere else. It’s not the end of the world when some asset class implodes, unless, of course, you have 100% of your assets in it. That implosion works to the benefit of another asset class somewhere else.

There are always relative winners and losers; things are rarely completely one-sided. This is the primary attraction of using relative strength for tactical asset allocation. It is able to identify shifts in supply and demand by measuring what assets are strong and what assets are weak. Markets all over the world operate and interact in this same way.

beanbag chair Beanbag Economics and Relative Strength

Beanbag Economist: Someone has to get those asset flows!

Source: www.indyagenda.com

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