Wednesday, December 14, 2011

The viscous cycle of international debt. How will it end?

Many have predicted in recent years, that the international debt bubble would lead to global inflation and sky high interest rates. So far, this has not happened. What's going on? Well, the debt has been propped up by more debt. How and when it ends is anybody's guess.

The European Union had yet another emergency summit and came up with yet another set of proposed solutions. Okay, not really solutions, but delays. One plan involves individual nations in the Euro group lending money to the International Monetary Fund (IMF), who would then make loans to troubled countries like Greece, Italy and Spain in return for assurances that they get their cash flow under control. This gets around an EU rule that does not permit European central banks to loan directly to member countries. It also takes the risk for such loans out of the hands of the EU central banks and places it instead with the IMF, which includes the U.S..

Another plan is to create new European Union rules that mandate certain budget constraints and has automatic penalties for violators. In exchange the European Central Bank would more aggressively buy member country bonds, keeping interest rates lower while they try to get their budgets under control. The details of the new rules and the automatic penalties have been conveniently delayed until at least March of 2012.

The reason for all this debt on top of debt is that the world's economies cannot support higher tax rates. Even if they imposed them, they'd actually lose revenue due to a further decrease in economic activity.

So why don't countries just print more money instead of borrowing? Well, the U.S. and the EU could certainly do that, and to some extent they have. In the U.S. we've had several rounds of what's called "Quantitative Easing" or QE. Essentially, the Federal Reserve creates new money and uses it to buy U.S. Treasuries (debt). So far, the demand for dollars has outpaced the production of new dollars and has not yet lead to inflation. So why has all this debt not caused massive inflation yet? Because the debt is still being primarily addressed with more debt.

Japan has a debt to Gross Domestic Product (total amount of goods and services produced in a year) of over 200%, yet their currency remains strong. This is because they continue to borrow and investors continue to lend. As long as Japan keeps issuing more debt, investors will seek Japanese currency to lend them. The same is true in the U.S.. The large banks and institutions continue to roll over profits and even proceeds from Treasury securities sales, back into Treasuries. They see few alternatives in the private sector, so they are even willing to loan the U.S. government money at zero percent interest for very short terms, and recently even at below zero which means they're willing to pay to keep their money safe until better days. Dollars flow from central banks to large organizations, corporations and countries, right back to the central banks. It's not showing up in the marketplace.

This only comes to an end when countries move from primarily borrowing to cover debt to printing instead. If the U.S. for example, suddenly decided to print their way out of debt, the institutions that had been investing in Treasuries would be forced to park their dollars elsewhere. If those trillions actually find their way to the private sector economy, inflation could pick up in a hurry and you could see "panic buying". That is, people would be desperate to exchange their currency for something, anything, that they can expect to hold it's value better. The value of the currency plummets and the price of everything skyrockets.

This obviously would be devastating for anyone on a fixed income. Additionally, the main tool used to counter inflation is higher interest rates, clobbering anyone with variable interest rate debt.

Another solution would be for countries to default, or not pay some or all of their outstanding debt. This is a no go, because most of that debt has been used as collateral for more debt. Hence a default on $100 could cause the elimination of many times that amount in capital. Economies would come to a complete standstill.

Of course governments could also drastically cut spending and embrace free market policies which would stimulate private sector earning and therefore tax revenues. This is not likely either because most of the powers that be don't believe in the free market. They cling to the belief that government can and must control the way resources are allocated and distributed. Leaving such important decisions in the hands of individuals is out of the question.

So at what point does it become necessary to stop borrowing and start printing with reckless abandon? I don't know. Maybe never. The central banks can continue with Quantitative Easing without causing inflation, as long as they do so at a pace that encourages investors to send that money right back to the Treasury markets. A sudden increase in private sector investment and economic activity would actually work against this plan, since it would take dollars away from Treasury investments, causing interest rates to spike, which might just prompt increased currency production. Absent some new innovation in the private sector that would cause such a thing, it's really up to the patience of the people. How long will the populace tolerate the continued downgrade of most of their standards of living while all the currency stays in the government/institution merry-go-round?

If hyper-inflation does come to pass, the good news is that it does eventually come to an end. It really is just another form of default, but the losses are spread out among the entire population rather than just among bondholders. It's nasty. It's tragic, and it can lead to lots more bad decisions if we're not careful, but it may just be the only real solution.

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