To understand why this has become such a pressing issue you need to head back into the teeth of the “credit crisis” some 12-18 months ago. Fundamentally, if you look through all the noise and tumult, one key thing happened: the liabilities from over-leveraged and over-indebted consumer and corporate balance sheets were transferred to governments. This happened in several ways – governments bailed out ailing financial institutions or underwrote corporate debt, governments bought debt when others shunned it, and they wrote cheques to consumers, via tax credits and similar mechanisms. The end result, though, was that the total amount of debt in the world did not actually shrink, despite the pain involved. The boil was not lanced at all, as there is significantly more debt in the world today than there was 2 years ago. Too much debt was the cause of the problem in the first place; the debt remains, but the liabilities simply shifted from “weaker” balance sheets onto stronger balance sheets – this time those of governments.In so doing a number of governments took very material gambles and they risked having their bluff called. For example, countries such as Ireland guaranteed their banking system but, in so doing, took on potential liabilities of 3x the size of their economy – a promise they clearly couldn’t keep. Because they were in the Eurozone, they rather got away with it. Iceland took even more of a gamble and guaranteed liabilities of 5x their GDP. Their bluff was called by the markets and, as a result, their banking system partially defaulted and debts remain unpaid to this day.
But in broad terms, the markets looked over the abyss and pulled back. For some time the crisis abated. In retrospect, the lesson to be learned from that chapter was that where there was a “run” on a bank, it was more about access to liquidity than about solvency per se. Worries about long-term solvency might have been the catalyst for investors to focus on a bank; but it was that bank’s lack of access to liquidity that caused a collapse. Indeed, the Bank of England analysis of the Northern Rock collapse concluded that if a bank has access to only 14 days’ liquidity it will survive. Yet, such events were self-fulfilling prophesies once confidence was eroded.
By early 2010 a broad based economic recovery was well underway but certain areas of the capital markets were, once again, becoming tense. The trigger for this was the realisation that some governments, most notably Greece, had been economical with the truth when describing the shape of their public finances. Not only were governments facing record deficits as they took on the liabilities of their consumers and companies, but the resolve to address their chasm of debt was lacking. Indeed the Greeks seemed unable to exactly quantify how much they really owed everyone. As it happens, Greece is by no means the worst offender of any sovereign nation in the world. Its total debt, whilst whopping, is lower than many other nations, even within Europe, and, whilst it has a projected and current annual deficit of eye-watering proportions, it’s arguably in better shape than the UK, Ireland or Italy. The reason why the markets alighted upon it is because everyone lost confidence in the reliability of the data being published as various, possibly underhand “off balance sheet” transactions through Goldman Sachs were unearthed. In the process, it became clear that the Greek position was worse than generally understood but, most importantly, contained massive discrepancies and unknowns. Confidence evaporated and Greek government bonds plummeted. Yields on Greek debt soared to the highest of any government in world, even higher than the generally accepted basket-cases. Echoes of the banking crisis of 18 months ago were everywhere. As worries began to extend to the debt markets of Spain and Portugal, the ECB and IMF have been forced to act. The governments of the EU have, finally, been decisive in their actions, having previously seemed to bicker. In so doing they will engender confidence, create liquidity and, for now, the crisis is averted once again; it is time to refocus back on the global recovery for a period.As we have observed before, this is a normal recovery in an abnormal cycle. Look past the storm clouds over southern Europe and all around you are the signs that this recovery is progressing nicely into a self-sustaining phase of growing consumer confidence and business investment. No longer is it solely about massive stimuli and inventory rebuild. Now, the employment situation is steadily improving, the consumer in the US is alive and kicking and Asian economies are growing so strongly that the risk for that region is of tightening measures to avoid overheating and attendant inflationary pressures. This improvement is reflected in corporate profits that are consistently exceeding expectations and, most significantly, the growth in profits is derived primarily from improved earnings rather than cost cutting. Indeed the present recovery is becoming much stronger than usually seen at this phase of the cycle, albeit from a much lower base.This creates the policy conundrum for the central banks. The financial system remains fragile and flighty. Capital quickly bolts and central banks must do their utmost to ensure that risk aversion does not materially reassert itself. We think that the authorities can, and will, be successful, but only by keeping interest rates at extraordinarily low levels. Yet recovery is gaining traction and they know that they are playing with fire by keeping the stimulus taps wide open, even if they have no choice at present. Whilst Asian and some emerging economies have the ability to tighten policy to control nascent inflationary pressures, the same luxury is not afforded to the West. That can only store up inflationary problems for the future but, for now, the sun is out and investors are well advised to make hay
However, let’s not forget that the package introduced in Europe addresses only liquidity on an immediate basis, not solvency. Unprecedented spending cuts and tax rises are required to stave off disaster. And lest anyone feel that such matters are confined to southern Europe, they would be well advised to note that George Osborne, the new Conservative chancellor in the UK, described UK public finances as “a work of fiction”.What’s going on here is that the second phase in the debt crisis is now unfolding: having shifted liabilities from weak consumers & corporations to sovereigns, debt liabilities are now being shifted from weak sovereigns to strong sovereigns. Some of this is about confidence, and this week’s package addresses this element head-on. But in the long term it is about fundamentals rather than confidence and there is a creeping realism amongst investors. It seems unlikely that governments have sufficient resolve to make the gouging cuts in spending needed or that interest rates can remain low enough for long enough in the face of burgeoning government debt, the risk of default and worries over inflation. In the longer term, the problem is simply that too much debt in the world remains. At some stage some of it must be destroyed, whether by inflation, devaluation or default. The problems for Greece may be averted but the spectre of a wider problem remains. The euro has tumbled to its lowest level in 18 months and might be entering a period of sustained weakness, analysts believe, on fears of years of weak economic growth as austerity measures across the continent bite. Spain and Portugal both announced austerity packages this week, which were likely to act as a drage on economic expansion in the 16-Nation Block.
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