Has anyone else noticed that world governments have been using debt to cure the indebtedness that bit us in the first place? While citizens everywhere have been defaulting or paying off their debts, governments have been accelerating their loans to worthless borrowers (Europe); sinking money into so-called stimulus projects (US, Japan); and subsidizing students (US), green energy (US, China and Europe), gas prices (Asia), social programs in aging demographies (Japan, US), property development (China) and so on. The result is that worldwide, debt is increasing despite the work that families have done to restructure their balance sheets. The 34 countries in the OECD (Organization of Economic Co-operation and Development) have seen their aggregate public debt top 100% of GDP in the last year, up from roughly 70% just a few years ago, swamping the debt reductions elsewhere in their economies.
How does this all end? There are various historical precedents for high levels of debt in specific economies (the US in the late ’20s and early ’30s for instance) but no instance in which most countries simultaneously have too much debt. We can hazard a guess however.
- First, expect declining living standards and slow growth. Paying back all this debt will take decades, and it will necessarily take money from other purposes. A great view on this comes from a new app for the iPhone, called Debt Bomb. You can get the app here. The point of the app is to show you that if you had to pay your share of the US deficit along with your taxes when you filed last Tuesday, your tax bill would have amounted to roughly 40% more than what you paid. Where would you cut spending to come up with those extra thousands? No vacations or new clothes maybe? Bingo: the economy slows.
- Declining living standards will lead to social and political instability. In the US, we are already swapping from party to party as elected officials seem unable to solve our problems or even make headway. In Athens, they prefer to bomb storefronts and go on strike.
- Expect a more volatile business cycle. During deleveraging, government regulations, spending, and cutbacks fall unevenly on the economy. Currently, housing and finance are in a funk, looking much worse than other sectors. That can shift, however. If Europe craters because of austerity, our manufacturers will feel it. Furthermore, very slow growth simply leaves less of a buffer for a mishap, like rising oil prices or a new war. Finally, investors will take more risk in a quest for better returns, leaving the economy vulnerable to new bubbles.
- Defaults. Yes, someone is going to lose money. There are hard defaults, like Greece, which won’t be paying back its debt under the same terms that it originally promised. Then there are soft defaults. These are the sneaky kind, like in the US where the Fed has driven interest rates below the rate of inflation for most bonds. If you’re a saver, you are losing money every day to inflation in the US, thanks to The Bernank. You are the victim of a soft default, and it’s contributing to your lower living standard.
Lest you think we can avoid all this because the deficit has never been a problem before, take a hard look at the average inflation adjusted wage in the US over the last several years, and you’ll see it declining as government debt has risen. Our living standards are already falling.
All in all, not a pretty picture. From an investor’s perspective, it’s hard to see the stock market performing very well under this scenario. In fact, you might just want to run out and buy bonds instead, along with everyone else who has reached the same conclusion. But that’s too easy and the markets are never easy. Stay tuned for The Endgame: Part Two for our take on why stocks can still do well despite a gloomy economic outlook.