Saturday, April 30, 2011

The Ugly EndGame by John Mauldin (Thoughts From the Frontline)

The Endgame Headwinds

Before we can get to how I think the Endgame of the debt supercycle plays out in the US, we need to quickly survey the current environment, and revisit (at least for long-time readers) a few basic economic themes that I will call the “headwinds” of economic growth. So many leaders in so many countries think that with the right policies they can grow (export) their way out of the problem. As I have written, not everyone can grow their way out of a crisis at the same time. Someone has to buy.

And while the right policies will in fact help, growth is, in my opinion, going to be severely constrained in the multi-year period of the Endgame. But, jumping right to the bottom line here, one way or another we will get through this very difficult period. Really. And my personal view is that in the period following the Endgame cycle we’re going to see a very real economic boom, for reasons we will visit briefly in this series and at length over the coming year. I am quite optimistic longer-term, but the flight to get there may be very bumpy if you are not prepared for it. I will try to do my part to help you.

Briefly, for new readers, let me define what I mean by the Endgame, as dealt with at length in Endgame: The End of the Debt Supercycle and How It Changes Everything ( The US in particular and much of the developed world in general began a cycle of ever-increasing debt in the late ’40s, after World War II, both in the private and public sectors. Government began to grow as a percentage of overall GDP in the latter part of this cycle. In addition, politicians created large (well, huge) entitlement programs of pensions and health-care benefits that require significant taxes and, as we shall see, are unsustainable in the our present medium term.
There is a limit to how much money an individual or country can borrow. We all intuitively know this. If you grow your debt faster than your income and your ability to service the debt over a long period of time, people will eventually stop loaning you money. This is true for individuals, businesses, and nations. The end result is a restructuring of the debt (default by one of several means, including serious inflation) or a very reduced standard of living (by previous standards) for a period of time in order to service the debt. For individuals, that may mean cutting off the cable, no eating out, no vacations, etc. For countries it means reduced government programs and benefits, and higher taxes.

And make no mistake. I believe that the situation in the US is becoming urgent all too quickly. We are risking the health of the economic body of the US. While the republic will survive the crisis, the shocks and burdens it will place on all of us will be very great. For those not prepared it will seem like the end of the world, as jobs and safety nets might evaporate without proper restructuring. As I argue, the goal of fiscal sanity is to get the growth of the debt below that of the growth rate in nominal GDP. Failure to do so will result in the US suffering much as Greece or Ireland are today. Ugly.

The 2008 banking crisis showed us the limits of how much individuals can borrow, at least against their home equity. Since then, private debt (except recently for student loans in the US) has begun to shrink. But governments everywhere stepped into the breach by massively borrowing. But even governments, including the US, have a limit. We see that in Greece and Ireland, and are watching the debt crisis unfold in Portugal and Spain as well. It will soon become all too painfully clear in Japan. As I have often noted, Japan is a bug in search of a windshield. Japan is big enough that when it hits its own version of the Endgame, it will shake the world. It will not be pretty. (But there are opportunities for the nimble.)

As we will quickly cover here, the economic environment in which individuals and governments either willingly or are forced by the markets to reduce their borrowing and debt is significantly different from the period where they could create ever-increasing amounts of leverage. I call this period the Endgame. What we think of as normal gets turned upside down. Volatility increases, at a minimum. For many people this will qualify as a true crisis. But if you can see it coming and prepare, you can at least insulate yourself (somewhat) from many of the negative aspects of the Endgame. And volatility and crisis also mean that there will be opportunities for those prepared for them.

Now, let’s look at three graphs. The first is familiar to long-time readers. It shows the rise of debt in the US. And even with the recent pullback in consumer debt, because of the enormous government deficits, the rise is still there if we update this chart to last year.

The next two charts come from the Bank of International Settlements. They outline for 12 countries what happens, in terms of the debt-to-GDP ratio, if current spending and tax rates remain unchanged (the top dotted line), what happens if there are efforts to rein in spending with small gradual spending cuts and tax increases (middle line), and what would happen with serious spending cuts and significant tax increases (the lowest line). Some countries, even with measures that could be considered draconian, simply do not recover. While the chart shows what would happen if age-related spending were held constant, most seniors would think that getting ever-smaller pensions and health care would be drastic measures indeed. These countries are in an unsustainable spiral, which means drastic (the word used by the BIS) measures will be needed.

Note that there is only one example of a country that ever saw its debt-to-GDP rise over 150% and did not default, and that is Britain at the height of its empire and power, with long-term rates at a very low level and a completely different investment and bond climate. But notice how many of the countries are now on a path to twice that level in the very near future.


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