The Mechanics of Debt Crisis

A debt crisis is like a divorce. If negotiations aren't amicable, it could be a disaster...

TIME AFTER TIME Europe manages to solve its debt problems...and every time they don't get solved at all, writes Daily Reckoning founder Bill Bonner.

Italian bond yields are edging back up. And Greece is negotiating a default. They want to avoid a naked, noisy default...so they are dressing it up as "voluntary" or 'soft.' But they can't disguise the fact that Greece has bills it can't pay. On the 20th of March it needs to come up with 14.4 billion Euros, followed by billions more in the months following. That is more than 6% of national GDP. It would be as though the US had to pay a trillion Dollars.

Where's the money to come from? The European Central Bank? The IMF? The Germans? Maybe. But little by little, even the fixers are beginning to realize that this is a problem than can't be fixed with Band-Aids and bailouts. Greece has too much debt. About 100 billion Euros worth of it will have to go away or the country will never be solvent.

In the German magazine Der Spiegel:

"When it comes to Greece, it's clear that it's hopeless. It would be better for the country to finally leave the Euro and transform its foreign debts to drachma, than to constantly beg for new aid and set itself up for lasting charity".

The fixers and the fixees are meeting, trying to figure out who takes the loss. It is a little like a divorce. If they can get everyone to cooperate, the whole thing will go fairly smoothly. If not, it could be a disaster. The resulting tussle could bring down not just Greek debt, but the debt of Italy, Spain...and even France.

Across all OECD countries, public debt-to-GDP ratios now average 100%. This leaves them all vulnerable. At 5% interest, they have to devote one 20th of their output to servicing old debt. If they have tax revenues of 20% of GDP, it means that a quarter of their revenues must be used to cover the debt. If interest rates don't rise, they can hold on. But if they are still running deficits larger than their growth rates, the situation is hopeless.

In America, for example, the deficit — in terms of GDP — is increasing at three times the rate of the economy beneath it.

Already, most of the big banks in Europe and America are probably insolvent. Without artificial support from the authorities, they would probably be unable to survive a crisis. Trouble is, the authorities have no real support to give. Most of the nations of the developed world are insolvent too. They can shuffle along now...but could not survive a run on their bonds.

The great hope of the feds is that they can stave off a crisis — by supplying beaucoup cash to the banks...who use much of the money to buy the feds' bonds. The longer they can prevent a day of reckoning, the more likely these debtors will be able to grow their way out of trouble.

But debt suppresses growth. When debt-to-GDP levels rise to over 90%, growth declines, sharply.

Wait, there is more...Even before debt became such a big problem, real growth had already begun to disappear from the developed world. There has been none in Japan for the last 20 years...and almost no real growth in the US private sector for the last 10 years. In Europe, grosso modo, the story is similar. And in America, all the glories of technology, capitalism, financial engineering and democracy have been unable to add a single penny to the average working man's hourly wages over the last 40 years.

Why? Nobody knows for sure. We have a two-part hypothesis:

1) Zombification. The process of decline was described by professor Mansur Olson of the University of Maryland. Special interests and lobbyists manage to subvert the political system so as to get favors for themselves. These giveaways and privileges cost money and lower output. The economy gradually becomes less dynamic and less able to increase wealth.

Another professor, Meghnad Desai, from the London School of Economics, says western capitalism has gone "geriatric." "Dynamic capitalism, with its energy, innovation and sheer greed for growth has moved east," he says.

A geriatric, zombified economy cannot produce real growth.

2) Declining marginal utility of oil. A modern economy is the fruit of oil. But the oil-burning machines that make the economy so productive were almost all invented before we were born, and put into service, in the developed countries, after WWII. Since the '70s, improvements in the machinery have been incremental...and insufficient to offset the rising costs of oil.

If these hypotheses are correct, there will be no significant growth in the developed world — not until the zombies are thrown out...and/or a new technological breakthrough dramatically increases productivity.

We were suspicious of the recent improvement in the unemployment numbers. And of the news that consumers were going into debt to shop, again. The data were inconsistent with the "Great Correction."

Besides, US bond yields have kept going down, with the 10-year US note reaching a yield of only 1.87% last week. Bonds were confirming the Great Correction, in other words.

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