The Bankwatch

Tracking the consumer evolution of financial services

Thoughts on ‘The End Game’ and ‘This Time is Different’

My weekly newsletter from John Maudlin, cross posted here on The Business Insider is valuable to me in setting context for the longer view in the economy for North America, Europe and Japan.  This week is no exception.  Having spent 2009 reviewing inflation, and deflation prospects, he has now turned to thinking about what the economy will look like in the mid term future – The End Game.

Over the next several months, we are going to start to explore various aspects of the end game. Whither Japan? Are they actually, as I think, a bug in search of a windshield? What does that mean for the world? How safe is the euro? Everyone over here seems to think Germany will bail out Greece. A breakup seems unthinkable to the people I’ve been talking to (so far). But what about Spain? Italy? Can you spell moral hazard?

The theme he is focused on is excessive debt and the results of deleveraging.  He points to important research on the topic and useful books are summarised by him and other contributor colleagues of his.  [Incidentally for my take on the impact on banks, see my small trilogy “The Great Unwinding” from last year.]

We can forget about new debt being sought to solve the leverage problem because new debt increases leverage.  This may offer context for governments complaining about banks restricting credit – in fact they are simply doing what is right for people, business and the economy.  Debt is always tied to ability to repay through asset value or income.   Anything else would be tantamount to negligence resulting in immediate bankruptcy.

Back to the Mauldin letter.  He points out a quote from 2009 Carmen M. Reinhart and Kenneth Rogoff from their new book, This Time is Different.

“As for financial markets, we have come full circle to the concept of financial fragility in economies with massive indebtedness. All too often, periods of heavy borrowing can take place in a bubble and last for a surprisingly long time. But highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked.

And these three from a group of five points that summarise why leverage is a problem that is not possible to grow out of.

  1. We glean five important factors from this work that pertain to our present situation. First, financial imbalances occur when aggregate domestic debt is excessive relative to income, regardless of whether the government or private sector is accumulating the debt. Once debt becomes excessive, countries do not grow their way out of the problem; they must go through the time consuming and often painful processes of debt repayment and increased saving.
  2. Second, whether the domestic debt is externally or internally owed is not as critical as the excessiveness of the debt.
  3. Third, government actions, even involving sizeable sums of money, are far less helpful than they appear. As the book states, “Infusions of cash can make a government look like it is providing greater growth to its economy than it really is.”

Relevance to Bankwatch:

The three points above are important.  They are conclusions based on research of eight centuries of economic crises.  In short, no debt is good whether personal or government, when it exceeds ability of income to repay.  Sounds like banking 101.

This analysis simply supports my increased belief that as consumers increase debts again in 2009/10 this cannot continue without some impact while governments are doing the same thing.   It will be important for banks to consider alternative product design that takes a longer view that is in the best interests of everyone’s best interest.

Written by Colin Henderson

January 24, 2010 at 17:27

Posted in economy

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