Debt and drastic solutions

As European politicians kick the debt can down the road, spin doctors frantically checking the thesaurus to ensure that whatever label is attached to a solution is not associated with ‘default’, it is sobering to think that perhaps we are entering the endgame of the Western world’s obsession with debt... or at least its ability to accumulate it on the never never.

Let us take Italy as an example. Although far better than basket case Greece, it is still subject to the golden rule that a wholesome debt is one that can be repaid, on time, as originally agreed, with no off-piste adventures. The bond market is now demanding higher yields from Italy, as risks are belatedly recognised. These include debt of 119 per cent of GDP coupled with weak economic growth averaging 0.3 per cent p.a. recently.

Growth prospects are poor given the cuts in government spending and rising unit labour costs. Bunga Bunga politics hardly inspire confidence either, charmingly colourful though they are. Italy is fortunate that most of its debt is domestic, not international. However, it will still need to be re-financed… and it is the second largest debt pile in the EU.

It is instructive to look back 150 years, at the time of the Risorgimento as it happens. A population of 22 million has ballooned to 60 million, life expectancy has gone from 33 years to 82. They must all be working in offices, instead of more honourable work in the field, judging by the daily food intake going down from 3.5 kgs of polenta, pasta and bread per day to 300g and wine consumption going down from 95 to 49 litres per person a year… yet the average weight going up from 64 to 73 kgs (men) and 50 to 59 kgs (ladies).

With such a widening pool of captive subjects one might naively think that the average tax burden could go down… yet taxes have gone up from 17 per cent of income to 43.5 per cent. This is in large part due to the need to service debt which has been accumulated to carry out its projects… and pay the bureaucrats. As GK Chesterton so elegantly put it: “No society can survive the socialist fallacy that there is an absolutely unlimited number of inspired officials and an absolutely unlimited amount of money to pay them.” No doubt Brussels is well aware of this.

Irrespective of whether we classify the expenditure as investment (and there is a distinction between good and poor investment) or spending it appears that Italy, like some of its European brethren, is on an unsustainable path of choking on the cost of its own debt.

Drastic solutions include possible break-up of the eurozone, unless political considerations assume primacy over economic considerations. That is not so unlikely given the track record. However, such a path would necessarily be sub-optimal. It is misguided to draw comfort from the notion that the system will not be allowed to fail. For every short term fix there is a long term consequence – ask the Japanese.

Nevertheless, one would expect the EU politicians to work towards self-preservation (even the least intelligent life forms do it) and not be constrained by inconvenient and (to them) irrelevant notions of what is right. Crude and desperate tactics such as threatening rating agencies, presumably unless they give AAA ratings to all member states in which case they will be deemed experts, are hardly surprising.

It is important to note that governments often justify taking on debt by making imprudent growth assumptions, but good investment decisions require you to contemplate what happens if your central thesis is wrong – and in the case of a debt crisis the consequences are dire.

We have now reached the frankly incredible juncture that financial gospel itself is being questioned. The gospel says that the US will never default. As the risk free rate, the US bond yield is the ultimate marker for deriving risk premiums in the financial universe, the cornerstone if you will. The fact that we are even contemplating a US default, that the US is not risk-free, represents a new nadir in the financial crisis.

Bernanke’s phrasing hardly inspires confidence: ‘‘I would urge Congress to take every step possible to avoid defaulting on the debt or creating even any significant probability of defaulting on the debt.” I would have preferred ‘remote possibility’ to ‘significant probability’ – this is a sacred cow we are talking about. By raising the debt ceiling a default will be avoided, but even that is a finite solution. Ultimately, you cannot reduce debt by increasing debt.

However, what you can do is let inflation eat away the value of what you are printing. Note how inflation has lost its power to shock – bond holders take note.

This article is the objective and independent opinion of the author. The information contained in the article is based on public information. Any opinions that may be expressed here above should not be interpreted as investment advice, nor should they be considered as an offer to sell or buy an investment. The company and/or the author may hold positions in any securities that might have been mentioned in this report. The value of investments may fall as well as rise and past performance is no guarantee of future performance. Curmi & Partners Ltd are members of the Malta Stock Exchange and licensed by the MFSA to conduct investment services business.

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Mr Webster is an equity analyst at Curmi and Partners Ltd.