- Joshua Konstantinos
The Next Recession (Whenever it Comes) Will Be About Sovereign Debt
What made the recession in 2008 the Great Recession was the failure of the Federal Reserve and the Treasury to prevent Lehman Brothers from collapsing. Allowing the collapse of an institution that was too big to fail is what started the deflationary spiral that almost brought down the entire global economy. Although there is always the risk of another similar misstep in any recession, it would be surprising if any central banker allowed the abrupt collapse of a major bank for another half-century or so. However, while it’s unlikely that the next recession will see another Lehman Brothers, the next recession will likely be worse than 2008 – but for a different reason.
The Massive Accumulation of Debt Since 2008
The nations of the world prevented the total collapse of the global economy in 2008 by bailing out their financial systems. However, this was accomplished at an enormous cost. Countries took on massive amounts of debt and this combined with the plummet in tax revenues strained national budgets.
According to the IMF “Leverage in the system has increased some 50%-60% since the financial crisis a decade ago, with debt now worth some 230% of economic output globally” This immense pile of debt – particularly the debt held by governments known as sovereign debt - poses a terrible risk to the world.
Europe is Mired in Debt
In Europe, the massive debt accumulation morphed the 2008 financial crisis into a sovereign debt crisis. Immediately after Lehman’s collapse, yields on government bonds began to rise in some countries as the risk rose that these nations would be unable to service their debt in the recessionary environment. By 2010, the Southern European nations of Portugal, Italy, Ireland, Greece, and Spain (referred to in financial circles at the time as the PIIGS) were in a full-blown sovereign debt crisis which saw the value of their bonds plummet and their costs to borrow soar.
It is important to understand that this wasn’t just a problem for Greece and Southern Europe. Greece owed billions of euros to French and German Banks. If Greece could not pay, not only Greece, but the French and German Banking systems would be insolvent.
Former Greek finance minister, Yanis Varoufakis, wrote in his 2017 book Adults in the Room:
The Credit Crunch of 2008 that followed Wall Street’s collapse bankrupted Europe’s bankers who ceased all lending by 2009. Unable to roll over its debts, Greece fell into its insolvency hole later that year. Suddenly three French banks faced losses from peripheral debt at least twice the size of the French Economy…If the Greek government could not meet its repayments, money men around the globe would get spooked and stop lending to the Portuguese, possibly to the Italian and Spanish states as well, fearing that they would be the next to go into arrears. Unable to refinance their combined debt of nearly €1.76 trillion at affordable interest rates, the Italian, Spanish and Portuguese governments would be hard pressed to service their loans to France’s top three banks…
This sovereign debt crisis has not been resolved. In fact, today Greece’s debt to GDP ratio is significantly higher than it was before the crisis.
Now, while it might seem similar to a banking crisis like the one we had in the United States, a sovereign debt crisis is fundamentally different. As Mervyn King, the Bank of England Governor at the time of the crisis noted:
Dealing with a banking crisis was difficult enough, but at least there were public-sector balance sheets on to which the problems could be moved. Once you move into sovereign debt, there is no answer, there is no backstop.
While the global situation is even less sustainable than it was in 2010, central bankers have been able to avoid a larger debt crisis with so-called unconventional monetary policy.
The European Central Bank (ECB) purchased the bonds of Greece and the other troubled nations and pushed their yields down artificially with QE. To the point that in May 2019 the yield on U.S. treasury five-year bonds are higher than on Greek five-year bonds. Not because Greek debt has less risk of default than US debt, but because the yield has been artificially manipulated lower.
This is the same approach that Japan took after the county was forced to bailout their financial system when their own massive asset bubble popped in 1991.
To deal with the massive debts arising from their asset bubble popping, the Japanese pioneered ryōteki kin’yū kanwa (quantitative easing) in 2001. This quantitative easing policy, or simply QE, was adopted by the rest of the G7 nations following the 2008 financial crisis when they too were forced to take on massive debts to bailout their financial systems. The quantitative easing engaged in by the major central banks has worked to push down long-term interest rates to unprecedented lows. This is the reason for the rise of negative interest rates around the world, and this is what ended the sovereign debt crisis in Europe. QE is how the world has been able to service the increasingly large debt burdens.
Quantitative Easing has not come without significant costs – such as the zombification (a real economic term I promise!) of the economy – but it has allowed deeply indebted nations like Greece, Japan, and Italy to service their debts.
Sovereign Debt Will Come to a Head in the Next Recession
The trouble is that QE is a fundamentally finite solution and some key central banks are unlikely to be able to continue it for much longer – let alone during the next recession.
There is a great deal of misunderstanding about quantitative easing and how it works. Some prominent investors characterized it as printing money and expected it to cause massive inflation. Others have used the lack of inflation as an argument about why sovereign debt doesn’t matter. Neither of these characterizations are accurate. Ultimately, QE is neutral to the monetary base and does not remove government liabilities -although it does act to lower debt-servicing costs. Former Federal Reserve chair Ben Bernanke has attempted to refute the idea that QE is printing money explaining that:
…sometimes you hear the Fed is printing money, that’s not really happening, the amount of cash in circulation is not changing. What’s happening is that banks are holding more and more reserves with the Fed.
Essentially, the mechanism of QE is that the Federal Reserve and other central banks are buying government bonds - but not directly from the Treasury Department. They’re buying government bonds from banks and paying for them with central bank reserves. Crucially, these cash reserves are held by the central bank and pay an interest rate just as the treasury bonds did. So, the banking system used to own government bonds, and now they have reserves at the central bank that pay interest just like the bonds did. Very little has fundamentally changed. No new currency has entered the economy and the banks gained the value of the reserves but lost the bonds and thus their balance sheets are fundamentally unchanged.
Economists for the Peterson Institute for International Economics and the Federal Reserve Bank of New York explain how this asset swap of reserves at the central bank for bonds impacts long-term interest rates. In the 2010 paper, The Financial Market Effects of the Federal Reserve’s Large-Scale Asset Purchases, they describe how:
The primary channel through which LSAPs [Large Asset Purchases - i.e. QE] appear to work is by affecting the risk premium on the asset being purchased. By purchasing a particular asset, a central bank reduces the amount of the security that the private sector holds, displacing some investors and reducing the holdings of others, while simultaneously increasing the amount of short-term, risk-free bank reserves held by the private sector. In order for investors to be willing to make those adjustments, the expected return on the purchased security has to fall. Put differently, the purchases bid up the price of the asset and hence lower its yield. This pattern was described by Tobin (1958, 1969) and is commonly known as the “portfolio balance” effect. [emphasis added]
Put more simply, by lowering the total amount of Treasury Bonds available in the private sector the central bank has reduced the amount of safe assets available to investors. With supply reduced and demand unchanged investors will bid the interest rates on government bonds lower. This portfolio balancing effect also impacts other securities. Investors searching for yield (and relative safety) will also bid interest rates lower on alternative investments such as highly rated corporate debt etc.
The Inevitable End of QE
Importantly though, this QE process is only possible as long as there are bonds being held by banks. Pension funds or other investors are not eligible to keep reserves at the central bank, and of course banks hold a finite amount of government bonds. Therefore, QE cannot be continued indefinitely.
Already the BOJ has begun to run out of eligible bonds to buy - or swap really - for reserves at the central bank. Ben Bernanke noted in late 2016 that “…constraints on the availability of JGBs [Japanese Government Bonds] were seen in many quarters as limiting the BOJ’s ability to maintain its easy policies beyond the next year or two.” Japan is very close to purchasing all of the outstanding JGBs - at which point it will not be able to continue its QE program.
In Europe, the European Central Bank (ECB) is also approaching a limit to its bond purchases. In September 2016, the Financial Times raised the question “When will the ECB run out of bonds to buy? Warning that the “QE programme could hit a wall as early as this year because of lack of eligible debt.” Although, in Europe's case, they are merely running into the rather arbitrary limit of 30% of outstanding bonds that Europe has self-imposed on itself.
The ECB, can simply change their own rules and increase the limit on bonds they can purchase - assuming they have the political will which is not a given. But eventually the ECB will purchase all outstanding bonds and reach the ultimate limits of the program. Japan is already very close to their physical limit.
If the BOJ or the ECB was to simply buy bonds directly from the treasury without removing an equivalent amount from circulation by holding it as reserves it would be massively inflationary. It would be the very definition of monetizing debt. QE is an inherently temporary solution.
The Next Recession
When the world enters the next recession, whenever that may be, the risk of sovereign debt spiraling out of control will increase sharply. As tax revenues fall, debt to GDP ratios will rise. Rating agencies will downgrade nations debt and investors will demand higher interest rates to compensate for the risk. This is what happened to Greece which sparked the sovereign debt crisis in Southern Europe.
In fact, sovereign debt has already begun to lose at least some amount of confidence. In the OECD Sovereign Borrowing Outlook 2018, the OECD reports that:
A number of countries have been downgraded by the three big credit agencies during the past decade –in effect shrinking the pool of government bonds in the prime category to 11, down from 19 a decade ago. Notably, Ireland lost its AAA rating status in 2009, Spain in 2010, the United States in 2011(only by Standard and Poor’s), Austria and France in 2012, the United Kingdom in 2013, and Finland in 2014. More broadly, credit ratings of many countries have steadily shifted down since the GFC [Great Financial Crisis]
in 2008, almost 90% of sovereign debt was issued at the highest possible rating - as of December 2017 only 30% of sovereign debt issued was rated AAA. In fact, while in 2008 only about 10% of debt was below the Prime and High ratings level, today roughly half of sovereign debt issued is Upper Medium grade or below.
This has been held back thus far with QE holding down long-term interest rates. But nation’s like Japan are very close to being unable to continue QE. And in Europe it is unclear if they will have the political will to continue. If they do find the political will it is unclear how long they could maintain QE in a recessionary environment. Moreover, heavily indebted nations like Italy are already seeing a wave of populism sweeping their countries. There is the very real that risk nations in Southern Europe will reach a breaking point in the next recession and leave the Euro to devalue their currency and escape their crushing debt burdens.
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Sleeping on a Volcano: The Worldwide Demographic Upheaval and the Economic and Geopolitical Implications Makes the case the sovereign debt is unsustainable in an aging world. The book takes into account not only the rapidly changing and uncharted waters of the global economy under unconventional monetary policy, but also the longer demographic and geopolitical trends which have already begun to shift.
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About the Author Joshua Konstantinos Founder and Global Macro Strategist at Cassandra Capital LLC and author of Sleeping on A Volcano: The Worldwide Demographic Upheaval and the Economic and Geopolitical Implications, Joshua has been obsessively following global trends and collecting data for over a decade. His analysis takes into account not only the larger view of the rapidly changing global economy but also the longer demographic and geopolitical trends.