How much country debt is too much? This is an issue of relativity. In this case relativity depends on the income flows from which debt service can be paid. Whether the debt belongs to the consumer or the government, the combined burden must be serviced from a country’s income stream.
While there is some economic growth theory that addresses a sustainable stock of capital assets relative to income, there is no similar theoretical basis for indicating how much debt is too much relative to income. However, the two should be related, as they represent the two sides of the balance sheet when debt is used to finance the accumulation of capital assets. The linkage between debt and capital starts to break down when much of the existing debt was funded in order to consume rather than generate productive assets. As a result, debt for the purpose of consumption hangs more heavily on the balance sheet as it does not generate any future output or income to sustain the debt.
Lacking a theoretical answer, the question of how much debt is too much has only been answered on an empirical level. Reinhart and Rogoff address the effects of government debt and find that a debt-to-income ratio of 0.9 is the threshold for when economic growth begins to slow down. But this estimate doesn’t include consumer debt or state and local government debt, which for the U.S. is also well above accustomed levels.
This still leaves open the question of how do over-indebted countries re-establish stock-flow balance. While it takes long periods of time to accumulate debt at a faster clip than income — and its fun while it builds and generates income —the reverse occurs when the debt-to-income ratio is shrinking.
If individuals and governments seek to “do the right thing” and save in order to reduce indebtedness, progress in de-leveraging is agonizingly slow. This prescription, better known as austerity, can only be successful if the economy has other means of support from business investment growth and/or net export growth. This roughly parallels a literature entitled “expansionary austerity.” Yes, as you would guess, expansionary austerity is an oxymoron. There are precious few successfully sustained episodes of income growth in the face of austere deleveraging. For example, take a look below at how Greece is faring with austerity as a de-leveraging policy.
But if the re-establishment of stock/flow balance through expansionary austerity is not successful (and we wish Europe the best of luck), the market alternative is default. This is the swift and painful market response. While the debtors are relieved of their debt burden all at once, the owners of the debt are similarly relieved all at once of their corresponding assets. That is to say, there is an instantaneous wealth meltdown, and all bad things follow that. We got a scary preview as we witnessed the Lehman Brothers financial meltdown in 2008 based only on mortgage debt meltdown.
Some of the defaulted debt is individually owned and hence it’s clear who has suffered a loss in that event. But the greater asset and wealth write-downs come from what most think are sacrosanct institutions, but they are not. Our private and public pensions, including Social Security (as its trust fund is 100% invested in U.S. Treasuries) will not pay out as promised. Nor will private insurance company annuities pay by contract terms. Our bank deposits and money market mutual shares will not pay 100 cents on the dollar — and don’t forget the impaired ability of endowments, charities and other trust funds to continue providing services in the face of their assets being written down. It seems safe to say that a developed country, particularly a democratically empowered government, will seek to avoid the correction to the debt-to-income imbalance, whether it is swift and painful or prolonged and agonizing. So, how do they preserve it?
Preservation of the imbalance is the road that we have embarked on. It requires that the asset/debt bubble be maintained indefinitely or until growth can be stimulated at a rate that outgrows debt accumulation. I call this the Helium Express, as it keeps the balloon floating in order to avoid the hard landing below. The intent is to keep balance sheets from imploding.
The Helium Express is occurring via super expansionary monetary policy the world over. It has become the policy of choice to keep the debt overload carrying cost affordable and hence sustainable as outlined in The Unintended Consequences of Saving the Sovereign.
Debt affordability and sustainability requires the Fed to pursue a goal of zero interest rates over the long haul in order to provide cheap and sustainable debt service that both the consumer and the government can afford.
In a very indirect way, this says that the Fed is seeking to maintain the right-hand side of the balance sheets of the big debtors, the consumers and the government. In doing so society’s balance sheet has an asset side as well and the two must balance. Hence, debt support is also generalized asset support. But how does that happen?
Well, there are many channels by which this works. Since the Fed implements the policy of affordable interest rates by purchasing Treasury debt at prices higher than market (to drive rates downward to historical lows), it also provides a capital gain to the seller of the bonds to the Fed. In turn that seller must now find a replacement asset with the proceeds of the sale to the Fed. As they look at a reinvestment in Treasuries they see yields so low that it doesn’t support conservative institutions investment income needs so another income-producing asset with higher yield must be found.
Hence conservative investors are forced into the “risk on” trade. They are seeking assets with investment income to support the income needs of the institution and must reach for greater default risk and volatility than their liking.
Another pressure to turn to the “risk on” trade exists when investors hold bonds with prices elevated higher than the redemption value by the Fed’s price support program. This provides the owner with an unrealized gain on their bond holdings and a smile on their face until they realize they are on the horns of a dilemma.
If the Fed stops inflating the value of Treasury bond in the market, the investor’s unrealized gain may never be realized if the Helium Express comes down to earth. Furthermore, even if the Fed’s price support is there for the long run — which is longer than the bond’s redemption date — the bond settles down to be worth only 100 cents on face value at redemption time (which is normally a big relief). In this case it is a lost opportunity not to cash in on the Fed’s subsidy.
Now the pressure builds to sell Treasury bonds to the Fed and invest in a less inflated asset.
The risk-on investments could take many forms, and the channel by which the financial purchasing power spreads out is intricate. These risk-on pressures have sent purchasing power first to income-producing assets such as bonds up the rating scale, dividend paying stocks, and preferred stocks. Now with those assets more robustly priced, new flows are beginning to be deflected to the next reaches of risk — even to real estate, and even to rental homes.
One big change from a year ago, when QE2 was underway, is that the risk-on asset is no longer emerging nation equity or a Swiss bank deposit. The countries that experienced capital inflows as a result of similar pressures to take the Fed’s subsidy and run abroad are now off-bounds for investors, as those countries have reacted to burn the speculators who caused their currency to appreciate and reduce their trade competitiveness. So, the Fed subsidy is staying in the U.S., with perhaps some Euro bond market buying as an alternative where the ECB welcomes a market vote of confidence in its currency.
Additionally, once this risk-on process is underway, even if no one sees changes in fundamentals to warrant higher prices of, say, equities, there is the unquestioned Pavlovian response known as “Don’t fight the Fed”. In this case it is “Don’t fight the Fed to the 5th power,” as all major central banks are involved in the Helium Express.
Actually, what is being called the risk-on trade is actually risk-off in the sense that the Fed is not wanting the market to correct the debt/income imbalance via default or deleveraging, so it works to preserve the Helium Express.
It’s not your textbook economic expansion with Fed buying Treasuries that pumps up commercial banks. Instead the funds are moving through the shadow banking system to reach the far corners of the risk-on trade.
This ends up causing a great deal of hand wringing by asset value fundamentalists (especially as corporate profit have been declining), by those who do not take lightly the continued prospects for a contagious sovereign default, or by those who are fearful that no good comes of excess money except inflation.
Unless one of the financial traumatic events that is facing the world occurs — and don’t forget the potential for a middle east oil shut down — the Helium Express has the power to not just lift the risky financial prices but the economy as well, though it will take some heavy lifting. The Helium Express provides cheap financing to firms able to reach the public capital markets as well as a private wealth effect. The Fed is being only a little subtle in encouraging all to enjoy the balloon ride they are sustaining.