Email of the day (1)
Comment of the Day

June 13 2011

Commentary by Eoin Treacy

Email of the day (1)

on debt from a different perspective:
"Enjoyed Tim Price's piece on debt.

"It is plain that absolute and relative sovereign debt levels are high in the West. So much newsprint has been spent on this issue over the last decade; we have all become Debt Groupies. But this is only one side of the story. I would like to open it up to the Collective to find analysis that shows the other side of the story as well.

"All balance sheets have two sides, assets and liabilities. And interest payments are balanced by income.

"To assess true indebtedness, private individuals and lenders in practice calculate not only the level of debt but also the value of the underlying asset (eg the house) to arrive at a net debt position. Surely it is no different with sovereign countries since their private sector economic agents own foreign assets? Does anyone know of work that adjusts for this balance sheet factor? I suspect that countries like the USA and UK -a renegade according to Mr Price- would show up well on this analysis. These private sector foreign assets are important (eg US corporations' businesses in Europe) as much is taxed at home even though it is not a sovereign asset. Foreign Double Taxation Agreements and clever tax optimisation will reduce this tax income but not completely.

"Other factors are also important. Economists guess that somewhere between 5% and 20% of Western European GDP takes place in the black economy (Greece used to be understated by about 20%). The "shadow" economy is perhaps 50-100% of GDP in countries in much of the developing world. Does anyone know of Debt to GDP ratios that are adjusted for this shadow economy factor? At a time of high public taxation, this shadow economy factor is likely to become more important, rather than less.

"Finally, debt is as much a cash flow problem as a balance sheet problem. If inflation is eating away (Tim Price would say "stealth defaulting") 3-5% of debt each year, absolute debt reduces by 3-5% per annum as well. Does anyone know of analysis that provides a "real" cash flow forecast of the indebted West given the austerity programmes underway?

"Let's take Mr Price's table showing super-indebted Japan. Let's imagine a real Mr Japan (ref Mr Price's table) with debt at 200% of salary (ie his GDP). Mr Japan should be smiling if his official income is Yen 100 (but really 110), his debt Yen 300 and his debt payment only 300 x 4% = Yen 12. This tiny debt service for Mr Japan, a mere 11-12% of income, is all the more tolerable if Mr Japan's debt reduces by 3% per annum whilst his salary increases with inflation. By the way, 10% unemployment has little effect on these numbers.

"The mere absolute measurement of debt is a blunt analytical instrument. It does not tell both sides of the story, though it seems to sell newspapers and newsletters."

Eoin Treacy's view Thank you for this email which raises a number of important points and I'm sure will be of interest to the Collective. A good part of the debt problem currently plaguing Europe and the USA is that there is no asset to balance the liability. In the case of fraud a debt is taken on and the asset posted as collateral is illusory.

For example extending a mortgage to someone with no chance of paying it back either because they have no job, or no income (so called NINJA loans) or extending a loan to an entity they lies about its ability to repay the debt such as Greece which manufactured economic data to ensure access to capital.

As you point out, absolute levels of debt are not solely the issue. Ability to service debts is at the core of the discussion this is part of why peripheral Europe has become such a focus of attention.

I have not seen research which allows for the "shadow economy" or examines how inflation erodes the value of debt but subscribers may be able to help on these fronts.

A subscriber sent me this report by Daniel Gros at the Centre for European Policy Studies on the subject of mobilising private sector savings to ease sovereign liquidity requirements which may be of interest. Here is a section:

The little data published by the associations of Irish pension funds and that of (life) insurance companies suggest that these two groups of financial companies own over €100 billion in foreign assets, of which about €25 billion are in non-Irish government debt and about €72 billion in foreign equities.

From the point of view of the country, it makes no sense that Irish pension funds invest in Bunds which yield about 2-3%, whereas the government pays close to 6% on fresh money to foreign official institutions (and Irish government bonds promise yields of close to 10%). A very strong case can thus be made that Irish pension funds and life insurance companies should somehow be 'induced' to invest their entire portfolio of gilts in Irish government bonds. The €25 billion in financing that this would yield for the government is equivalent to the entire contribution of the IMF to the rescue package.

A similar case can be made for the €72 billion in foreign equity investments. If two-thirds of that sum (or €48 billion) were also be invested in Irish government bonds, the total financing available for the government would rise to over €73 billion, more than all the foreign funds made available to Ireland under the rescue package.

There is more than a whiff of capital controls to the proposals submitted in this report but it does offer a more comprehensive view of the debt issue than simply concentrating on the outstanding figure.

More often than not debtors get into trouble because of a lapse in governance. Our debt troubles are usually self-inflicted and the adjustment required to fix them is very often painful. To restore confidence debtors with liquidity problems need to demonstrate that they are willing to make the sacrifices necessary to improve their situations. At least part of the reason Greece is currently such a centre of attention is that it has not yet made enough of the sacrifices necessary to convince investors it is serious about trying to meet its obligations.

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