Global Economic Risks - Debt

Global Economic Risks - Debt

By David Willden

Weak links in our global financial systems have a ripple effect throughout. In 2013, over 1000 experts from industry, government and academia identified "major system financial failure" as the top risk that would most negatively impact the world. This refers to a financial institution or currency regime collapsing and impacting the global financial system. The second most likely risk to occur is the "failure to redress excessive debt obligations.

In 2013, the International Monetary Fund indicated that the global economic situation remains fragile. With the current levels of government debts and deficits the advanced or highly developed economies, “it will take years of concerted political and economic effort before debt to GDP levels of the United States, Japan and many Euro Area countries are brought down” to stabilize at lower levels." 

Total World Debt

Economists with ING stated in 2013 that the world's total debt is $223.3 trillion. This number includes government-sector, financial-sector, household or corporate debt . Over 70 percent of this debt, or $157 trillion, is in developed economies. Around 30% or $66.3 trillion of this debt is in emerging economies. Public-sector was $55.7 trillion, financial sector $75.3 trillion, and household or corporate debt was $92.3 trillion. Within the U.S. the total indebtedness is $176,833 per-capita. In other developed economies it is $170,401. In emerging economies it is $11,621

Government Debt

Governments, whose primary purpose is (or should be) to care for the common good of their people, are the worst culprits of debt. Greece, Japan, Lebanon, Grenada, Portugal, Italy and Ireland all have government net debt rates of over 100% of GDP. Greece is 155% of GDP (2012 data), Japan at 134% (2011 data). Countries that have government debt rates at over 50% of their GDP (excluding the countries just mentioned) include Cape Verde, Antigua and Barbuda, United States, France, Belgium, United Kingdom, Belize, Jordan, Hungary, Dominica, Space, Israel, Seychelles, Egypt, Iceland, Albania, Morocco, Pakistan, Guyana, Germany, Serbia, Austria, Ghana, Malawi and Mauritius) 

Public debt is at dangerous levels all around the world. Viral V. Acharya from New York University and Raghuram G. Rajan with the University of Chicago believe most governments are focused on the short-term. Getting elected ends up being more important than reducing debt and thus government services. In their article "Sovereign Debt, Government Myopia, and the Financial Sector" they attempt to answer the question of why governments avoid defaulting on their loans: 

More and more of a country’s debt is held by domestic financial institutions, defaulting on sovereign bonds is costly. It reduces the lending capacity of the banks and in the worst case renders them insolvent. 
Short-term focused leaders would rather just pass along debt, thereby increasing the probability that future leaders will need to default on debt. 
"Me" oriented political leaders only care about current cash flows. They are add to their debt because defaulting would turn-off their money spigots. 

Drastic measures are needed to address government liabilities. Most Western countries will be confronted with low economic growth for the next decade or more due to debt and aging work-forces. Higher interest payments, expanded social entitlement payouts, and increased borrowing create significant risk. 

U.S. National Debt

"The American Republic will endure until the day Congress discovers that it can bribe the public with the public's money." - Alexis de Tocqueville

The U.S. is the world's largest national economy. It creates approximately a quarter of the nominal global GDP. 

The U.S. national debt is the sum of all outstanding debts owed by the Federal Government. Over 67% of the debt is for money owed to the people, businesses and foreign governments who purchased treasury bills, notes and bonds. The other 33% of the debt is money held in government account securities. This is money the government has borrowed for itself. It includes Social Security and other trust funds. 

U.S. federal spending will likely come to a total federal deficit of $642 billion dollars. Publicly held debt in the United States will likely exceed 76 percent of gross domestic product in 2013. In the next decade, chronic deficits are projected to push the U.S. debt levels up to 87 percent. 

U.S. Federal Reserve

The Federal Reserve's (Fed) primary function is to control inflation. It is also responsible for overseeing the U.S. banking system, maintaining the stability of the financial markets, being the central bank for other banks, the U.S. government, and foreign banks. 

The Fed controls inflation by managing credit. It restricts credit by raising interest rates and making credit more expensive. In other words, it reduces money supply by raising interest rates which is intended to curb inflation. When inflation isn't a risk, it can lower interest rates. This increases the money supply, which is intended to spur business growth and ultimately reduce unemployment.

To monitor inflation, the Fed uses the Consumer Price Index. It also oversees roughly 5,000 bank holding companies, 850 state bank members of the Federal Reserve Banking System, and any foreign banks operating in the U.S.

As the Central Bank for the U.S., the Fed sets reserve requirement for banks. Banks generate income by making loans. To leverage their ability to make loans, they make a reserve deposit with the Federal Reserve. Most banks must hold 10% of their deposits every night. The rest (90%) can be loaned out. So, if a bank has $100M in reserves it can make loans for up to $1B. If the bank doesn't have enough in reserves, it borrows from other banks that charge them a Federal Funds Rate. 

In an effort to expand the economy, the Central Bank buys short-term government bonds thereby hoping to lower short-term interest rates and thus spur business growth. When short-term interest rates are close to zero, the Fed may use "quantitative easy." In other words, it purchases financial assets from commercial banks and private institutions. 

As mentioned, the levers the Fed uses are tied to the issuing of loans or purchase of securities. The assumption is that more loans = increased business growth = higher employment rates. Common sense says that more savings = better investment decisions = higher quality and lower cost products and services = sustained economic growth. 

Financial-Sector Debt

In 1952 the debt of the financial sector as compared to total debt was 2%. In 2008 it was 32.7% and in 2012 it was almost 34%. Why did it shot up from 2% to 34%? In 2008, we came close to having a global financial collapse. Why? 

On the surface, it was because of excessive financial sector speculation (e.g., derivatives, high leverage) and the conversion of loans into securities (securitization) to sell to investors. The debt bubble burst in 2008 and is still bursting because the root cause of the problem - excessive debt - has not been addressed. The financial-sector was saved by the deep pockets of the government. 

Banks and other financial institutions make money by lending. These entities are incentivized to increase the number of loans. Bankers don't personally take a risk. If the loans default, they are safe. They already have their money. When sound loaning opportunities dry up they begin to loan out to speculators who take the money and in turn buy financial assets and gamble that these assets will increase in value. As speculators buy these financial assets, the value of these assets increase artificially. In other words, the financial assets inflate while the real value of the asset does not. When this is discovered, a downward cycle begins where price of the financial assets drop and borrowers default leading to reduced price reductions, and so on. 

The financial industry created almost irresistible financial loans that were easy to get. The economy and property values were expanding at a good pace. It seemed like common sense to take advantage of the loan options. Who is to blame for the 2008 recession? The financial industry, households and businesses. 

Household Debt

Household debt was 310% of GDP in 2008. That was the highest debt level since 1929 - the Great Depression. In 1929 private debate was 240% of GDP. The International Monetary Fund (IMF) stated in 2012 that: "household (consumer) debt sored in the years leading up to the Great Recession. In advanced economies, during the five years preceding 2007, the ratio of household debt to income rose by an average of 39 percentage points, to 138 percent." 

The National Bureau of Economic Research published a new paper analyzing 138 years of economic history in 14 advanced economies. The report proves that high levels of consumer or household debt cause severe recessions. Alan Taylor looked at the economic history of 14 advanced economies during the years of 1870 to 2008. What he found was that there is a correlation between the growth of consumer debt and financial crisis. Consumer or private debt is a better gauge of a financial crisis than even public debt. High levels of public debt is are clearly problematic, but the measure of consumer debt is a better indicator. 

Total Debt Still Growing in Western Economies 

In a 2012 report, McKinsey Global Institute found that since the 2008 financial crisis, that total debt had actually grown for the world's ten largest mature economies - Australia, Canada, France, Germany, Italy, Japan, South Korea, Spain, United Kingdom and the United States. The increase in total debt was largely due to rising government debt. They found that the ratio of total debt to GDP has declined in only three countries: Australia, South Korean and the United States. 

In June of 2013, the U.S. Federal Reserve submitted its Household Net Worth report for the first quarter of 2013. Within the U.S. there is $12.8 trillion in household debt, $12.9 trillion in non-financial-sector business debt, and $14.9 trillion in total government debt. U.S. non-financial debt growth was up by 4.6% and was about one-quarter of a percentage point lower than in 2012. On a positive note, especially for those of us clinging closely to the advice of tax calculators and estimators, household net worth reached $70.3 trillion, up about $3 trillion from the end of 2012. Household debt managed to tick downward as well by 0.6% in the first quarter. Home mortgage debt was down 2.3% as consumer credit rose at an annual rate of 5.7%. Non-financial business debt was up by 5.3% as corporate bond issuance brought that figure higher, likely based upon companies capturing and locking in extremely low interest rates for the next generation.

An Analogy

It is easy for to get lost in the mumble jumble of economic experts. Economics should be simple. The objective is spend less than you make. Even wiser, is to save some for a rainy day. 

Assume that your annual income is $100,000 dollars. Imagine you have accrued $100,000 dollars of debt. This debt isn't for your home,  it is accumulated debt from loans to sustain the lifestyle you wanted to keep.  Let's say you have combined your debt and you have a 10-year loan at annual rate of 5%. Your monthly income, before taxes, is $8,333 dollars. Your monthly payment is $1,060.66. That is 12.7% of your pretax income.

Imagine that your lifestyle needs are growing. You look around for additional loans. Let's also assume you have an enemies who are eager to destroy you.  It is important that you invest in protecting yourself. Your enemies are investing heavily in developing new technologies to destroy you. You need to invest to ensure you have the best technologies to protect yourself.  Pretend that those you love are not yet in a position to protect themselves - so you want to protect them to the extend you can as well. 

What Do You Think?  

Is the current debt and deficit spending sustainable?  

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Global Economic Risks