2016: A Year of Sovereign Debt Defaults?

Ms. Carmen Reinhart, Harvard professor and co-author of the book that chronicled financial crises during the last eight centuries entitled "This Time is Different", sees 2016 with a grim outlook. She has sounded the sirens on the increased likelihood of government debt defaults this year. And such string of  government debt defaults may start with, or be triggered by emerging markets.

An excerpt extracted from Project Syndicate (bold added)

As 2016 begins, there are clear signs of serious debt/default squalls on the horizon. We can already see the first white-capped waves.

For some sovereigns, the main problem stems from internal debt dynamics. Ukraine’s situation is certainly precarious, though, given its unique drivers, it is probably best not to draw broader conclusions from its trajectory.

Greece’s situation, by contrast, is all too familiar. The government continued to accumulate debt until the burden was no longer sustainable. When the evidence of these excesses became overwhelming, new credit stopped flowing, making it impossible to service existing debts. Last July, in highly charged negotiations with its official creditors – the European Commission, the European Central Bank, and the International Monetary Fund – Greece defaulted on its obligations to the IMF. That makes Greece the first – and, so far, the only – advanced economy ever to do so.

But, as is so often the case, what happened was not a complete default so much as a step toward a new deal. Greece’s European partners eventually agreed to provide additional financial support, in exchange for a pledge from Greek Prime Minister Alexis Tsipras’s government to implement difficult structural reforms and deep budget cuts. Unfortunately, it seems that these measures did not so much resolve the Greek debt crisis as delay it.

Another economy in serious danger is the Commonwealth of Puerto Rico, which urgently needs a comprehensive restructuring of its $73 billion in sovereign debt. Recent agreements to restructure some debt are just the beginning; in fact, they are not even adequate to rule out an outright default.

It should be noted, however, that while such a “credit event” would obviously be a big problem, creditors may be overstating its potential external impacts. They like to warn that although Puerto Rico is a commonwealth, not a state, its failure to service its debts would set a bad precedent for US states and municipalities.

But that precedent was set a long time ago. In the 1840s, nine US states stopped servicing their debts. Some eventually settled at full value; others did so at a discount; and several more repudiated a portion of their debt altogether. In the 1870s, another round of defaults engulfed 11 states. West Virginia’s bout of default and restructuring lasted until 1919.

Some of the biggest risks lie in the emerging economies, which are suffering primarily from a sea change in the global economic environment. During China’s infrastructure boom, it was importing huge volumes of commodities, pushing up their prices and, in turn, growth in the world’s commodity exporters, including large emerging economies like Brazil. Add to that increased lending from China and huge capital inflows propelled by low US interest rates, and the emerging economies were thriving. The global economic crisis of 2008-2009 disrupted, but did not derail, this rapid growth, and emerging economies enjoyed an unusually crisis-free decade until early 2013.

But the US Federal Reserve’s move to increase interest rates, together with slowing growth (and, in turn, investment) in China and collapsing oil and commodity prices, has brought the capital inflow bonanza to a halt. Lately, many emerging-market currencies have slid sharply, increasing the cost of servicing external dollar debts. Export and public-sector revenues have declined, giving way to widening current-account and fiscal deficits. Growth and investment have slowed almost across the board.

From a historical perspective, the emerging economies seem to be headed toward a major crisis. Of course, they may prove more resilient than their predecessors. But we shouldn’t count on it.

This Time is Different: Fiscal Discipline Not Required

This time is different. Each time a literature or study proposes to show that government discipline is required to avert a crisis, some rejoinder will be issued to justify the opposite.

From Bloomberg,

A paper by Harvard University economists Carmen Reinhart and Kenneth Rogoff that has been cited by Republican lawmakers to justify eliminating the budget deficit contains “serious errors,” according to a study by a group of University of Massachusetts academics.

The Reinhart-Rogoff paper, “Growth in a Time of Debt,” argued that countries with public debt in excess of 90 percent of gross domestic product suffered measurably slower economic growth.

The new study -- by economists Thomas Herndon, Michael Ash and Robert Pollin -- says that the Harvard economists excluded some data and unconventionally weighted the statistics they included to reach their conclusions.

This led to “serious errors that inaccurately represent the relationship between public debt and growth,” Herndon, Ash and Pollin said in the paper published yesterday.

In an e-mail, Reinhart and Rogoff defended the conclusions of their 2010 paper and said that “on a cursory look” the new study also finds growth slowing in nations with excessive debt. “We literally just received this draft comment, and will review it in due course,” they said.

Ash said in a telephone interview that his paper does show “a modest diminishment of growth” in countries with big debts yet nothing like “the stagnation or decline” seen in the study by Reinhart and Rogoff.

Note: The kernel of the paper’s objection to Rogoff-Reinhart’s study: “modest diminishment” versus “stagnation”.

More of Reinhart-Rogoff response at the Wall Street Journal Blog, they rebut,

cumulative effects of small growth differences are potentially quite large. It is utterly misleading to speak of a 1% growth differential that lasts 10-25 years as small.

Based on the Bloomberg article, the critique is an example of the silly quibbling over statistics while ignoring of the real human effects of a debt laden economy (mostly hobbled by higher taxes, financial repression, byzantine regulations and politicization of markets--all of which diminishes growth and whose economic losses will never be captured by data). 

While I am no big fan of Professors Reinhart and Rogoff, for what I see as their skewed views of capital flows and their advocacy of inflationism as means to reduce debt, at least they recognize of the hazards or of the perils of a leveraged economy from their chronicles of 8 centuries of crises.

As Carmen Reinhart and Kenneth Rogoff writes in their book This time is different Part I Financial Crisis: An Operational Primer (bold mine)

The essence of this-time-is-different syndrome is simple. It is rooted in the firmly held belief that financial crises are things that happen to other people in other countries at other times; crises do not happen to us here and now. We are doing things better, we are smarter, we have learned from our past mistakes. The old rules of valuation no longer apply. Unfortunately, a highly leveraged economy can unwittingly be sitting with its back at the edge of a financial cliff for many years before chance and circumstance provokes a crisis of confidence that pushes it off.

For the mainstream: This time is different. Yes, this is mania at its finest.

Harvard’s Carmen Reinhart: Pensions are Screwed, Higher Inflation is a Safe Bet

Harvard economist and professor Carmen Reinhart, who along with co-Harvard peer authored a book chronicling world crises in the bestseller, This Time is Different has recently been interviewed by the Der Spiegel. (bold mine, hat tip zero hedge)

On the real reason for negative interest rates and QEs… 

Reinhart: No central bank will admit it is keeping rates low to help governments out of their debt crises. But in fact they are bending over backwards to help governments to finance their deficits. This is nothing new in history. After World War II, there was a long phase in which central banks were subservient to governments. It has only been since the 1970s that they have become politically more independent. The pendulum seems to be swinging back as a result of the financial crisis.

Oops. Financing government deficits has indeed become the norm. This is an essential ingredient to the risks of hyperinflation

On the difference between today and World War II…

Reinhart: No, but after World War II austerity was easier to pursue, because you had a younger population and therefore less entitlements. Furthermore, military expenditure was easier to reduce. So, the build-up in debt we have seen since the crisis is very rare. Usually you get that kind of build-up when there is a war.

Why huge debt has been a burden…

Reinhart: I am not opposing this change, I am just stating it. You have to deal with the debt overhang one way or the other because the high debt levels are an impediment to growth, they paralyze the financial system and the credit process. One way to cope with this is to write off part of the debt.

Why governments resort to plundering of people’s savings by financial repression…

Reinhart: The technical term for this is financial repression. After World War II, all countries that had a big debt overhang relied on financial repression to avoid an explicit default. After the war, governments imposed interest rate ceilings for government bonds. Nowadays they have more sophisticated means..

Monetary policy is doing the job. And with high unemployment and low inflation that doesn't even look suspicious. Only when inflation picks up, which is ultimately going to happen, will it become obvious that central banks have become subservient to governments.

Financial repression policies only adds to the debt stock, real austerity is required.

Reinhart: No. Restructuring, inflation und financial repression are not substitutes for austerity. All these measures reduce your existing stock of debt. Unless you do austerity you keep adding to the debt. There is no either-or. You need a combination of both to bring down debt to a sustainable level.

Why we should expect higher inflation…

Reinhart: There are no silver bullets. If central banks try to accommodate and buy debt, there are risks associated with it. Somewhere down the road you are going to wind up with higher inflation. That is a safe bet -- even in Japan …

Again financing deficits heightens risks of hyperinflation.

Surprisingly Ms. Reinhart offers an implied Austrian school solution (except for the higher inflation advice)…

Reinhart: The best way of dealing with a debt overhang is to never get into one. Once you have one, what can you do? You can pray for higher growth, but good luck! Historically it doesn't happen -- you seldom just grow yourself out of debt. You need a combination of austerity, so that you don't add further to the pile of debt, and higher inflation, which is effectively a subtle form of taxation …

Why savers are screwed…

Reinhart: No doubt, pensions are screwed. Governments have a lot of leverage on what kinds of assets pension funds hold. In France, for example, public pension funds have shifted money from shares (on the stock market) to government bonds. Not because their returns are great, but because it is more expedient for the government. Pension funds, domestic banks and insurance companies are the most captive audiences, because governments can just change the rules of the game.

The morality of financial repression…

Reinhart: Let me be a little blunter: A haircut is a transfer from the creditor to the borrower. Who would get hit by a haircut? French banks, German banks, Dutch banks -- banks from the creditor countries. So you can see why this is politically torched. This is why it is not done, it's a redistribution. But ultimately it is going to happen, because the level of debt is too high.

The US will default too but by the inflation route…

Reinhart: Yes, but who are the large holders of government bonds? Foreign central banks. You think the Bank of China is going to be repaid? The US doesn't have to default explicitly. If you have negative real interest rates, the effect on the creditors is the same. That is also a transfer from China, South Korea, Brazil and other creditors to the US.

Why the system will keep continuing until it can’t…

Reinhart: Why do we have such low interest rates? The Federal Reserve Bank is prepared to continue buying record levels of debt as long as the unemployment situation isn't satisfying. And China's central bank will also continue to buy treasuries, because they don't want the renminbi to appreciate.