Europeans Will Eventually Choose Default
Europeans Will Eventually Choose Default
I was sent an email over the weekend from a fellow value investor who had attended the recent Value Investing Congress in New York. He loosely quoted Kyle Bass, one of the presenters, saying that the ‘United States could still, hypothetically, fix the long term problems but there is no way, politically, that is a possibility’.
That concept ties in quite nicely with one of the main themes of This time is different: Eight Centuries of Financial Folly. Carmen Reinhart and Kenneth Rogoff, the authors of this indispensable guide to government default over the past 800 years, go to some lengths to point out that most sovereign defaults don’t occur because a country can’t pay.
They occur because a country’s leaders choose not to repay the debts. The vast majority of sovereign defaults (there have been hundreds) have occurred with debt to GDP ratios of less than 60%.
History has shown that when the political costs of forcing fiscal adjustment on a country’s people is greater than the financial costs of defaulting, politicians will choose to default (or ‘restructure’ in modern language). This, presumably, is what Bass was getting at.
Mathematically it’s not the slightest problem for the US to meet its obligations. All it requires is a relatively minor adjustment to the trajectory of its occupants’ standard of living over the next 100 years. Whether its constituents are prepared to make the necessary sacrifices is an altogether different question.
If it’s not politically possible to fix the problems in the US, then the troubled European countries are no chance. Witness millions of protesters on the Paris boulevards outraged at the government’s attempts to raise the retirement age from, wait for it, 60 to 62. When the average life expectancy was 65, a retirement age of 60 made some sense. Now life expectancy is 80. And most young Europeans see it as a divine right to study (at the government’s expense) until they are 30.
That leaves the French 30 years of work out of 80 years of life (35 hours a week, mind you). It’s farcical and yet, when the government tries to change it by a relatively minor two years, the population brings the country to a standstill.
France, along with most of its European neighbours, needs much bigger changes than a two year increase in the retirement age to meet its future obligations. Doing so is going to be a battle between politics and finances. The images of the past week are a timely reminder of a lesson repeated many times throughout history: it's usually the politics that wins.
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Hi Steve,
Being originally from Ireland I keep a close eye on the economy there and the Irish government seem to be doing whatever they can to bail out the failed banks at the expense of the people.
So the leaders are doing all they can to repay the debt to appease the various bondholders, Brussels etc... The problem being there is that it looks like it's a losing battle. Falling government reveuenues, high unemployment, emigration, sprialling debt and austerity measures seem to be sending Ireland into a death spiral.
So while Ireland's leaders seems to be doing the right thing and trying to pay down debt, history might show that Ireland did not choose to default, it simply had no choice.
Hi Shay, I've been keeping an interested eye on Ireland too. It's an unfortunate situation when you end up with a banking sector that dwarfs the overall economy in size. Not quite Iceland, but it's a mess.
The pain of adjustment can be taken through the political mechanism or through the currency. The US can take it through the latter, Europe - probably not likely given the Euro?
It's interesting to observe the USA where US Treasuries are priced at a 0-3.6% yield and there is perceived safety in municipal bonds judging by the weight of money.
While I agree with your premise there seems to be less risk seen by the US market than seen by yourself (and myself).
Ah, the macro! In a changing global economy even as value investors I believe we will need to pay more attention to macro issues than we have previously, otherwise you risk getting caught in value traps.
Working in the investment industry I have been lucky enough to see Dr. Philippa Malmgren who is an American expert on Geopolitics and how it influences investing. She spoke in detail about the inevitable defaults ahead, bearing in mind she considers debt moratoriuns- such as Dubai world as well as inflating away debt as forms of default. She also discussed the 'social contract' which you have touched on here in detail.
Pippa has a blog and I think you would find her posts of interest: http://pippamalmgren.com/commentary.html
She is one of the sharpest presenters I have ever seen and I am quite a cynical judge.
When George Soros originally said that Europe's single currency experiment was destined to fail, I was very sceptical.
The benefits seemed so enormous and so obvious that I thought that it would be a no-brainer for the member states to do whatever it took to keep the Eurozone working.
The rules of the stability and growth pact that all Eurozone member states signed are very clear, and yet, with the exception of Finland, every single member state is presently in flagrant violation of those rules!
As the situation unfolds, it is becoming clearer that my scepticism was misplaced and that Soros is going to be vindicated once again.
It seems that irrespective of whether you're talking about the environment, the economy or any other area where key decision-making is concentrated into the hands of the public sector, in the long run human folly trumps sound logic every time.
I should add that this is a great topic for raising the issue of sewing the seeds of the next financial crisis: in the aftermath of the GFC, which was popularly believed to be originally caused by the bursting of the subprime housing bubble (personally, I think that this view is myopic nonsense, the real underlying cause was twenty years of monetary mismanagement and moral hazard by Messrs Greenspan and Bernanke, if it hadn't been a housing bubble, there would have been some other bubble), financial intermediaries and their regulators around the world reacted by moving more of their assets into "risk free" securities like government debt.
Greece came somewhat close to triggering another global financial meltdown and Greece is an economic pipsqueak.
Imagine what is going to happen to the global financial system when France, Italy or Spain defaults.
A Japanese debt crisis in the next ten years also seems like a near certainty to me.
Steve. I am not sure whether what I have been told is correct. However, a friend at work tells me the Australian media has INCORRECTLY reported the Paris protests are against raising retirement age from 60 to 62. He tells me the current retirement age for most French citizens is 65 not 60 as reported. He tells me the disputes are against the retirement age for Public Servants only being raised from 60 to 62. In Australia the current retirement age is 55 if born prior to 1960, rising to 60 if born after 1960. That is the age you can access a superannuation pension. It's only the unfunded old age pension you have to wait until you are 64 for women and 65 for men. Most European pensions are at least partially funded with direct contributions over a working lifetime, similar to our superannuation pensions.
Sorry that should be rising to 60 if born after 1965.
Actually, according to what I have read elsewhere, the retirement age of 62 actually only holds with a minimum of 40.5 years of contributions (to be increased to 41.5); otherwise, it's currently 65 (and from 2018 even 67). But this is apparently not widely known. Your point is still well taken.
Ah yes - so eager to bash those french Frogs aren't we...
Shut up Mars.
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