Bill Gross and the deficit ring of fire

Bill Gross is out with his latest monthly investment outlook. He is taking on the issue of sovereign debt. This is an issue that has moved center stage, especially in the wake of the surprise Thanksgiving debt moratorium announcement in Dubai.

What caught my eye was this chart below.


The obvious implication of the chart is that there are three separate groups of sovereign debtors in the major industrialized world. 

The first group has a relatively small current public sector deficit problem and low public sector debt. The implication is they will benefit from low yields as a result.  Those are the bonds investors want to invest in as a safe haven. We’re talking Australia, Denmark and Finland.

A second group of countries has slightly higher public sector debt burdens. In general, though, this group does not have enormous current deficit problems.  Therefore, the implication is they too are safe bets – although perhaps less so. This group includes: Canada, the Netherlands, Sweden, Germany, and outlier Norway which has benefitted from the North Sea.

The third group is the one to watch. This is where the problem children are. Public sector debt levels are higher and rising.  Moreover, there are across the board current large and unsustainable deficit gaps within this group. The obvious implication is that debt from these sovereigns will underperform going forward.

The foregoing analysis dovetails with the Obama Administration’s recent turn to deficit hawkishness. However, the chart points out that it is the nexus of both present deficit spending and longer-term debt levels which makes for a problem.  That is certainly why Obama’s recent deficit salvo is a superficial political stunt which does nothing to address these longer-term issues.

From a market perspective, you would want a relative value play of long Finland and Denmark but short Japan and Greece is the right read of this chart.

For his part, Gross says:

The Reinhart/Rogoff book speaks primarily to public debt that balloons in response to financial crises. It is a voluminous, somewhat academic production but it has numerous critical conclusions gleaned from an analysis of centuries of creditor/sovereign debt cycles. It states:

  1. The true legacy of banking crises is greater public indebtedness, far beyond the direct headline costs of bailout packages. On average a country’s outstanding debt nearly doubles within three years following the crisis.
  2. The aftermath of banking crises is associated with an average increase of seven percentage points in the unemployment rate, which remains elevated for five years.
  3. Once a country’s public debt exceeds 90% of GDP, its economic growth rate slows by 1%.

Their conclusions are eerily parallel to events of the past 12 months and suggest that PIMCO’s New Normal may as well be described as the “time-tested historical reliable.” These examples tend to confirm that banking crises are followed by a deleveraging of the private sector accompanied by a substitution and escalation of government debt, which in turn slows economic growth and (PIMCO’s thesis) lowers returns on investment and financial assets. The most vulnerable countries in 2010 are shown in PIMCO’s chart “The Ring of Fire.” These red zone countries are ones with the potential for public debt to exceed 90% of GDP within a few years’ time, which would slow GDP by 1% or more. The yellow and green areas are considered to be the most conservative and potentially most solvent, with the potential for higher growth.

Remember, however, there are the private sector debts as well – and as this downturn has shown, private sector debts can be foisted onto the public sector via the politics of privatized gain/socialized loss.

Source: The Ring of Fire – Investment Outlook, Bill Gross | February 2010

  1. demandside says

    “… a deleveraging of the private sector accompanied by substitution and escalation of government debt, which in turn slows economic growth (PIMCO’s thesis) …”

    Also Minsky’s thesis twenty-five years ago, except the “in turn” part, which conceals the fact that the government is backstopping whatever private banking institutions “innovate.” So the private actors run up the debt bill, the economy goes into crisis, the government bails it out, and it blows up the debt balloon. What is not clear in my cursory reading is the fact that the situation is progressive.

    Also dovetails with Soros’ superbubble.

    So, then, the answer is to ….?

    Write down the debt, move credit into productive assets in the public sector, and let the private actors who played cowboy deal with the fact they ran their horse to death.

    1. Edward Harrison says

      Agreed. That is good Keynesian policy. The bad form is what we are now seeing where the private actors who played cowboy get a new horse.

  2. dansecrest says

    Bill Mitchell at had some things to say yesterday about the Reinhart/Rogoff book —

    (Reinhart and Rogoff) are talking about problems that national governments face when they borrow in a foreign currency. So when so-called experts like Mauldin claim that their analysis applies to the “entire developed world” you realise immediately that they are in deception mode or just don’t get it…

    Reinhart and Rogoff are only talking about debt that is issued in a foreign jurisdiction typically in that foreign nation’s currency.

    Japan has no foreign currency-denominated debt. Many other advanced nations (including the U.S.) have no foreign currency-denominated debt…

    It turns out that many developing nations do have such debt courtesy of the multilateral institutions like the IMF and the World Bank who have made it their job to load poor nations up with debt that is always poised to explode on them. Then they lend them some more.

    But it is very clear that there is never a solvency issue on domestic debt whether it is held by foreigners or domestic investors.

    Reinhart and Rogoff also pull out examples of sovereign defaults way back in history without any recognition that what happens in a modern monetary system with flexible exchange rates is not commensurate to previous monetary arrangements (gold standards, fixed exchange rates etc). Argentina in 2001 is also not a good example because they surrendered their currency sovereignty courtesy of the US exchange rate peg (currency board)…

    Britain has defaulted only once in its history – during the 1930s – while it was on a gold standard. The Bank of England overseeing an economy ravaged by the Great Depression defaulted on gold payments in September, 1931. The circumstances of that default are not remotely relevant today. There is no gold standard, the sterling floats. Britain has never defaulted when its monetary system was based on a non-convertible currency.

    A large number of defaults are associated with wars or insurrections where new regimes refuse to honour the debts of the previous rulers. These are hardly financial motives. Japan defaulted during WW2 by refusing to repay debts to its enemies – a wise move one would have thought and hardly counts as a financial default.

    But if you consider the “virgin” list – how much of the World’s GDP does this group of nations represent? Answer: a huge proportion, especially if you include Japan and a host of other European nations that have not defaulted in modern times.

    Further, how many nations with non-convertible currencies and flexible exchange rates have ever defaulted? Answer: hardly any and the defaults were either political or because they were given poor advice (for example Russia in 1998).

    Reinhart and Rogoff don’t make this distinction – in fact a search of the draft text reveals no “hits” at all for the search string “fixed exchange rates” or “flexible exchange rates” or “convertible” or “non-convertible”, yet from a Modern Monetary Theory (MMT) perspective these are crucial differences in understanding the operations of and the constraints on the monetary system.

    1. Marshall Auerback says

      This is completely correct.

      1. Edward Harrison says

        Somewhat off topic since I am talking about Russia here but there case is instructive in regards to default:

        I said a few months back:

        Russia defaulted voluntarily, an event which the geniuses at Long-Term Capital Management failed to model correctly. Moreover, the immediate stress on Russia was not the rouble-denominated debt but the mountain of foreign currency obligations via an unrealistic currency peg which were draining reserves. Similar events unfolded in Argentina a few years later as their currency board crumbled and the Peso was devalued by three-quarters.

        the point is that a government can always make good on its own fiat currency obligations if it chooses to do so. The real question is why a country might voluntarily default on its own currency debt or involuntarily on foreign currency debt. The answer usually has to do with taxes. In Argentina and Russia, the government was unable to prove that its taxation policies were benefitting its citizens, creating rampant tax evasion, especially in the monied classes.

        America has no foreign currency debt to speak of. There is no default risk. There is inflation risk yes, interest rate risk yes, currency depreciation risk. But that is all.

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