Some Thoughts on the Debt Disaster in the US and UK and Possible Alternatives

This is a rather important essay in that it nicely frames up the problem that we face, and the constraints on the remedies at our disposal.

We will be speaking more about that in the near term, but for now here is a framework by which to understand the boundaries, the 'lay of the land.'

The key point is that the debt to GDP ratio has become unsustainable. The way to correct this is to lower it to a level that is manageable and to work it down.

It will likely require a combination of inflation and debt reduction by bankruptcies and writedowns in order to restore the economy to something which can be used to achieve a balance.

Liquidationism is a trap because it reduces GDP and cripples the productive economy as it reduces debt. It is similar to poisoning a patient to treat an infection. It is favored only by those who believe that they can insulate themselves and profit by it.

Without serious systemic reforms, any remedies will not obtain traction, merely provide a new step function for a repetition of the cycle of debt expansion, as was done in the series of credit bubbles under Alan Greenspan and Bush-Clinton.

The impact will be felt around the globe because of the interconnectedness of the world economy and finance, but the heart of the problem is in the US and the UK.


Economic Times
US and UK on brink of debt disaster
20 Jan, 2009, 0419 hrs IST

LONDON: The United States and the United Kingdom stand on the brink of the largest debt crisis in history.

While both governments experiment with quantitative easing, bad banks to absorb non-performing loans, and state guarantees to restart bank lending, the only real way out is some combination of widespread corporate default, debt write-downs and inflation to reduce the burden of debt to more manageable levels. Everything else is window-dressing. (Quantitative easing, bad banks, and state guarantees are the instruments of inflation. The amount of inflation that the West can manage will greatly affect the amount of these more draconian measures - Jesse)

To understand the scale of the problem, and why it leaves so few options for policymakers, which shows the growth in the real economy (measured by nominal GDP) and the financial sector (measured by total credit market instruments outstanding) since 1952.

In 1952, the United States was emerging from the Second World War and the conflict in Korea with a strong economy, and fairly low debt, split between a relatively large government debt (amounting to 68 percent of GDP) and a relatively small private sector one (just 60 percent of GDP).

Over the next 23 years, the volume of debt increased, but the rise was broadly in line with growth in the rest of the economy, so the overall ratio of total debts to GDP changed little, from 128 percent in 1952 to 155 percent in 1975.

The only real change was in the composition. Private debts increased (7.8 times) more rapidly than public ones (1.5 times). As a result, there was a marked shift in the debt stock from public debt (just 37 percent of GDP in 1975) toward private sector obligations (117 percent). But this was not unusual. It should be seen as a return to more normal patterns of debt issuance after the wartime period in which the government commandeered resources for the war effort and rationed borrowing by the private sector.

From the 1970s onward, however, the economy has undergone two profound structural shifts. First, the economy as a whole has become much more indebted. Output rose eight times between 1975 and 2007. But the total volume of debt rose a staggering 20 times, more than twice as fast. The total debt-to-GDP ratio surged from 155 percent to 355 percent.

Second, almost all this extra debt has come from the private sector. Despite acres of newsprint devoted to the federal budget deficit over the last thirty years, public debt at all levels has risen only 11.5 times since 1975. This is slightly faster than the eight-fold increase in nominal GDP over the same period, but government debt has still only risen from 37 percent of GDP to 52 percent.

Instead, the real debt explosion has come from the private sector. Private debt outstanding has risen an enormous 22 times, three times faster than the economy as a whole, and fast enough to take the ratio of private debt to GDP from 117 percent to 303 percent in a little over thirty years.

For the most part, policymakers have been comfortable with rising private debt levels. Officials have cited a wide range of reasons why the economy can safely operate with much higher levels of debt than before, including improvements in macroeconomic management that have muted the business cycle and led to lower inflation and interest rates. But there is a suspicion that tolerance for private rather than public sector debt simply reflected an ideological preference.

THE DEBT MOUNTAIN

The data makes clear the rise in private sector debt had become unsustainable. In the 1960s and 1970s, total debt was rising at roughly the same rate as nominal GDP. By 2000-2007, total debt was rising almost twice as fast as output, with the rapid issuance all coming from the private sector, as well as state and local governments.

This created a dangerous interdependence between GDP growth (which could only be sustained by massive borrowing and rapid increases in the volume of debt) and the debt stock (which could only be serviced if the economy continued its swift and uninterrupted expansion).

The resulting debt was only sustainable so long as economic conditions remained extremely favorable. The sheer volume of private-sector obligations the economy was carrying implied an increasing vulnerability to any shock that changed the terms on which financing was available, or altered the underlying GDP cash flows.

The proximate trigger of the debt crisis was the deterioration in lending standards and rise in default rates on subprime mortgage loans. But the widening divergence revealed in the charts suggests a crisis had become inevitable sooner or later. If not subprime lending, there would have been some other trigger.

WRONGHEADED POLICIES

The charts strongly suggest the necessary condition for resolving the debt crisis is a reduction in the outstanding volume of debt, an increase in nominal GDP, or some combination of the two, to reduce the debt-to-GDP ratio to a more sustainable level.

From this perspective, it is clear many of the existing policies being pursued in the United States and the United Kingdom will not resolve the crisis because they do not lower the debt ratio.

In particular, having governments buy distressed assets from the banks, or provide loan guarantees, is not an effective solution. It does not reduce the volume of debt, or force recognition of losses. It merely re-denominates private sector obligations to be met by households and firms as public ones to be met by the taxpayer.

This type of debt swap would make sense if the problem was liquidity rather than solvency. But in current circumstances, taxpayers are being asked to shoulder some or all of the cost of defaults, rather than provide a temporarily liquidity bridge.

In some ways, government is better placed to absorb losses than individual banks and investors, because it can spread them across a larger base of taxpayers. But in the current crisis, the volume of debts that potentially need to be refinanced is so large it will stretch even the tax and debt-raising resources of the state, and risks crowding out other spending.

Trying to cut debt by reducing consumption and investment, lowering wages, boosting saving and paying down debt out of current income is unlikely to be effective either. The resulting retrenchment would lead to sharp falls in both real output and the price level, depressing nominal GDP. Government retrenchment simply intensified the depression during the early 1930s. Private sector retrenchment and wage cuts will do the same in the 2000s.

BANKRUPTCY OR INFLATION

The solution must be some combination of policies to reduce the level of debt or raise nominal GDP. The simplest way to reduce debt is through bankruptcy, in which some or all of debts are deemed unrecoverable and are simply extinguished, ceasing to exist.

Bankruptcy would ensure the cost of resolving the debt crisis falls where it belongs. Investor portfolios and pension funds would take a severe but one-time hit. Healthy businesses would survive, minus the encumbrance of debt.

But widespread bankruptcies are probably socially and politically unacceptable. The alternative is some mechanism for refinancing debt on terms which are more favorable to borrowers (replacing short term debt at higher rates with longer-dated paper at lower ones).

The final option is to raise nominal GDP so it becomes easier to finance debt payments from augmented cashflow. But counter-cyclical policies to sustain GDP will not be enough. Governments in both the United States and the United Kingdom need to raise nominal GDP and debt-service capacity, not simply sustain it.

There is not much government can do to accelerate the real rate of growth. The remaining option is to tolerate, even encourage, a faster rate of inflation to improve debt-service capacity. Even more than debt nationalization, inflation is the ultimate way to spread the costs of debt workout across the widest possible section of the population.

The need to work down real debt and boost cash flow provides the motive, while the massive liquidity injections into the financial system provide the means. The stage is set for a long period of slow growth as debts are worked down and a rise in inflation in the medium term.

Murkiness in the NYMEX Pits As the Banks Hoard Oil

"Morgan Stanley hired an oil tanker to store crude oil in the Gulf of Mexico, joining Citigroup Inc. and Royal Dutch Shell Plc in trying to profit from the contango, two shipbrokers said in reports earlier today."

There is a sharp contango in the near months in the NYMEX oil pit, and it will get sharper as the attempts to suppress the price near term, most likely to punish Russia, Venezuela and Iran, falter. Then it will flatten as market adjusts prices to normalcy.

Let's see if Bloomberg gives us a more coherent update. But its funny that Citigroup, Morgan Stanley, and probably other banks are buying oil now to store in tankers and deliver later when the paper chase falters. Nice use of the bailout money. Why lend when you can speculate on market inefficiency which you help to create?

Bloomberg
Goldman Sees ‘Swift, Violent’ Oil Rally Later in Year
By Grant Smith

Jan. 19 (Bloomberg) -- Goldman Sachs Group Inc. commodity analyst Jeffrey Currie said he expects a “swift and violent rebound” in energy prices in the second half of the year.

Oil prices may have reached their lowest point already, after falling to $32.40 in mid-December, and are expected to rise to $65 by the end of this year, the analyst said. There is scope for a “new bull market” in oil, Currie said. (The December '09 futures are trading around there already - Jesse)

World oil demand is likely to fall by about 1.6 million barrels a day this year, the Goldman analyst said today at a conference in London. That’s bigger than the reduction expected by the International Energy Agency, which last week forecast a decrease of about 500,000 barrels a day, or 0.6 percent, this year.

A recent tactic of using supertankers to store crude oil to take advantage of higher prices later this year is “difficult” to profit from and is “near the end of this process” anyway, the Goldman analyst said. (We can only use the NYMEX 'front month' to punish Iran, Venezuela, and Russia for so long - Jesse)

New York crude futures for delivery in December, trading near $56 a barrel, currently cost some $15 a barrel more than March futures, a market situation known as contango, where prices are higher for later delivery. (This is poorly worded at best - Jesse)

The contango is likely to flatten as supply cuts by OPEC and other producers take effect, reducing the availability of oil for immediate delivery, Currie said. (Contango is when the future months are higher in price. This is the case for the futures. But December delivery, according to this article, is in backwardation, where true 'spot' is higher than paper prices, and a sure sign of price manipulation. - Jesse)

The Organization of Petroleum Exporting Countries started another round of supply cutbacks at the start of this month. The group’s compliance with its overall efforts to cut production will probably peak at 75 percent, or a reduction of about 3 million barrels a day out of an announced aim of 4.2 million barrels a day, Goldman Sachs said.

In several steps, 10 OPEC members have pledged to reduce production to 24.845 million barrels a day, a cut of 4.2 million barrels a day from September’s level.

Morgan Stanley hired an oil tanker to store crude oil in the Gulf of Mexico, joining Citigroup Inc. and Royal Dutch Shell Plc in trying to profit from the contango, two shipbrokers said in reports earlier today.

West Texas Intermediate Benchmark Diverging Widely from World Oil Prices

If there indeed is a glut of oil in the US at a bottleneck, as NYMEX appears to contend, then world prices should diverge, and more oil would be flowing to other venues.

Interestingly enough, there is also a huge difference in price between the February contract at 36.51 for WTI and the March contract at 42.57.

So let's see how this short term oil glut in Oklahoma gets squared away. Sure to be interesting. It would be a shame if the NYMEX loses some of its credibility as a price discovery mechanism.


Reuters
Signs of shift away from WTI
By Javier Blas in London
January 18 2009

Oil traders are quietly pricing some of their deals away from the West Texas Intermediate contract, traditionally the world’s most important oil benchmark, as it is being distorted by record inventories at its landlocked delivery point.

The move is a setback for the benchmark that since the launch of the Nymex WTI futures in the early 1980s has dominated physical and financial oil markets.

The surge in oil inventories in Cushing, Oklahoma, where WTI is delivered into America’s pipeline system, has depressed its value not only against other global benchmarks, such as Brent, but also against other domestic US crudes.

Julius Walker, an oil market analyst at the International Energy Agency in Paris, said there was “anecdotal evidence” of traders moving away from WTI and “doing deals based on other US oil benchmarks”.

The IEA monthly report said Brent was now “arguably more reflective of global oil market sentiment”. However, Bob Levin, managing director of market research at Nymex said that the WTI contract was performing “transparently”, reflecting a “loss in oil demand and sharply rising inventories”.

“WTI is better reflecting global oil fundamentals than Brent,” Mr Levin said. “The oil industry has not abandoned the WTI contract and it has confidence in it.”

Nevertheless, traders in London, New York and Houston confirmed a small number of transactions away from WTI after its price plunged last week to record discounts against other global and domestic benchmarks. The traders cautioned that the move could reverse if the WTI situation normalised. Lawrence Eagles, at JPMorgan, said any move away from WTI would face “strong resistance as none of the other US benchmarks have the price transparency of an exchange market”.

Highlighting the price disconnection with the global market, WTI, which usually trades at a premium of $1-$2 a barrel to Brent, last week plunged to an all-time discount of $11.73. The detachment hit the US market too, where Light Louisiana Sweet, jumped to a $9.50 premium, the highest in 18 years.

Brent ended last week at $46.18 a barrel, well above WTI at $36.

Walter Lukken, outgoing chairman of the Commodities Futures Trading Commission, told the FT the regulator was following “very closely” the WTI disconnection.

This is not the first time WTI has diverged from other benchmarks, but the discrepancy is far more severe this time.

Royal Bank of Scotland to Report $37 Billion in Losses and Goodwill Writedowns

RBS
RBS to unveil up to $37 billion of losses
By Adrian Croft
18/01/09

LONDON (Reuters) - Royal Bank of Scotland will unveil up to 25 billion pounds ($37.30 billion) of losses for 2008 on Monday due to bad debts and writing off goodwill on its acquisition of ABN AMRO, a British newspaper said on Monday.

RBS will say it incurred about 7 billion pounds of losses in 2008 and that it is taking a goodwill writedown of between 15 billion and 20 billion pounds, The Daily Telegraph reported, calling it the "biggest loss in UK history."

RBS declined to comment on the report.

Britain is set to throw its banks another multi-billion pound lifeline on Monday by allowing them to insure against steep losses and guaranteeing their debt to stop the credit crunch pushing the economy into a deep slump.

The British government will swap up to 5 billion pounds of preference shares in Royal Bank of Scotland for ordinary shares, increasing its stake in the British bankL, a person familiar with the matter said on Sunday.

The move aims to remove pressure on RBS -- whose shares fell 13 percent on Friday -- to pay 12 percent annual interest on the preference shares.

The government owns 58 percent of RBS after buying 15 billion pounds of ordinary shares last November. The stake could rise to near 70 percent if all the preference shares are converted. RBS again declined to comment.

RBS, once Britain's second-biggest bank, was left short of capital as a result of hefty write-offs against debt-backed securities. The 2007 acquisition of parts of Dutch rival ABN AMRO put further strain on its capital reserves.