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The Debt Supercycle

Somewhere Over the Rainbow

The Path to Profligacy

Things That Cannot Be

Vancouver, Maine, and Europe

By John Mauldin

I have been writing about The End Game for some time now. And writing a bookof the same title. Consequently, I have been thinking a lot about how the credit crisisevolved into the sovereign debt crisis, and how it all ends. Today we explore a fewmusings I have had of late, while we look at some very interesting research. What will aworld look like as a variety of nations have to deal with the end of their Debt Supercycle.Well jump right in with no but firsts this week.

Part of this weeks writing is colored by my next conference. Next week I go to

Vancouver to speak at the Agora Investment Symposium. I have a number of very goodfriends who will be there, both speaking and attending. This is generally a hard money,gold-bug-type crowd (and a very large conference). Some (but not all) of the speakersbelieve that all fiat currencies, including the US dollar, will default in one way or another,either outright or through inflation, as mounting debts and out-of-control entitlementobligations force large-scale monetization, leading to high inflation if not hyperinflation.

There are a couple of panels and debates that I presume I will be involved in, andI have been meditating on how the panels will go. Bill Bonner, founder of Agora and abook-writing machine, has a steel-trap mind with an ability to turn a phrase that is waybeyond that of your humble analyst. The preponderance of the panel members will likelybe in the soft-depression camp, and most of us will card-carrying members of the OftenWrong but Seldom in Doubt school of economics and investing (the Latin for which, Iam told, is Saepe mendosus, nunquam dubius.) And yet, I am not quite there with mostof that thinking, so the debates will be lively.

Understand, I started in the newsletter business back in 1981 or so, working withDr. Gary North (also known as Scary Gary). Gary is an Austrian, and although I took alot of economics courses at Rice, I had never read anything even remotely close to theAustrian school. I caught up rather quickly, and in the mid-1980s even wrote my owngold-stock newsletter (although I must admit I know next to nothing of the current gold-stock world). I was mostly limited to books, newsletters, and journals for readingmaterial.

Then came the mid 90s and the internet, and the world opened up. I becameincurably addicted to information and read widely and deeply. At some point the smalllens of Austrian thought became difficult to continue to peer through, as I looked forperspectives on the larger world. I now worship at a number of economic altars, in theongoing effort to understand what is happening in the real world, not just in the world of

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theory or the world of what we would like to be. So, with that background, lets look atThe End Game.

The Debt Supercycle

When I mention The End Game, youll immediately want to know what is ending.What I think is ending for a significant number of countries in the developed world isthe Debt Supercycle. The concept of the Debt Supercycle was originally developed by theBank Credit Analyst. It was Hamilton Bolton, the BCA founder, who used the wordsupercycle, and he was referring generally to a lot of things, including money velocity,bank liquidity, and interest rates. Tony Boeckh changed the concept to the more simpleDebt Supercycle back in the early 1970s, as he believed the problem was spiralingprivate-sector debt. The current editor of the BCA (and Maine fishing buddy) MartinBarnes has greatly expanded on the concept.

Essentially, the Debt Supercycle is the decades-long growth of debt from small

and easily-dealt-with levels, to a point where bond markets rebel and the debt has to berestructured or reduced or a program of austerity must be undertaken to bring the debtback to manageable proportions.

As Bank Credit Analyst wrote back in 2007:

The history of the U.S. is characterized by a long-run increase in indebtedness,punctuated by occasional financial crises and subsequent policy reflation. The subprimeblow-up is the latest installment in this ongoing Debt Supercycle story.During eachcrisis, there are always fears that conventional reflation will no longer work, implying theeconomy and markets face a catastrophic debt unwinding. Such fears have always provedunfounded, and the current episode is no exception.

A combination of Fed rate cuts, fiscal easing (aimed at relieving subprimedistress), and a lower dollar will eventually trigger another upleg in the Debt Supercycle,and a new round of leverage and financial excesses. The objects of speculation are likelyto be global, particularly emerging markets and resource related assets. The Supercyclewill end if foreign investors ever turn their back on U.S. assets, triggering capital flightout of the dollar and robbing U.S. authorities of any room for maneuver. This will nothappen any time soon.

I was talking with Martin a few months ago, and about the topic turned to theending of the Debt Supercycle. Martin said we are nowhere near the end, as the

government is stepping in where private debtors are cutting back. We have just shiftedthe focus of where the debt is coming from. And he is right, in that the Debt Supercyclein the US, Great Britain, Japan and other developed countries (yes, even Greece!) is stillvery much in play as governments explode their balance sheets. Total debt continues togrow.

Somewhere Over the Rainbow

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And yet, and yet While the Debt Supercycle may not yet have ended, I think wecan begin to see a clear case that, like the sandwich-board-wearing cartoon prophetwarning, The End is Nigh! Greece is the harbinger of fundamental change. Spain andPortugal are pointing to the same outcome, as their cost of debt keeps rising. AndIreland? The Baltics?

There is a limit to how much debt you can pile on. But as the work of Reinhartand Rogoff points out (This Time Is Different), there is not a fixed limit or some certainpercentage of GNP. Rather, the limit is all about confidence, a theme I have written onmany times. Everything goes along well, and then Boom! it doesnt. That Boom hashappened to Greece. Without massive assistance, Greek debt would be unmarketable.Default would be inevitable. (I still think it is!)

The limit is different for every nation. For Russia in the 1990s, it was a ratherminor total debt-to-GDP ratio of around 12%. Japan will soon have a debt-to-GDP ratioof 230%! The difference? Local savers bought government debt in Japan and did not in

Russia.

The end of the Debt Supercycle does not have to mean calamity for each country,depending on how far down the road they are. Yes, if you are Greece your choices arebetween very, very bad and disastrous. Japan is a bug in search of a windshield. Eachcountry has its own dynamics.

Take the US. We are some ways off from the end. We have t ime to adjust. Butlets be under no illusions, we cannot run deficits of 10% of GDP forever. At some pointthe Fed will either have to monetize the debt or the bond market will simply demand anever-higher interest rate. Why cant we go the way of Japan? Because we do not have thelevel of savings they have traditionally had. But their savings levels are rapidly declining,which says that if they want to continue their deficit spending at 10% of GDP, they willhave to go into the foreign markets to borrow money at a much higher cost, or theircentral bank will have to print money. Neither choice is good.

The Path to Profligacy

How did we get here? We simply kept borrowing ever greater amounts of moneyat an increasingly rapid pace. Look at the chart below. It is about six months old, but notmuch has changed.

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In the beginning, each dollar of debt brought about a corresponding dollar ofincrease in GDP. But that early money was invested in houses and in the means ofproduction, which helped grow the economy. As time went on, and especially after the80s, more and more of the debt was used for consumption (of which much has come tobe from foreign sources) and not for the increase of productive capacity. Toward the end,it took $3 of debt to create a $1 rise in GDP in the US. And now, each $1 rise in debt isgovernment debt, which some research (not neo-Keynesian Paul Krugmans!) says has aslightly negative multiplierit actually hurts GDP.

And it is not just the US. Take a look at the chart of G-7 debt (courtesy of GMO,more about which later). That is one ugly and unsustainable chart. In 1950 the G7countries were recovering from very large war-time debts. Now we dont have thatexcuse. Nor do we have the option of doing what they did. They cut military spending,inflated a little in nominal terms, and grew their way out of the problem.

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Things That Cannot Be

Talk about unsustainable. The next chart is one of something that cannot be. TheUS cannot borrow $15 trillion in the next ten years. Its just not there. Long before that,the bond market will simply rebel, rates will rise, and the aftermath will make the lastcrisis seem like a cakewalk.

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For most countries with debt problems, The End Game is a binary-path-dependentfuture. Countries can elect to get their fiscal houses in order over time, getting the fiscaldeficits below the growth of nominal GDP. That is not without consequence, as it willmean slower growth in the short term (less than one year), but cutting deficits year afteryear, even gradually, will mean a very slow-growth, Muddle Through economy for asustained period.

Some say the coming election is the most important we have had for a long time. Idisagree. It is one thing for the Tea Party movement and independents to elect aRepublican Congress. If I am right and the economy is still slow and unemployment

lingers around 8% by 2012, it is likely we will see a Republican president at that point.So some will say 2012 will be the important election.

However, I think the really important election will be in 2014. Lets make the(clearly) optimistic assumption that Republicans get religion and really go to work on thedeficits. The economy will not be booming in 2014, as a result of the tightening andmove to austerity, whether through cuts or tax increases or both. Cutting more than $1trillion annually out of spending over 7-8 years is not easy or without pain.

Will voters in 2014 decide there is too much pain? Will they stay the course forfiscal control or will they scream for more stimulus? Will they take the long view and letpoliticians make hard choices or will they send the message that short-term choices arewhat they want? Will they give lip service to going on a diet and exercising and then stayon the couch and eat chips and watch TV? Or will they really get fiscal religion and getwith the program?

Its all well and good to say that you want fiscal rectitude. Its another thing whenit is hitting budgets near and dear to you. And to get back to a remotely sustainable deficit

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is going to take pain in every corner. It is going to hit near you, gentle reader. Some willget hit harder than others.

And this is the case in every country running large and out-of-control deficits. It isnot just a US problem. The Irish are in what can only be called a depression, along with

the Baltic states and Hungary. Greece will soon be there, once they have to meet marketrates for their debt, or force their labor markets to endure a very serious deflation to makethemselves more competitive.

So, can we know how The End Game will turn out? The short answer is no. Eachcountry will have to make its own political choices. Could we see hyperinflation in theUS on Britain or Japan? It is possible, with bad policy decisions. I doubt it that it gets tothat. But could we see inflation? The answer is yes.

That has been the traditional method of default for many countries over the years.Instead of outright default, they simply inflate away debt. And the logic is compelling. If

you have 5% inflation along with 3% real growth, you get a nominal growth rate of 8%.That means in nine years the economy is twice the size in dollar terms, but only about35% bigger in inflation-adjusted terms. If somewhere along the way you can get yourdeficits down to just 3%, then you can reduce your debt-to-GDP ratio by 5% a year. Inless than ten years, you cut your debt-to-GDP ratio in half. Sounds good, right?

Of course, you have destroyed the purchasing power of your currency, given areal hit to the incomes of the middle class, defrauded those who bought your debt, and inall likelihood you did not hold inflation to just 5%. Think the 70s.

And getting the deficit down to 3% is no easy proposition for many countries.Look at the chart below, again from GMO in a paper by Edward Chancellor on sovereigndebt. I highly commend it to you. It is all over the net, but the easiest place I found toread it is athttp://www.zerohedge.com/article/must-read-reflections-gmos-edward-chancellor.

We can think of fiscal debt in two ways, structural and cyclical. Structural debt isthat caused by government spending programs. Cyclical debt occurs during recessions asrevenue drops. One assumes that at some point things get back to normal and revenuesbegin to rise and the cyclical part of the deficit goes away. But that still leaves thestructural debt. That can only be dealt with by cutting spending, raising taxes, or holdingspending flat while growing your way out of the problemor some combination of allthree.

I find it interesting that Italy has a far less problematic fiscal situation than manyof its neighbors. And while politicians in the US always say they will cut out wastefulspending, there just isnt all that much here, percentage-wise. Italy has a lot of places tocut. As an example, there are 629,000 official cars, some of them high-priced Maseratis,that ferry government officials around. That is ten times more than in other Europeancountries and, on a percentage-of-GDP basis, 50 times more than in the US. They could

http://www.zerohedge.com/article/must-read-reflections-gmos-edward-chancellorhttp://www.zerohedge.com/article/must-read-reflections-gmos-edward-chancellorhttp://www.zerohedge.com/article/must-read-reflections-gmos-edward-chancellorhttp://www.zerohedge.com/article/must-read-reflections-gmos-edward-chancellorhttp://www.zerohedge.com/article/must-read-reflections-gmos-edward-chancellorhttp://www.zerohedge.com/article/must-read-reflections-gmos-edward-chancellor

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cut out half of them and save about $15 billion, by my back-of-the-napkin calculation,which is more than 0.6% of total GDP. Reduce the number to the European average andyou could cut half the structural debt. (I assume about $50,000 per year for maintenance,depreciation, and drivers.) Oh, that we in the US had such easy pickings.(http://www.economist.com/node/16102798?story_id=16102798)

The Province of Uncertainty

Edward Chancellor closes his paper so eloquently. Let me quote:

As a result of the financial crisis, the worlds leading sovereign credit marketshave left the world of risk, where probabilities of gains and losses can be measured, andentered the darker province of uncertainty. The future performance of sovereign creditsdepends on future events and decisions that are unknowable.

Will the global economic recovery be sustained? Or will economic growth andtax revenues remain weak for a prolonged period? Will policymakers in leading countriesfind the political strength to restore their government finances to order? Or will, as somefear, the attempt to cut deficits actually increase them (by hurting the economy andreducing tax revenues)?

http://www.economist.com/node/16102798?story_id=16102798http://www.economist.com/node/16102798?story_id=16102798http://www.economist.com/node/16102798?story_id=16102798http://www.economist.com/node/16102798?story_id=16102798

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Will central banks engage in further bouts of quantitative easing until they reachthe point of no return? Or will they err on the side of caution and tighten too early? Willthe current deflationary policies within the Eurozone persist? Or will the ECB turntoward the monetization of excessive debt levels? Will interest rates on long-termgovernment debt remain low? Or will bond vigilantes take fright and demand higher rates

as compensation for all this uncertainty and risk?

These are interesting but intractable questions. Nobody knows their answers.Current yields on government bonds in most advanced economies (PIGS excepted) are atvery low levels. Under only one conditionthat the world follows Japans experience ofprolonged deflationdo they offer any chance of a reasonable return. But this is not theonly possible future. For other outcomes, long-dated government bonds offer a limitedupside with a potentially uncapped downside. As investors, such asymmetric pay-offprofiles dont appeal tous. Caveat (sovereign) creditor!

As noted above, The End Game is path-dependent for each country. By that I

mean that the end result will stem directly from the course they choose. It is not clearwhat those choices will be.

For instance, I have often noted that the euro is not a currency so much as anexperiment. But it is also not an economic currency, but rather a political currency.Whether the euro lasts in its present form is a political decision to be made by numerousnational actors. It is too soon to tell.

All of the developed countries that are in trouble have hard decisions to make. Topretend that we know exactly what that involves requires a fair degree of hubris. But wecan see the various paths. In most cases, the number of paths is quite limited, because badchoices were made that have brought us to our current set of choices. As we attempt tosort out those paths, we will find there are signposts along the way telling us which pathwe are taking. As investors, we can then position ourselves accordingly.

And even for countries that, relatively speaking, have kept their act together, weare talking about a large part of world GDP at risk. It is an interesting world in which welive.

Vancouver, Maine, and Europe

As noted above, next week I am in Vancouver. I will be doing a seminar for myCanadian partner John Nicola on Tuesday evening. Drop me a note if you want an invite,assuming there is room. Then on to the conference, where there are so many friends andcompatriotsI am really looking forward to it. Back home for two weeks and then off toNew York for a day for some media, then to Maine for the annual fishing trip with DavidKotok and friends. Looks like CNBC will not cover it this year after all.

I will be going to Europe in the middle of September. For sure London,Amsterdam, and Malta. Maybe a few other cities. I will spend a weekend at the vacation

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home of European partner Niels Jensen in Mallorca (along with South American partnerEnrique Fynne). More on that as the schedule settles.

Thinking of Europe has me once again thumbing through my latest copy of InternationalLiving. I often wonder (fantasize?) about the places they describe and wonder what it

would be like to have a less hectic life. Maybe someday, but for now I take it in bits andpieces as I travel. You can get your own inexpensive copy of International Living andfind out about what locales are inviting or just dream along with me.http://www1.internationalliving.com/outside/july10/invins/

This weekend is going to be a busy working weekend. My co-author for the book,Jonathan Tepper of Variant Perception, is in from London; and we will spend the nextthree days editing, writing, critiquing, and thinking about the book. The goal is to have arough first draft by the end of July and then final edits by the end of August, and then getit to the publisher and out the door as soon as possible after that. Frankly, writing a bookis a lot harder than writing this e-letter. I know it is mostly mental, but a book seems so

much more, well, serious. It takes 3-4 times as long to write the same amount of copy.But I think this book is going to be well worth the time.

It is time to hit the send button. It is late and I have to get up (relatively) early.Jonathon is young (at least to me!) and seems to need no sleep, so I have to try and keepup with him. Well see how that goes.

Have a great week! Even if we are thinking about The End Game, that doesntmean we cant have fun in the summer!

Your ready to get this book out analyst,

John Mauldin

International Living

http://www1.internationalliving.com/outside/july10/invins/http://www1.internationalliving.com/outside/july10/invins/http://www1.internationalliving.com/outside/july10/invins/