A Primer: Sovereign Debt Defaults = Social Unrest + Much Higher Gold Prices
by Arnold Bock, FinancialArticleSummariesToday.com |June 2, 2010Print
The magnitude of current private and government debt, coupled with massive unfunded contingent liabilities for promises of future services to their citizens, will prove to be impossible for many nations to fund. Massive inflation in the money supply will become the preferred vehicle to deflect the default monster and will result in vastly devalued currencies and price inflation as a prelude to default. Such action will be a desperate attempt to buy time to stave off the inevitable and will result in social unrest caused by persons whose comfortable lifestyle and elevated standard of living is about to disintegrate before their very eyes.
'Sovereign Debt' was once only a phrase found in the arcane prose of economists writing in academic journals. Internet blogs started carrying commentary on the subject after the near-death experience of many large banks but only in the last few months has the mainstream media tuned into the issue of sovereign debt. Quite simply, they could not ignore the omnipresent financial clouds any longer.
What is 'Sovereign' Debt?
In its simplest form, ' sovereign' debt means 'government' debt, the financial debt of a country. It usually also means the accumulated debts of government sub-entities such as states, provinces, municipalities, agencies, boards and commissions for which the senior government is ultimately responsible.
While existing government debt is the problem for today, contingent liabilities for promises of future services to its citizens dramatically complicates the current debt problem. Unfunded future liabilities are obligations which represent the one ton gorilla peering through the front window of many nations.
What does Debt 'Default’ Mean?
'Default' is a word similar to the word ‘bankrupt’ when referring to the inability of a private individual, business or institution to meet its financial obligations. When debt is unable to be repaid, a formal declaration of this fact triggers a bankruptcy in a court of law. In the case of government, the inability to pay its accumulated debt from past spending, because it can’t raise adequate taxes or borrow additional funds, means that the government has become insolvent forcing a formal default on its debt.
Which Countries are Most Likely to Default?
According to the Maastricht Treaty which sets the terms of compliance for the sixteen member nations of the Euro currency club, annual deficits are limited to 3% of GDP. Of the 27 European Union member states, according to the IMF and the Global Financial Stability Report of April 2010, only 5 countries (Luxembourg, Finland, Denmark, Sweden and Bulgaria) are below that ceiling. Even worse, of the 22 that do not comply, 14 have a ratio that is more than twice the established and agreed upon limit. Indeed, the EU-27 as a whole, posts a huge 6.9% budget deficit-to-GDP ratio which is expected to increase in 2010 to 7.5% matching Japan’s at 7.5% but paling in comparison with the U.S.’s deficit-to-GDP of 9.2%! For the record, Canada’s stands at 3.0% and Sweden’s is only 0.8%!
Moreover, when we contemplate the Maastricht Treaty's limit on gross external debt as a % of GDP, set at 60%, we note that the majority of EU member states fail to comply. Indeed, according to a recent study by the IMF, of the top 20 offenders when it comes to gross external debt to GDP globally, 15 were European Union members with the other 5 including the countries of Japan and the United States.
According to the Bank for International Settlements the number-one offender globally in 2011 is projected to be Japan at 204% gross debt as a % of GDP followed by Greece and Italy at 130%; the U.S. at 100%; France at 99%; Portugal at 97%; the U.K. at 94%; Ireland at 93%; Germany at 85%; the Netherlands at 82% and Spain at 74%. Interestingly, the U.S. level of 100% is actually greater than all but one of the much ballyhooed countries of Portugal, Ireland, Greece and Spain (the PIGS). On average the EU had a gross debt to GDP ratio of only 72.6% in 2009 (albeit up from only 61.5% in 2008) but this is expected to reach 83.7% in 2011 (88.2% in the euro area) as compared to 41% for Asia, only 35% for Latin America and just 29% for central Europe.
Economists Reinhart and Rogoff recently published comprehensive new research covering several hundred years of economic history which determined that countries that reached debt levels of 90% of their GDP, rapidly descended into the flames of default hell. Specifically they found that when government debt-to-GDP rise above 90%, it lowers the future potential GDP of that country by more than 1% and locks in a slow-growth, high-unemployment economy. The authors point to history that shows that public debt tends to soar after a financial crisis, rising by an average of 86% in real terms. Defaults by sovereign entities often follow. That being the case, it certainly raises a very red flag as to what we can expect the future to hold for the U.S. and the U.K. let alone Japan, Italy, Ireland and Portugal given that current interest rates are at multigenerational lows, it seems entirely plausible that when interest rates start rising, the burden of higher interest rates on the bonds issued to secure additional borrowed funds, will become virtually unserviceable. If interest rates were to double from their current 3% levels on 10 year maturing bonds or double from the current 5% on 30 year bonds, most of these nations would very quickly reach the brink of default.
What are the Common Characteristics of Debt Default Candidates?
Many countries are advanced first world economies with high standards of living. Most share political traditions and values whereby the welfare state ensures high living standards and guarantees protection and security against most of life’s challenges. Such cradle to grave security requires ever higher levels of savings and investments which result in wealth generation and serve as a growing tax base sufficient to deliver on promises of current and future benefits, especially with the universal demographic of rapidly aging populations.
Virtually all countries subject to concerns about default, however, show shortfalls in economic growth resulting in anaemic tax revenues requiring more credit and borrowing in order to compensate. Now that credit is either tightening or isn’t available and interest rates are rising again, this game of spend and borrow is about to end.
Can Debt Default be Avoided?
Remember the alarm we experienced less than 2 years ago when the largest investment banks seemed to be taking the entire world into a financial abyss? More importantly, remember how it was ‘resolved?’ Over US $700 Billion was allocated immediately by the U.S. Congress to the Treasury Secretary for whatever mitigation measures were thought necessary. The Federal Reserve Board followed with many other exceedingly inventive measures costing US $Trillions of borrowed taxpayer dollars designed to lubricate creaky financial joints. That was government bailing out private institutions in the financial sector, but what happens when governments themselves require emergency financial assistance?
Greece represents only 2.5% of the Euro club GDP economy, yet it took weeks to arrange US $140 Billion of assistance. What happens when countries with much larger economies and needs ask for assistance? The International Monetary Fund is making itself visible, but after the recent levy on member nations, they have only managed to bring their kitty from US $50 to $500 Billion. Spain, Italy or the UK could mop that amount up in short order. Then what? Financially broken nations will be funding other financially broken nations. Does that seem like a workable plan? What happens when the banks which are creditors of these nations line up for assistance again, as they did in late 2008? Who bails them out this time when their own governments are broke?
A cynic might even suggest that sovereign debt bailouts are not primarily designed to assist nations nearing default, rather it allows them to pay their obligations to their foreign bank creditors which hold the bonds of the nations nearing default. In other words, collective efforts from the likes of the French, German, British, Spanish governments and others recently, was merely an elaborate ruse to keep their own banks solvent from the impending default of debtor nations.
The staid and highly regarded Bank of International Settlements based in Switzerland recently issued a sobering report in which it stated the need for “drastic measures ... to check the rapid growth of current and future liabilities and reduce the adverse consequences of long term growth (of debt) and monetary instability.” It went on to note that there is currently over US $600 Trillion of global financial Derivatives Debt ... which is 10X annual global GDP.
Can sovereign debt default be avoided? Unfortunately, it doesn’t look like that is in the cards.
Where Should You Invest in Times Such As These?
Precious metals are ‘Real Money' which will be your safe haven during the very financially troubled and volatile period ahead and shield you from the rampant inflation and currency devaluations that are on the horizon. As such, I believe that investments in gold and silver in the form of bullion or mining company shares, complemented by investments in other commodities such as select base metals, oil and gas and agricultural grains, will give you peace of mind.
Copyright © 2010 Arnold Bock