Endgame the End of the Debt Supercycle and How It Changes Everything, John Mauldin and Jonathan Tepper, John Wiley & Sons, Inc., New Jersey, $27.95, 2011, 318 pages.
American Gridlock Why the Right and Left Are Both Wrong, H. Woody Brock, John Wiley & Sons, Inc., New Jersey, $27.95, 2012, 273 pages.
In Charles Dickens’ novel David Copperfield, Mr. Micawber identifies an essential difference between happiness and misery.
“Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.”
Two recent books consider the muddle politicians, bankers and economists have made of the world’s finances, during which the Micawber doctrine sadly got forgotten. They focus on the debt burden we have strapped on to the backs of coming generations and tackle the inability of current political systems to confront the ensuing mess.
The authors of Endgame make the case that excessive debt is a core game-changing, revolutionary problem. Many in Europe, accepting that debt may be a big problem, behave as if it is really only a problem for banks and the US, and that it has nothing to do with “us”. However US bank assets as a percentage of GDP are approximately 82%, while comparable ratios in Europe are much higher, with, for example, Germany at 246%. When state, corporate, and personal (private) debt are aggregated to bank debt, it turns out that Europe is much more heavily indebted than the US. This problem therefore is in fact all about “us” in Europe, and one that will change all our lives fundamentally. One of the Endgame authors Jonathan Tepper has just (April 2012) been shortlisted for the £250,000 Wolfson prize for his work on exit mechanisms for countries leaving the euro zone as a consequence of this debt.
Allowing debt to become so bloated when Europe faces a slow-motion demographic time bomb is a colossal failure of governance. With falling and ageing populations in most European states demanding significant extra healthcare and pensions funding from governments, business, and individual citizens, the last thing Europe needs is a debt burden of unprecedented levels, minimising room to manoeuvre, and maximising the pain and dislocation likely over the next few decades.
Some governments in Europe have begun to focus on some of these challenges. In Sweden, social security costs, including retirement payments, are linked to GNP. Thus if GNP goes down, then social security payments are reduced. Germany also took some early action.
Many, including myself, have criticised Germany’s approach to the euro zone crisis, and in particular the role-played by its banks and financial institutions – who coincidentally made up 50% of the total number of European banks recently accessing the second tranche of ECB bank funding (LTRO). But looked at from within Germany, where the population is expected to fall from 82 million in 2000 to 71 million by 2050, it appears legitimate to confront fellow European countries, particularly Spain, Italy and Greece (all of whom face severe demographic crises), with the consequences of ignoring the changes that increasing healthcare and retirement costs will bring. Borrowing-led business as usual is no longer an option.
A recent report by the Bank of International Settlements (BIS), which underpins the thesis offered by Endgame, graphically illustrates the impact of the debt problem. 1 The BIS is essentially the central bank to central banks. It does not have formal power, but is highly influential and was one of the few international bodies that consistently warned about the dangers of excessive borrowing and credit growth before the current crises.
The BIS paper looked at fiscal policy in a range of countries in 2010, and combined that with the implications of increased age-related spending to determine the impact on debt levels in the countries reviewed.
“Our projections of public debt ratios lead us to conclude that the path pursued by fiscal authorities in a number of industrial countries is unsustainable. Drastic measures are necessary to check the rapid growth of current and future liabilities of governments and reduce the adverse consequences for long-term growth and monetary stability.” Note the phrase “drastic measures”. This is very strong language in the mouth of a central banker.
The BIS went on to predict that markets would put pressure on governments, as they did, predicting that, in many countries, employment and growth were unlikely to return to the pre-crisis levels in the foreseeable future.
The report then considered the path of the debt/GDP ratio in a dozen major industrial economies, Austria, France, Germany, Greece, Ireland, Italy, Japan, the Netherlands, Portugal, Spain, the UK and the US. It adopted a 30-year horizon to include the large unfunded liabilities stemming from future age-related expenditure, and made other assumptions which if anything were rather optimistic. Even so their conclusions are stark:
“First, in our baseline scenario, conventionally computed deficits will rise precipitously. Unless the stance of fiscal policy changes, or age-related spending is cut, by 2020 the primary deficit/GDP ratio [excluding interest payments] will rise to 13% in Ireland; 8-10% in Japan, Spain, the UK and the US; and 3-7% in Austria, Germany, Greece, the Netherlands and Portugal…”
“But the main point is the impact that this will have on debt. The results show that, in the baseline scenario, debt/GDP ratios rise rapidly in the next decade, exceeding 300% of GDP in Japan; 200% in the UK; and 150% in Belgium, France, Ireland, Greece, Italy and the US. And as is clear from the slope of the line, without a change in policy, the path is unstable. This is confirmed by the projected interest rate paths, again in our baseline scenario … [The figure] shows the fraction absorbed by interest payments in each of these countries. From around 5% today, these numbers rise to over 10% in all cases, and as high as 27% in the UK … Seeing that the status quo is untenable, countries are embarking on fiscal consolidation plans…”
The BIS then modelled the impact of current fiscal adjustment plans and concluded that they would not be sufficient to ensure that debt levels remain within reasonable bounds over the next several decades. It then looked at the alternative implications of gradual fiscal improvement accompanied by a freezing of age-related spending to GDP at the projected levels for 2011. (A rather optimistic scenario.) The results were surprising in some cases: what was a rising debt/GDP ratio reverses course and starts heading down in Austria, Germany and the Netherlands. In several other countries, the policy yields a significant slowdown in debt accumulation. “Interestingly, in France, Ireland, the UK and the US, even this policy is not sufficient to bring rising debt under control…”
The BIS report then asked what level of primary balance would be required to bring the debt/GDP ratio in each country back to its pre-crisis, 2007 level.
To make this adjustment over five years would require an average annual primary surplus of 8-12% of GDP in the US, Japan, the UK and Ireland, and 5-7% in other countries. These levels of surplus are just not possible.
Smoothing the adjustment over a longer period, say, 20 years, reduces the annual surplus target at the cost of leaving governments exposed to high debt ratios in the short to medium term. The risks of running higher debt ratios for longer periods include higher interest rates (due to increased risk premiums), the direct impact of higher levels of debt on longer-term growth and the crowding out of productive private capital.
“Our examination of the future of public debt leads us to several important conclusions. First, fiscal problems confronting industrial economies are bigger than suggested by official debt figures … As frightening as it is to consider public debt increasing to more than 100% of GDP, an even greater danger arises from a rapidly ageing population. The related unfunded liabilities are large and growing, and should be a central part of today’s long-term fiscal planning…”
“Secondly, large public debts have significant financial and real consequences. Countries with a relatively weak fiscal system and a high degree of dependence on foreign investors to finance their deficits generally face larger spreads [and so higher interest costs] on their debts…”
Thirdly, the BIS noted the risk that persistently high levels of public debt will drive down capital accumulation, productivity growth and long-term potential growth.
“Finally, looming long-term fiscal imbalances pose significant risk to the prospects for future monetary stability … Although we do not offer advice on how to go about this, we believe that any fiscal consolidation plan should include credible measures to reduce future unfunded liabilities … An important aspect of measures to tackle future liabilities is that any potential adverse impact on today’s savings behaviour be minimised. From this point of view, a decision to raise the retirement age appears a better measure than a future cut in benefits or an increase in taxes.”(My emphasis.)
Ignoring these now clearly predictable developments has costs. The much maligned bondholders who are providing funding to euro zone countries currently spending more than they are earning (even before bank and other bailout costs are taken account of), are equally capable of reading these analyses and drawing the appropriate conclusions, namely that funding will only be provided at unacceptably high and unsustainable interest costs, if at all.
And one can be sure that many of those bondholders will be reading Endgame, by John Mauldin and Jonathan Tepper. Mauldin is the author of a US weekly investment e-newsletter (Thoughts from the Frontline) and a best-selling author, while Tepper is the founder and chief editor of Variant Perception, a macro-economic research group catering to hedge funds and high-net-worth individuals. And as we have seen he has been shortlisted for the prestigious Wolfson prize.
A key theme of Endgame is that the level of debt in many Western countries is historically unique by any measure and therefore a game-changer. Hence the title of this occasionally infuriating book which nonetheless strikes the key problem of unsustainable levels of debt right on the head, and keeps hitting it in case anyone is in any doubt of the revolutionary implications.
Endgame endorses the analysis of the 2010 BIS paper, and expects Spain, Portugal, and Ireland to follow Greece into a debt firestorm.
Why Spain? Much is due to the impact of the massive Spanish housing bubble. “Spain now has as many unsold homes as the US … Spain is roughly 12% of EU GDP, yet it accounted for 30% of all new homes built since 2000 in the EU … Spain has more than one million unsold homes. Unfortunately many of the homes are on the coast, and without the return of over-leveraged British tourists, they are likely to remain unsold. Spain’s homes are all in the wrong places.”
Housing is part of a much bigger credit/banking crisis, which has left Spanish banks particularly exposed, and which has still not been properly addressed. Taking account of its very negative fiscal position and well-rehearsed unemployment problem (approximately 50% of Spaniards under 25 are unemployed), Spain faces a whole series of unsustainable choices. Endgame suggests that debt default will be the inevitable outcome, triggering carnage in the rest of the euro zone. Any attempt at financial oppression of creditors would lead to immediate exit of foreign bondholders. Then, who would finance Spanish deficits?
This grim analysis does not take account of Spain’s dire demographics. Between 2005 and 2050, it is projected that the Spanish population will decline by 25%, while the “population over the age of 60 will increase substantially … from 21.4% to 39.7% [of the total population].” 2
The population of neighbouring Portugal will decline by approximately 10% in that same period, which on top of its poor fiscal and economic situation also makes it a likely candidate for default. Ireland is in the firing line too despite its much better demographic profile.
Which raises the question – why is the euro zone structurally prone to such negative outcomes?
Robert Mundell3, who won a Nobel prize for his work on an optimal currency area, wrote that a currency area is optimal when it has:
- Mobility of capital and labour
- Flexibility of wages and prices
- Similar business cycles
- Fiscal transfers to cushion the blows of recession to any region.
As the euro zone has almost none of these, it is not a sound, sustainable currency area. Like others, Endgame points out that the modern euro is like the gold standard. It forces adjustment in real prices and wages instead of exchange rates. And much like the gold standard, it has a recessionary bias. In addition, the burden of adjustment is always placed on the economically weaker countries, not on the strong countries such as Germany, which at present is refusing to stimulate its economy to help the peripheral economies grow out of their problems.
All of this culminates in Endgame calculating (based on an IMF analysis) the fiscal adjustment between 2010 and 2020 needed by the peripheral euro zone states to meet the Maastricht criteria taking account of their current unsustainable debt levels. This shows Greece with the largest adjustment of 16%, Ireland next highest at 13%, Spain at 9% and Portugal at 7%.
Endgame concludes that these adjustments are too large. “There is no chance that European periphery countries (with the exception of Italy, which has a path if it has the political will) will succeed in their goal of abiding by the Maastricht criteria and de-leveraging [reducing public and private debt] at the same time. To do so will require these countries reduce their trade deficits by enough that it could only mean a local depression for some time. It would mean depressed incomes and wages, low tax revenues, and in short, a very ugly picture.”
If the peripheral euro zone states make the wrong policy choices, and unfortunately they are all now difficult choices, Japan is a prediction of what is likely to happen to them.
The abject refusal of Japan’s political class to enact necessary fundamental reforms has led to the loss of more than two decades of growth for its citizens, and a future that now has only dire or catastrophic alternatives. “Japan is a country that spent the past 20 years in a hangover from one of the greatest bubbles of the modern era … Even today, the country is still trying to rid itself of deflation … Japan’s debt is more than 12 years of general account tax revenues, and within a year, it will be closer to 15. It will take half a generation of Japanese taxes to pay down the debt. This ratio is twice as high as the next highest in history, Britain, following World War II … Japan is a dying country, as the population is shrinking each year … Very soon, Japan will have more retired people than working people, and savings rates will continue to be drawn down.”
“ A major debt and currency crisis in Japan is a case of when, not if.”
There are no good choices facing the euro zone in this area any more. But the wrong choices or policy gridlock a laJapan can have devastating consequences.
As US financial analyst Woody Brock explains in American Gridlock, internal contradictions can fundamentally undermine liberal democratic societies, just as internal contradictions of a very different kind discredited communism, leading to its eventual collapse. Left and right both have it wrong, he argues, and such divisions are not helping anyone.
Under communism, the contradictions stemmed from structures that made it rational for individuals to act in a way that promoted economic decline rather than growth. In the case of liberal democracies, the contradictions stem from incentives for politicians facing re-election to continuously mortgage and remortgage their countries’ future. They do so by promising constituents ever-higher levels of benefits that cannot be paid for. The true fault in this situation lies neither with “craven politicians” nor with “greedy voters”. Rather it stems from the overall incentive structure of the political system, a structure that will lead to the demise of the welfare state, as we know it and liberal democracy itself unless current policies are changed.
At its core we face an entitlements spending crisis that may spell the end of liberal democracy if it is not properly addressed. However liberal and democratic principles operate to defeat the reforms necessary. The ultimate catch 22.
This situation has led to a strong undercurrent, particularly in the business community, “recognising” the attractions of a temporary benign autocratic model – China is frequently mentioned – to deliver the necessary changes in the West. History judges harshly those who focus on business interests in supporting illiberal regimes for short-term gain. Brock’s book directly addresses, conceptually and at a practical level, all those affected by such pessimism about democracy – proposing a way to generate win-win solutions for these seemingly intractable issues. For that reason alone it is a must read, although anything but an easy or pleasant one on occasions.
Brock notes that no one, not even governments, now represent the interests of the state overall, a point made by the late US economist Mancur Olson4 in his Rise and Decline of Nations. As countries get richer, special interest groups become so entrenched that there is no one left representing the collective interest of the people as a whole. The claims and counterclaims of the different special interest/lobbying groups become so politicised, the mass of people gets totally lost in the detail. Paralysis, confusion, and cynicism set in. A good example is “Obamacare”, which as Brock puts it “half the American people support … and half do not, while almost all admit that they do not understand it at all.”
Brock stresses the primacy of politics over economics and notes that many of the tools of micro- and macroeconomics cannot solve today’s problems. Liberal democracy needs to adopt as its core model the concept of politics as multilateral bargaining behaviour between overlapping interest groups. When you think it through, that is what social life is all about, with one notable exception, economic behaviour in a market economy where prices coordinate human activity and the concept of bargaining is not normally required. Logically this makes sense. It is in areas such as healthcare where the market cannot generate the correct solution, and special interest groups proliferate, that political science tools can help with the inevitable multilateral bargaining that must take place.
As Brock puts it: “whenever issues of “public goods,” “externalities”, or “imperfect competition” arise, interest groups affected must determine via multilateral bargaining exactly what gets provided to whom, and who is to pay how much of the bill. In a more general global context, issues of coping with misaligned currencies, vast trade imbalances, and theft of intellectual property rights will only be resolved politically via multilateral bargaining between impacted interest groups.
Looked at in this fashion, the need for multilateral bargaining, and a sound deductive basis to carry it through is self-evident: “most of the important issues that could stymie future world growth and precipitate war remain quintessentially political in nature. For starters: who gets how much water at what price? Who will pay how much for global warming? How much will tomorrow’s youths be taxed to pay for the elderly? How high a tax bill will they be willing to pay before defaulting upon the debt they inherit?” We are all members of different yet sometimes overlapping coalitions advancing the variety of overlapping interests we have as human beings.
Brock’s approach is based on the use of deductive logic, and is grounded in game theory, a system of evaluating systematically how people will respond to the decisions and actions taken by others, using complex computerised mathematical models. Game theory was widely used in the early days of the nuclear deterrence era, has considerable scientific and analytical credibility, but may have become somewhat “suspect” because of that connection. Brock shows that a suitable model of multilateral bargaining already exists, based on these game theory origins, and can be brought to bear on the highly divisive and very fundamental issues of who pays and who benefits, and when.
The model he recommends is based on the remarkable theory of bargaining set out by John F Nash Jnr in the 1950s5, when he showed how two people can compromise their differences and arrive at a mutually acceptable position during bargaining. Another game theorist, John Harsanyi, subsequently extended Nash’s theory to “games” with any number of players and coalitions. For their work both were awarded the Nobel Memorial Prize in Economic Sciences in 1994, though neither were economists.
Based on their work it is possible to clarify such concepts as “relative power”, ” balance of power”, “political economy”, “credible threats”, and “interest group politics” etc., and apply them appropriately to obtain the best possible outcome in multilateral bargaining, both within and between states. Brock gives considerable detail on his conceptual approach to multilateral bargaining, which need not be rehearsed here.
So much for the analysis, what about solutions?
Brock applies his model to an extended analysis of why the world hit the financial crises it did in 2007 and 2008, and what to do about the subsequent fallout we are still coming to terms with. In passing he notes that greed, incompetence, and conflicts of interest magnified the crises, but were not in fact necessary for their occurrence. Why? Simply because these traits always exist, are part of human nature, and will always be with us.
His conclusion is simple – the reason for our current financial crises is excessive leverage (or excessive borrowing, see below). Most of us “know” this, Brock “proves” it.
Consider the underlying model of business profitability. The Harvard model, as it is termed, shows conclusively that to maximise the return on capital in any business you need to maximise three ratios – the net profit percentage; the level of asset utilisation (the higher the better); and the level of debt, which when compared to the equity in the business, is called leverage.
To explain leverage, if a business has a profit ratio of say 8%, and can borrow at 4% to increase its business, the extra business generated through those borrowings is hugely profitable (an extra 4 %) to the business. The caveat is the risk that too much debt, in a downturn or recession, or if a once off problem hits, can destroy the business because it is vulnerable to the need to repay the debt, or fund the interest, at a time when the business is simply unable to do so.
So the usage of leverage should reflect the level of risk in the business, and the possibility that things could go wrong. However human nature, particularly in a boom or bubble period, focuses less on the downside, the risks, and more on the upside, including the gains that others appear to be making. Until their accounts have to be settled…
Similarly personally, those with excessive leverage in a recession end up in serious difficulties financially, insolvent, or bankrupt, while those with moderate leverage that took account of the possible risks end up surviving, but with reduced net worth and income.
In national terms we are all now living with the implications, and have instinctively understood what Brock concludes: “It turns out that excessive leverage does nothing to increase the long-run growth of the economy as a whole, or the wealth of workers … It just creates a much riskier environment with far more pronounced business cycles.”
“Yet it is axiomatic in economics that society should only assume more risk if the expected returns (average wealth growth) rise appropriately. But this is not the case with excess leverage, as is known within the theory of economic growth. The reason is intuitively clear: periods of economic boom due to excessive optimism and leverage are inevitably offset by subsequent periods of busts…” He shows that long run growth delivers the same end result as growth fuelled by excessive leverage, and then concludes: “Excess leverage is indeed a public bad, and must be checked. The case for government intervention to limit leverage is thus well grounded in first principles.”
His policy proposals are twofold:
- Reducing leverage in financial institutions much more than current reforms propose.
- Significant reforms of too-big-to-fail finance institutions.
Based on my own research in this area, I believe that the proposals generated by his theory of multilateral bargaining to control excessive leverage are exactly what are needed.
It helps that Brock is quite honest and perceptive about what is really going on in many of these financial institutions. His final comments about the “dirty little secret” of excessive finance sector executive remuneration are powerful: “But what these players will not tell you is that their stratospheric incomes are due in large part to leverage. Nor will they confess that talent has less to do with their success than they might think, notwithstanding that brilliant fund managers do indeed exist, as is true in any calling. Leverage, financial sector cartelisation and luck play a larger role than skill.”
Having gained confidence in the reliability of his concepts and the relevance of multilateral bargaining, it is interesting to see what his analysis produces in some of our other major challenges.
The possibility of austerity leading to a lost decade (or two, if Japan is relevant, which it may well be) leads to his distinctive characterisation of “good” versus “bad” deficits. Simply put, no one is going to finance “bad” deficits any more, because they are now asking “why should country X be allowed spend any more than it earns any more?” Here he points out that non-productive spending is not bad per se, it clearly is not, but that such spending must be matched by tax revenues, so not to increase the burden (or mortgage the future) of tomorrow’s taxpayers. This is a point special interest groups never mention, for obvious reasons.
However he shows that “good” deficits that are generated by spending on profitable investments (human capital and infrastructure) which are certified by independent research to generate a positive expected return on capital, will and should be financed. The logic is impeccable – but the issue is who will speak for the general public good in shifting government spending from current expenditure with huge interest group support, to capital expenditure that meets these investment criteria, but has not yet developed institutionalised interest group support?
Brock then confronts the major entitlements spending crisis in healthcare. Although written from a US perspective, his comments apply to most countries in the West. He takes as his overall objective for healthcare reform – increased and meaningful access to healthcare along with control of total health care expenditures to reduce such expenditures long-term as a percentage of GDP. He deduces that both goals are achievable if the overall (aggregate) supply of health-care services increases at a rate faster than the growth of demand. [In economic terms the wording would be that the “supply curve” must shift outward faster than the “demand curve”.”] At the micro level this would require that each particular reform must conform to this supply-greater-than-demand goal.
This is so simple and powerful, and well supported by his analysis. Why have governments not taken on what is an obvious point?
The answer lies in how you achieve such an increased supply: “Particular emphasis will [have to be] placed on the need to decartelise, deregulate, and automate the provision of healthcare services. For the increased competition and productivity that these reforms give rise to is what outward-shifting supply curves are all about. They lie at the heart of what is needed for successful healthcare reform.”
Entrenched special interest groups exist here whose purpose is to ensure such changes never occurs. Confronting them with the simple but powerful argument that without reform, and the increased employment generated by such reforms, the healthcare system and the state itself will either eventual collapse, or proper healthcare will be available only to those who can pay ever-increasing outrageous health insurance costs, may be the only way forward. It will not be easy. President Obama is fighting a re-election campaign on the back foot on this very issue.
To those who have ideological issues with this type of analysis, Brock makes a simple point: “We produce more food of comparable quality at a cost representing a lower share of GDP than in the past, far more phone calls for a lower share of GDP, more computers, more consumer electronic products, and so forth. The reason why in all these cases is that the supply curve shifted outward faster than the demand curve over time, when these concepts are properly understood. Why should healthcare be any different?”
Brock applies the theory in his book to a number of other “big issues”, including dealing with China and how capitalism should work and the appropriate role of government.
Much of Brock’s approach encompasses what I consider the fundamental reordering necessary of how we in the West see the relationship between the individual citizen and the state. Hundreds of years ago citizens had many responsibilities and no rights. Now the pendulum has swung too far in the opposite direction – too many people see themselves as having extensive rights and no responsibilities for themselves, or to their fellow citizens or their state. Bringing individual rights and responsibilities back into a fair and sustainable balance in the new economic and financial era we now live in will be the challenge that determines the survival or otherwise of liberal democracy. In that regard the key question will continue to be who represents the common good?
Unfortunately right now most governments in the West are busy proving that they do not do so.
It would be easy to dismiss Endgame because of its investment-led focus, and Brock as a naive political blue-sky thinker, but both books are grounded in essential and unpleasant truths about debt, and ageing and declining populations, which we will have to tackle at some stage. Fresh thinking of this kind is required, particularly from the perspective of the people as a whole, rather than the endlessly vocal vested interests so protective of only themselves. Both books contribute significantly to such an approach and do so from refreshingly different perspectives. There are strands in both works which ring true and which point – if not to the way forward – to directions worth following.
In addition Brock’s book is a practical illustration of how one might apply in practice some of the elements of the new theoretical concept of ‘trans-generational’ democracy, which attempts to take into account the legitimate interests of generations-to-be in the democratic process. It is high time, particularly in Europe, for such a focus.
Richard Whelan is a commentator on international affairs who has spent much of his working life in the financial services industry, and is the author of a book on Al Qaeda.