Gross: Is it possible to get out of a debt crisis by increasing debt?

Bill Gross is a bond guy. And in the bond world, the return of capital counts for a heck of a lot more than the return on capital. So, naturally, with debts being socialized from the private to the public sector, Gross has been asking himself and his investors first and foremost which countries will default. To wit, ever since the Dubai World crisis, almost all of his recent monthly newsletters have been about sovereign debt, rather than corporate debt.

Below are a few posts I wrote about his commentary – all of which are about government stimulus "exit strategies" and sovereign risk. Notice Gross’ newfound populist flair, which the titles reflect:

Only last month did Gross depart from the sovereign debt theme when writing about the ratings agencies. He still retained his populist meme though.

So what does that mean for investors. To my mind, it speaks to risk aversion. For bond investors, it certainly means that some developed economies like Greece will have sovereign debt that trades more like Emerging Market debt. Having emerging market characteristics necessarily means that in these countries some (internationally-oriented) corporates are going to have better ratings than the formerly risk-free sovereign.

But it also means that some of these countries will default. I certainly think this is true with Greece at a minimum (and one reason the Greeks should be pushing for a restructuring instead of only endless austerity and competitive currency devaluation). We have already seen comments from Gross that PIMCO won’t touch Greek sovereign debt for this very reason. But he again asks rhetorically whether it is "possible to get out of debt crisis by increasing debt." His answer: yes.

Yes – was the answer, but it was a qualified yes. Given that initial conditions were favorable – relative low debt as a % of GDP, with the ability to produce low/negative short-term policy rates and constructively direct fiscal deficit spending towards growth positive investments – a country could escape a debt deflation by creating more debt. But those countries are few – the U.S. among perhaps a handful that have that privilege, and investors, including PIMCO, have strong doubts about U.S. fiscal deficits leading to strong future growth rates.

My answer is no, but a qualified no.

In Europe, the Eurozone has operational constraints given the single currency that limit how much debt governments can take on. Moreover, you have countries like Greece, which I have already mentioned has a tough road ahead. Their debt is incredibly high, as are the burdens in Italy and Belgium. With everyone in the Eurozone about to embark on fiscal austerity, there’s no way the growth that allows one to ‘grow’ out of debt problems is coming. More likely you get depression and a worsening debt picture.

Gross says:

Granted, sovereign debtor nations are now saying all the right things and in some cases enacting legislation that promises to halt growing debt burdens. Not only Greece and the southern European peripherals, but France, the U.K., Japan, and even the U.S. are sounding alarms that might eventually move them towards less imbalanced budgets and lower deficits as a percentage of GDP. Still, credit and equity market vigilantes are wondering if in many cases sovereigns haven’t already gone too far and that the only way out might be via default or the more politely used phrase of “restructuring.” At the now restrictive yields of LIBOR+ 300-350 basis points being imposed by the EU and the IMF alike, there is no reasonable scenario which would allow Greece to “grow” its way out of its sixteen tons. Fiscal tightening, while conservative in intent, leads to lower and lower growth in the short run. Tougher sovereign budgets produce government worker layoffs, pay cuts, reduced pension benefits and a drag on consumption and the ability of the private sector to accept an attempted hand-off from fiscal authorities. Recession becomes the fait accompli, and the deficit/GDP ratio moves ever higher because of skyrocketing risk premiums and a plunging GDP denominator. In many cases therefore, it may not be possible for a country to escape a debt crisis by reducing deficits!

But Gross seems to suggest that the Germans could ostensibly grow their way out when he writes "constructively direct fiscal deficit spending towards growth positive investments." I am not so sure given the anaemic growth in Germany for the past decade. So, my answer is a firm no for Europe.

In contrast, the US could theoretically run up debts for quite a while because it is a sovereign issuing debt in its own currency. The promise to repay US Dollar denominated debt is merely a promise to repay with more of the same currency which the US government creates. Look at Japan. This is what they have done. The problem, of course, is the malinvestment and the currency revulsion that it creates.

For sovereigns with debt in their own fiat currency, there is not the operational constraint that you and I face. After all, they can go to the backyard and just pick some bills off their money tree – something we can’t do unless we want to go to jail.

Remember, many countries like the U.S. or the U.K. can just print money to meet creditor demands. After all, the only financial obligation of government in a fiat currency system is the payment of more fiat money. This is a confidence game then. Creditors will only accept more fiat money from the debtor if they believe that the money represents good relative future value (i.e. when debt repayment occurs and where value is relative to other currencies or real assets at that time).

So while there is no operational constraint on government because of the electronic printing presses, there is an effective constraint in the form of debt and currency revulsion and price instability (large measures of deflation or inflation).  On countries like Greece or Portugal in the Eurozone, the operational constraint is a lot more real than it is on the U.K. because of currency union. The same is true for countries with a currency peg or large foreign currency debts like Latvia, Hungary or Dubai.

On the sovereign debt crisis and the debt servicing cost mentality

Think about Gross’ words; can the US or the UK "constructively direct fiscal deficit spending towards growth positive investments?"  In my view, no.  That has certainly been the case in Japan as they have tried to grow their way out of debt. Theoretically, you can bring the debt load down. But, in reality, the Predator State intercedes and shuffles the investment off to those poor stewards of capital which are being propped up by government. Meanwhile, government will print as much money as  it can reasonably get away with, which could eventually lead to tax and currency revulsion. So I am not sanguine about the US or the UK either.

In any event, I am sure governments will try to grow their way out of this if and when the sovereign debt crisis abates. So, I will end with the chart buried in Gross’ post which points to the stumbling block to sustained growth: debt.

US Debt to GDP, private and public

Source

Three Will Get You Two (or) Two Will Get You Three – Bill Gross, PIMCO

Update: Here is a video of Bill Gross on Bloomberg explaining his take on why a Greek debt restructuring is inevitable.

9 Comments
  1. Jon says

    Are you against a second stimulus, or are you assuming that new issuances are made solely to prop up TBTF banks and GSE’s?

    Great stuff as usual!

  2. Daniel says

    “Moreover, you have countries like Greece, which I have already mentioned has a tough road ahead. Their debt is incredibly high, as are the burdens in Italy and Belgium.”

    I don’t think that you can compare Greece to Italy or Belgium. Italy has a 100%+ debt/GDP since over 20 years. That’s not a problem if you have low private debts and a low trade deficit. Belgium also has very high government debt since….well…. a very very long time. But they have a positive net external debt position, so high public debt is no problem for them. Greece has a horrible net external debt position which makes the whole thing much worse. High public debt=high burden=no growth is not true.

    “But Gross seems to suggest that the Germans could ostensibly grow their way out when he writes “constructively direct fiscal deficit spending towards growth positive investments.” I am not so sure given the anaemic growth in Germany for the past decade. ”

    I am not so sure why you mentioned germany since Gross didn’t say anything about germany, but germany grew itsself out of its debt during the last decade. During that time, job growth was positive
    http://www.destatis.de/jetspeed/portal/cms/Sites/destatis/Internet/DE/Content/Statistiken/Zeitreihen/WirtschaftAktuell/Schluesselindikatoren/Erwerbstaetige/bild__erwilo,property=image.png

    Like in Japan, total Debt/GDP ratio declined (I’ve read that in the McKinsey Quarterly Report about debt cycles, it went round the blogosphere a few month ago). Here is a picture from Japan

    http://pragcap.com/wp-content/uploads/2009/08/JapanDebtToGDP.jpg

    btw. isn’t there also another graph of total US debt/GDP flying around that shows that the ratio has peaked? I’m not 100% sure but I connect Albert Edwards and his deflation warnings with this memory.

    1. Edward Harrison says

      Daniel, I’m not comparing Greece to Belgium and Italy. I am pointing out, however, that they are the three countries with the highest debt to GDP levels in the eurozone. As to whether that’s a problem, I would say yes it is because Italy and Belgium are now users of currency and not the creators of one. In a depressionary scenario, these debts will become an Albatross around the necks of those countries regarding growth.

      Gross doesn’t mention Germany by name but I surmised that was the country he was mentioning since I know from back channels that some of his associates are not as sanguine about his US-hawkish/German dovish stance since the ring of fire post.

  3. Daniel says

    “Moreover, you have countries like Greece, which I have already mentioned has a tough road ahead. Their debt is incredibly high, as are the burdens in Italy and Belgium.”

    I don’t think that you can compare Greece to Italy or Belgium. Italy has a 100%+ debt/GDP since over 20 years. That’s not a problem if you have low private debts and a low trade deficit. Belgium also has very high government debt since….well…. a very very long time. But they have a positive net external debt position, so high public debt is no problem for them. Greece has a horrible net external debt position which makes the whole thing much worse. High public debt=high burden=no growth is not true.

    “But Gross seems to suggest that the Germans could ostensibly grow their way out when he writes “constructively direct fiscal deficit spending towards growth positive investments.” I am not so sure given the anaemic growth in Germany for the past decade. ”

    I am not so sure why you mentioned germany since Gross didn’t say anything about germany, but germany grew itsself out of its debt during the last decade. During that time, job growth was positive
    http://www.destatis.de/jetspeed/portal/cms/Sites/destatis/Internet/DE/Content/Statistiken/Zeitreihen/WirtschaftAktuell/Schluesselindikatoren/Erwerbstaetige/bild__erwilo,property=image.png

    Like in Japan, total Debt/GDP ratio declined (I’ve read that in the McKinsey Quarterly Report about debt cycles, it went round the blogosphere a few month ago). Here is a picture from Japan

    http://pragcap.com/wp-content/uploads/2009/08/JapanDebtToGDP.jpg

    btw. isn’t there also another graph of total US debt/GDP flying around that shows that the ratio has peaked? I’m not 100% sure but I connect Albert Edwards and his deflation warnings with this memory.

  4. Daniel says

    btw. I found the following pdf very interesting because it’s about Japan and balance sheet recessions / debt deleveraging. Unfortunately, we don’t have many examples of these cycles, so we should learn as much from Japan as we can.

    http://www.bankofengland.co.uk/publications/speeches/2010/speech434.pdf

    I got it from Krugman

    Inflation, Deflation, Japan

    […]
    Which brings me to a very insightful talk (pdf) by Adam Posen, my favorite Japan expert (and now on the policy board of the BOE). There’s a lot in this talk, but let me just focus on one issue: the effects of Japan’s “quantitative easing” policy, which involved pushing up the monetary base in the hope of getting some traction. (Unlike what we now call quantitative easing, this didn’t involve large purchases of nontraditional assets.)

    […]
    http://krugman.blogs.nytimes.com/2010/05/25/inflation-deflation-japan/

    1. Edward Harrison says

      The most significant feature of this episode is that we are witnessing the first synchronous global recession since the Great Depression. The problem with using Japan as a model is that they had an asynchronous experience.

  5. cswake says

    “In my view, no. That has certainly been the case in Japan as they have tried to grow their way out of debt. Theoretically, you can bring the debt load down. But, in reality, the Predator State intercedes and shuffles the investment off to those poor stewards of capital which are being propped up by government.”

    Edward, I think you capture the fallacy of fiscal stimulus perfectly here. (Which is why I still fault the theory of MMT supporters, since their argument can be used to constantly grow higher deficits at an accelerating rate, indefinitely into the future. Debt doesn’t matter for countries that have monetary systems like the U.S., U.K., and Japan.) The belief that more and more fiscal stimulus will generate higher and higher growth to avoid the depressions of debt will work up to a point, at which the debt will unhinge everything.

    It appears that politicians worldwide will ensure that our governments test what happens once that point is reached.

    1. Marshall Auerback says

      We never say that debt per se doesn’t matter. That’s a caricature. The
      deficit spending should always be viewed in context. That’s the same
      mistake Steve Keen makes in his critique of MMT. The government just has to
      provide enough deficits for NET saving of the government sector to be
      sufficient to get to full employment, not AGGREGATE saving. The point isn’t to get
      rid of all private debt ia govt deficits. That would be silly. We’ve
      never said that.

      In a message dated 5/28/2010 06:15:27 Mountain Daylight Time,
      writes:

  6. Sam Costanzo says

    Traders like Gross have simplistic models of the world that leave out all variables not perceived as directly affecting their narrow activities. Gross says:

    “But, in reality, the Predator state intercedes and shuffles the investment off to those poor stewards of capital which are being propped up by government.”

    What if the predator state pumps purchasing power to the unemployed and other consumers screwed by his kind? What’s the harm in that? And he won’t admit, of course, that the capital shuffled off to the poor stewards on Wall Street saved his ass.

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