Peak Government Debt for Most Western Economies


By David Merkel of Aleph Blog

We’re in an interesting situation where most developed country governments are borrowing at a rapid rate, and their central banks are financing it.  Public old age retirement and health plans are underfunded.  Most major developed countries can’t grow rapidly, and there’s really nothing that can be done about it — competition from cheaper labor in developing countries is forcing developed country wages down.  We can’t grow out of the debt.

We wait for the tipping point.  When will investor sentiment change from believing debts will be paid in equivalent purchasing power, to believing that they will not get paid back in equivalent purchasing power terms?

This Tiger grand-cub was flat during Q2 but is ready for the return of volatility

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Greece is past the tipping point.  Other nations in Europe teeter.  Is Japan nearing such a point?  They rejoice to see the Yen weakening as the BOJ finances the government deficit.  Be careful what you wish for, Japan — what is good in small, can become self-reinforcing if lenders lose confidence in the Japanese government.

Part of the trouble is with central banks repressing savers, deficits are considerably lower than they otherwise would be because short bond yields are low.  If rates rose, deficits would begin to rise gradually but distinctly in proportion to the maturity structure of the country.  That’s the tipping point.  There are only two states with an unstable equilibrium between them — government debt is trusted, and government debt is not trusted.

Now there is no simple answer here — how will the government react?

  • Raise taxes dramatically?
  • Cut spending dramatically?  Tell seniors that Medicare will no longer do what it used to?
  • Inflate the currency?
  • Default?  (Can make sense when a country does not need access to the debt markets.)
  • Try to drive a debt reduction deal, like Greece has done, and Argentina sorta did.

Each situation has a different best investment.  That’s a boon to governments, or disaster would have happened already.  Doubt as to policy blunts the rush to panic.  There may be worry but they don’t know what to do.

One more note: when one nation passes the tipping point, the question will be raised on other nations.  Imagine a world where many developed nations default on their debts.  There would be few certainties and silver and gold would likely become new currencies.

These are just some musings of mine; all sorts of kooky things could happen, but the pressure to use the five reactions listed above will be considerable globally.  Prepare as best you can; this one isn’t easy.

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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