“With parsimony a little is sufficient; and without it nothing is sufficient; whereas frugality makes a poor man rich” — Lucius Annaeus Seneca
The world is on the hunt for the next financial crisis. Perhaps, not wrongfully. It seems like Black Swan events occur so frequently there is nothing outrageous in the world today. Truth has far outpaced fiction in terms of its strangeness. The 2008 subprime mortgage crisis in the United States woke up the world to the possibility of a local epidemic becoming a global contagion capable of effectively shutting down countries in a heartbeat. There are various conjectures about the origin of the next financial crisis. It could be student loans or perhaps something bigger — a sovereign public debt default.
Before the 2008 crisis, the world did not truly understand the interconnected nature of economies. Globalization forged strong economic connections between economies and derivative instruments such as Credit Default Swaps (CDS’s) and Mortgage Backed Securities (MBS’s) helped make those connections riskier. These instruments were originally designed to bring liquidity into the banking system. Today, Lewis Ranieri-the creator of MBS’s laments the role his creation played in wreaking havoc in global financial markets. This article explains sovereign public debt and poses another question: will the high levels of sovereign public debt result in the next financial crisis? Or, should we be looking elsewhere?
Public debt, or national debt, is the total debt borrowed all government bodies of a county. This debt can be borrowed from a country’s citizens or from outsiders by issuing bonds. Private debt is the debt accumulated by individuals and private corporations e.g. student loans, mortgages, credit cards, working capital loans, debentures etc.
Not All Public Debt Is Created Equal
One Friday morning in 2001, I was on a flight to Kenya. My cousin sister was sitting next to me. As some brothers would, I queried her about her plans to go shopping for antiques in Kenya. She smiled and responded ‘I have created a well crafted budget that does not involve spending any money on credit cards’. At the time, I was quite amused at her attempt at being frugal. Her reasoning was that it was hard to keep track of money spent on credit cards and it was very easy to overspend. That in essence explains the makings of a sovereign public debt default.
When a nation borrows more than it can possibly repay, it defaults on its debt. Thereby, rendering the financial instruments (bonds) held by the people who lent the nation the money in the first place effectively worthless. If the country has a history of overspending on borrowed money, the global market starts viewing the country with suspicion and its bonds keep getting rated lower and lower by independent credit rating agencies.
In financial terms, this means the credit spread (difference) between the effective return (yield) on the bonds of a country with a stable spending history and the effective return (yield) on the bonds of a riskier country widens. In other words, the riskier country has to offer a higher return to its lenders.
If you look at the table above, you will feel the world is over-leveraged. But, the debt story looks very different for different countries. Imagine a friend with a huge network of people who depend on him, who always gets by asking for debt from other friends but repays it very slowly. Yet, people trust him to repay. Now, imagine a friend who is known to ask for money for frivolous expenses e.g. a tattoo which is not going to help him repay the debt in anyway. That is how countries are different.
Even though the US and Japan have a large amount of public debt, they are the world’s largest economies on which the rest of the world depends. In Japan’s case, most of the public debt is held by its own people despite negative interest rates. For the US, China and Japan hold most of the public debt but both these countries are inextricably linked to the US for their growth.
However, for countries such as Argentina, Greece, Spain, Portugal and Venezuela, a lot of public debt could bring them close to default. Argentina and Greece have already defaulted once. Ironically, their economies have rebounded later with minimal shocks to the rest of the world.
The fact still remains that borrowing money for building infrastructure or investing the borrowed money to create jobs, improve education etc. may still end up generating income to repay that debt albeit a little slowly. But, using public debt to keep paying the principal and interest on the previous debt when interest rates are rising can be a recipe for a disaster.
A Simple Explanation of the 2008 Financial Crisis
Let me preface this part of my article by saying that the world is a complicated place so please excuse me if my brevity reduces the richness of the lessons learnt from the 2008 US housing crisis. However, my brevity is a trade off for simplicity. I am trying to explain the origins and the spread of the crisis to the common reader.
Let’s say you $100 to invest. Depending on the country you are in, you could put in a checking account with zero interest, a savings account with some interest, a government bond or treasury bill with some interest or in stocks. Generally, the government bond and the savings account are considered relatively “risk free”.
Suddenly, a new investment option is introduced. It is called a Mortgage Backed Security. In simple terms, if you buy a $100 MBS, the interest payment on that MBS will come from repayments made by the underlying mortgage holders. MBS are an outcome of a process called “Securitization” in which mortgages on bank balance sheets are pooled together and MBS’s are issued against this pool. For example, 10 mortgages each worth $200,000 can be pooled together to form a bundle of $2 million. Let’s say the interest rate on the mortgages is 5%. The borrowers will keep paying 5% on a monthly basis. Now, if you buy a MBS with an interest rate of 5%, the 5% in interest that the mortgage borrowers pay will be ‘passed through’ to you. As long as the borrowers on the mortgage are in good standing, you earn money. For the bank, the mortgages get ‘off’ the balance sheet because you (the investor) have paid money to buy MBS’s to the bank. So, theoretically, you now own the risk of default on those mortgages. Private investors can come in all shapes and sizes e.g. sovereign wealth funds, private equity, qualified investors etc. Public investors can be the government, Government Sponsored Entity’s such as Fannie Mae or Freddie Mac etc.
Now, imagine a scenario where all 10 mortgage loans are made to people with bad credit history (FICO scores) or without enough monthly earnings to pay the instalments. When they default, the MBS holders don’t get anything. Imagine if the MBS holder is a bank in Iceland. Now, you have the perfect transmission mechanism for the US housing crisis of 2008 to grow into a global contagion.
The Concept of Real Earnings
Think about a scenario where inflation outstrips the earnings on savings bank accounts and bonds. In other words, the real interest rate (nominal interest rate — inflation).
Let’s say you earn 2% on your savings account but the existing inflation rate is 2.2%. In other words, if you use the earnings on a $100 savings account which is $2 (2% of $100 annually), you will find it to be 20 cents shorter than your annual household expenditure. So, in reality, you are worse off.
Inflation is typically measured by the Personal Consumption Expenditure (PCE) Price Index. It measures changes in household expenditure on goods and services. The PCE typically excludes volatile gas and food prices.
In reality, inflation can be felt before it is measured. You can actually see your friends and colleagues complaining about how they aren’t able to save enough on a monthly basis.
The other outcome is that you will increasingly see people trying to create multiple lines of income possibly through entrepreneurial activities to combat the decline in real earnings. In an era where the net new jobs are coming in the areas of data science, Artificial Intelligence and other exponential technologies, mass retraining of the labor force becomes the only viable option.
Public spending on education and partnerships with the private sector become inevitable. But, if public debt is not invested properly and is used instead to make payments to foreign holders of bonds in terms of principal and /or interest, the economy suffers.
Use Symptoms To Complete The Picture
To be able to really connect the dots calls for a personality that has an analytical rigor similar to Warren Buffet or similar to the man who foresaw the mortgage crisis looming- Dr. Michael Burry (played by Christian Bale in the movie “The Big Short”). Michael is an extremely smart individual, a physician turned hedge fund manager who waded through oceans of data on mortgages underlying MBS’s to predict the looming mortgage defaults.
However, the overwhelming evidence today skews towards civil unrest. As I mentioned above-in a global economy with generally rising prices, stagnant or flat economic growth and wages, shifting job markets and massive misuses of public debt, there is a high chance of the middle class losing its cool and increasingly becoming more violent on account of the growing frustration. Just like the 2008 financial crisis, seemingly disconnected dots can come together as a shining example of ‘chaos theory’ where a butterfly flapping its wings in one country can have massive ripple effects in another country in a different continent.
Exponential technologies are fundamentally shifting the world of work in ways similar and dissimilar to the industrial revolution. The ‘luddites’ of today could become the revolutionaries of tomorrow. That scenario seems closer to a financial crisis disguised as a civil revolt and looks more likely to happen. As I said before, very few have the knowledge and academic rigor to connect the dots and see what others can see. I can only see what my limited knowledge allows me to see. I can only share as best as I can communicate.However, the 3 best pieces of advice I can give anyone today are:
- Develop The Ability To Connect The Dots: To read voraciously to develop a vision that very few have. Believe me, reading today is the single most powerful, oft repeated and most underrated activity people indulge in
- Monitor Finances Weekly or Daily: To stress test your financial situation for extreme global shocks including huge declines in equity and debt markets. Save as much as you can and as early as you can
- Become a Lifelong Learner: To set aside time every week to re-educate yourself on understanding and interpreting the results of machine learning. Begin by learning more about Python programming
These pieces of advice are simple and yet profound. That’s because they are nothing but common sense which in today’s world is increasingly uncommon. Not unlike many of you, I am just a common man. However, the thing we must realize is that our single most powerful trait should be our curiosity. Combined with common sense, it is one of the only two things needed to understand the world we live in.