The Everything Bubble Series: Can A Nation Default/Restructure Their Debt?
Welcome to day 2 of our series on global debt.
Yesterday, I outlined the incredible amount of debt the world owes.
By way of review:
- Globally, the debt-to-GDP ratio is 322%.
- United States: 106%
- Germany: 61%
- Japan: 196%
- The United Kingdom: 85%
- Canada: 89%
- France: 98%
Now, there are three ways to deal with excessive debt:
- Pay it off through growth or fiscal restraint.
- Attempt to inflate it away by debasing your currency.
Yesterday I explained why option #1 is impossible. Which brings us to #2: default or restructuring.
This, like option #1, is impossible.
Option #2: Default/Restructuring the Debt
Sovereign bonds (i.e. US Treasuries, German Bunds, Japanese Government Bonds) are the bedrock of our current financial system.
Put simply, the yields on these bonds, particularly Treasuries, are the “risk-free” rate of return against which all risk assets are priced. So if these yields spike higher because the underlying bonds are being restructured, EVERY asset on the planet would suddenly be repriced based on their increased riskiness.
In the case of stocks and real estate, “repriced” means “would crash.” Imagine the political fallout this would cause for whoever is in the White House/Congress if the US experienced both a housing and a stock market crash.
You’re talking about wiping out two of the primary assets owned by voters. That is political suicide.
Moreover, there is another more nefarious reason why no major nation will want to default on or restructure its debt.
Globally, the large banks own over $555 trillion worth of derivatives that are based on bond yields.
If you’re unfamiliar with the concept of derivatives, Investopedia offers the following definition:
A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, index or security. Common underlying instruments include: bonds, commodities, currencies, interest rates, market indexes and stocks.
Futures contracts, forward contracts, options, swaps and warrants are common derivatives. A futures contract, for example, is a derivative because its value is affected by the performance of the underlying contract. Similarly, a stock option is a derivative because its value is “derived” from that of the underlying stock.
In simple terms, a derivative is essentially a bet between two parties about the future price or value of a particular asset. The large banks LOVE to issue a particular kind of these assets called “over the counter” (OTC) derivatives because they are unregulated and can be priced at whatever levels the large banks desire.
It was a particular type of OTC derivatives called credit default swaps that blew up the financial system in 2008. At its peak, the credit default swap market was only $50-60 trillion in size.
Again, the OTC derivatives market based on bond yields is $555 trillion in size.
What do you think would happen to the financial system if a market 10x larger experienced a “Lehman event” from a major country defaulting on its debt?
Every major bank would implode.
Suffice to say, NO major country is going to risk that.
Which brings us to the last option major nations have for dealing with their excessive debt loads… inflating it away.
We’ll tackle that tomorrow. Until then…
Editor, Money & Crisis