Debt/GDP ratios are too backward-looking and considerably underestimate the fiscal challenge faced by advanced economies’ governments. On the basis of current policies, most governments are deep in negative equity.
This means governments will impose a loss on some of their stakeholders, in our view. The question is not whether they will renege on their promises, but rather upon which of their promises they will renege, and what form this default will take.
That’s the starting point of a new report by Morgan Stanley called “Ask Not Whether Governments Will Default, But How.” Here’s the deal: Governments are in debt; they can’t keep doing what they’ve been doing forever; something’s gotta give. Deep-in-debt governments will soon decide which of their many fiscal promises they can’t keep and who isn’t going to see its money back. Foreign investors? Domestic investors? Future retirees? Public employees?
The conclusion is rather depressing but, I fear, realistic.
Outright default is not the only way to impose losses on creditors. Financial oppression — the fact of imposing on creditors real rates of return that are negative or artificially low — can take other forms: repaying debt in devalued money (e.g., through unanticipated inflation), taxation or regulatory incentives on institutions to purchase government debt at uneconomic prices, for instance (see also “Default or Inflate or…”, The Global Monetary Analyst, February 24, 2010). Repaying debt in devalued money is particularly effective when the initial stock of debt is high — as it is now. Distorting prices in the government’s favour is particularly effective when the financing requirement is high — also a situation we face now and for years to come.
History is not so reassuring after all. Financial oppression has taken place in the past as an alternative to default in countries that are generally considered to have a spotless sovereign credit record.