Monday, July 12, 2010

A creative war to dig out of the debt hole

Since the G20 meeting there has been a lot of hand wringing over the level of sovereign debt. Calculated Risk posted alarmingly about the frequency of sovereign debt in the past.

Defaults tend to come in clusters, and the behavior of lenders often changes substantially after defaults. In the Volatility Machine, Michael Pettis asserts that sovereign default contagion follows predictable patterns, and that contagion is primarily due to investors in the first defaulting country also having investments in other countries which are vulnerable. This is especially the case with leveraged investors.
So far, investors have firewalled many of these debt default concerns in the US. In fact, every time something blows up somewhere, Treasuries have rallied. Can this state of affair continue indefinitely?

The answer is no. The United States has to find a long term solution to its problem of growing debt. But how serious is this problem? Deus Ex Macchiato posted a chart of the British debt-to-GDP ratio for a very long term perspective:

The first peak in debt to GDP occurred just after the Battle of Waterloo in 1815 and the second just after the end of World War II in 1945. Some market observers have pointed out that the US debt to GDP ratio has been higher than they are today. It is also instructive to go back to an earlier era to learn about how Britain dug itself out of her debt hole after the Napoleonic Wars.

The answer is India. It began with the British East India Company rule of India and progressed to the British Raj. Simply put, the British went to India and took things as part of their colonial adventures.

Could the US go down the same path? Tim Knight at the Slope of Hope posted that financial crises and crashes have led to wars. While the causation and historical links between financial stress and war look a little tenuous, there is a kernel of truth to the story.

War is a possibility, but not a highly probable one. Avner Mandelman has written about this very issue (see Watch out if a cash-poor U.S. seeks new spoils and Austerity in the West? Not if the generals can be useful).

During the 1990s, I said privately that the solution to Japan’s Lost Decade was to land 100 of the Japanese Self Defense Forces on the disputed Kuril Islands. The effects would be highly reflationary for Japan's economy. I also blogged on April Fool’s Day about A modest proposal to restore America.

Ironically, war would likely be bullish for the markets, though it is not a possibility that most of us would like to contemplate. It is nevertheless a path that we have to allow for in our investment planning scenarios.

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