Crisis Progress Report (2), by Robert Gore

Greek Finance Minister Yanis Varoufakis says his country is bankrupt. Will the bankruptcy be recognized by the rest of Europe? If so, who bears the losses? Stay tuned for how those questions get worked out, but financial markets have already marked down Greek debt, ahead of ratings’ agency downgrades. In a world of minuscule yields for developed nations’ debt, where shorter maturities often sport negative yields (creditors are paying debtors to hold their money), the Greek ten-year bond yields over 10 percent.

Greece may not be technically bankrupt, but its debt load is clearly onerous and the plurality of Greeks who voted for Syriza do not want to continue making the drastic reductions in their standard of living necessary to pay it. However, no matter what the resolution with the EU, the standard of living of the average Greek will be further reduced. Debt funds present consumption from expected future revenues; paying it down or writing it off necessarily entails reduced spending and loss recognition by lenders, borrowers, or, as usually is the case, both. Greece’s debt-to-GDP number is not that much higher than a number of other countries. The EU is taking a hard line against debt relief because it would put Portugal, Spain, Italy, and eventually, perhaps France, in line looking for the same thing. Greece is the tip of the iceberg in terms of unsustainable public and private debt loads, government spending, and future entitlements, and that iceberg surely includes not just much of Europe, but Japan, China, and the US.

McKinsey and Co. issued a report this week (see “A World Overflowing With Debt,” by Simon Kennedy, SLL, 2/5/15) that put total world debt at $199 trillion, up $57 trillion since the end of 2007 and at 286 percent of world GDP compared to 269 percent in 2007. How does the all-time heaviest debt load coexist with all-time low interest rates? Savers and creditors should be in the driver’s seat. They are not because central banks have been buying debt in record amounts, preempting what would seem to be the irresistible impetus for higher rates and concerns about deteriorating credit quality. The only wind the central banks have had at their backs has been the ineffectiveness of their own policies. Despite the debt buying, recoveries have been anemic or nonexistent and the default option for financial markets, when confronted with economic weakness, has been to buy perceived high-quality debt.

Greek yields demonstrate what happens when the quality of debt is called into question. The last “Crisis Progress Report” delineated the Command and Control Futility principal: governments and central banks can control one or more, but not all variables in a multi-variable system; and its corollary: due to the impossibility of controlling all variables, they will usually lose control of even the variable or variables they have attempted to control. No variable has been more under the thumb of central banks than interest rates. Last week, developed-country interest rates began to rise from microscopic levels. Financial markets have an ugly habit of surprising people when they least expect—and can least afford—it. The last thing the world’s massively over-indebted governments and highly leveraged financial systems need are rising interest rates, especially against the increasingly severe global deflationary backdrop. If interest rates continue upward around the world, it may indicate a loss of government and central bank control of that variable.

In other words, the demand to borrow and governments’ deteriorating credit quality may be overwhelming private savings and central bank monetization, forcing up interest rates, notwithstanding the still-waxing forces of economic contraction and deflation. This is not to say short any and all debt instruments—SLL has been looking in vain for this credit market phenomenon for years. However, if that is what is happening, it would be the ultimate canary in the coal mine, an unmistakable ratcheting up of the global economic and financial crisis. So keep an eye on interest rates. If they keep creeping up (they may not creep, they may lift off, as they have in Greece) the next few months are going to be interesting.