Global Macro Monitor produces informed opinion about markets and the global economy. This was originally published on January 11, 2011
Here is a European Commission chart that appeared in the online version of Der Spiegel. It could be a decoy to deflect the markets attention off Europe and push back to what they may perceive as America’s wallowing in schadenfreude over the Eurozone’s demise. It is probably neither, however.
Any intelligent person in the United States understands the sovereign debt crisis is coming to America if the Administration and Congress do not address the country’s structural fiscal deficit and debt overhang, and does so quickly. In fact, this was one of, if not, the message of the November election.
The U.S. has a one-year window, in our opinion, otherwise expect the Nostrodomus’ 2012 prediction “The Great Dog will howl at night” to come to pass. It is our interpretation that: a) because sovereign bonds x/emerging markets are now acting like “dogs that don’t hunt”; and b) the U.S. does have the largest stock of sovereign bonds in the world; Nostro must have been referring to a huge U.S. bond market crash in 2012.
Seriously, as we should be careful in interpreting prophecy, so to should we when looking at data and this EC chart, in particular. First, we have learned from this crisis, even though the rating agencies may have not, that a country’s banking system is an implicit liability of the sovereign unless it is willing to let it collapse during a time of great stress. One of Europe’s major economic vulnerability is that many countries are over banked. Ireland and Spain’s bank assets to GDP ratio are over 300 percent of GDP, for example. Many of those assets were put on during a huge housing bubble.
When the Irish government backstopped its banks during the crisis they took on huge contingent liabilities that are now coming home to roost. The U.S banking system’s assets are under 100 percent of GDP, however. There are other contingent liabilities of the central government, such as those of Fannie and Freddie, that may come under fire if the crisis spreads here, however.
Second, Europe didn’t have a crisis until interest rates shot up on European periphery bonds. If Greece and Ireland could still finance at German interest rates, their periphery banks wouldn’t be under as much pressure and there would be no sovereign debt problem, at least not yet, in our opinion.
The U.S. government’s net interest to GDP has actually fallen even during the massive debt accumulation over the past two years, mainly because the collapse of interest rates. As you can see from the chart, this isn’t sustainable and once interest rates begin to rise, the net interest burden will not only become an economic problem but a huge political problem as it crowds other public spending.
There is a “tipping point” debt level and interest rate, which nobody knows and can calculate the levels, where markets begin to lose confidence that the government will be unable able to service its debt in full and begins to impair its ability to rollover existing bond maturities. This is the point where a sovereign debt crisis becomes acute and really begins to accelerate.
This is why some very smart people are watching Japan, where sovereign debt to GDP is now 200 percent, financed primarily by domestic investors with a yield curve of 12 bps at the front-end for 3-month Bills and a 2.13 percent 30-year bond. If there is a sustained rise in interest rates in Japan — not impossible, but seem unlikely — its time to start channeling our inner Nostrodomus.
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