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Debt as Heroin

A shocking title, but I just read a fascinating analysis by Albert Edwards (from SocGen).  Edwards has been working on the sovereign debt problem.  Those investors who benefited the most from shorting Greece will remember his Q3/09 commentaries [around US Thanksgiving] where he mentioned that the PIGS were in immediate danger of defaulting on their debt obligations.  Earlier this week he wrote a more comprehensive analysis based in part on the work of Jagadeesh Gokhale (Senior Fellow at the Cato Institute – a rightwing think-tank…).

Edwards’ analysis is fascinating.  He makes a very interesting observation: those countries that suffer from the worse structural deficit – a government deficit even when the economy is operating at full steam, are behaving like heroine addics; they will promise anything as long as they can get their next fix!  Edwards takes the view that those same countries that have the largest gap are those who historically been the worse at managing their debt burden.  The guiltiest parties are the usual names plus a few surprises (Norway...):

Difference between required and actual primary surplus (% of GDP)




It gets worse, much worse, if “off balance sheet” obligations are included the operating surplus certain European countries need to generate are staggering.  

 


Taking France as an example, their structural deficit is around 1.75%, currently the French government is running a government deficit in the range of 8.2% (depending on a number of assumptions).  Because of France’s “unfunded liabilities” the total surplus it needs to generate is slightly north of 9%.  The difference is almost 12%, which is simply unmanageable, there is no way (politically or socially) for France to move to this type of surplus.  A solution will require not only a reduction services but also a dramatic reduction in benefits; retirement age will have to increase (e.g. truckers retire with full benefits when the turn 55).  Canada is in somewhat of different position.  In fact, it can run structural deficit because of the nature of its economy – natural resources exporter (Canada’s government also aggressively tackled its fiscal deficit in the mid 90s).  

The assumptions on which Gokhale makes his “unfunded liabilities” projections are fraught with risk (Generational Accounting) especially with regards to their magnitude. However, for the purpose of this analysis it is largely irrelevant because the gulf between where we are and where we need to be is so large that error factor is irrelevant.  In the case of France whether the structural surplus is 8% or 12%, doesn’t impact the overall message of social and economic dislocation.

It would appear that the European central bank and Germany are not buying the "addicts" line that after this one fix they will change their way.  This morning Angela Merckel indicated that there would be no German guarantee forthcoming for Greece.  

This should be interesting!

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