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PATH FINANCIAL LLC
Registered Investment Advisor
1990 Main Street #750
Sarasota, FL 34236
941-350-7904
Raul Elizalde - Monday, December 13 2010
After many years of not really caring, American people are now horrified with how much the United States owes. Federal debt held by the public almost doubled in five years, the federal deficit has grown to 10% of GDP, and interest payments on government debt are projected to double to more than $800bn by 2015.
Much of the political and media rethoric insists that runaway spending is the root of the problem and that it must be reined. While Americans used to look down on Europe, many today point at tough, newly-imposed fiscal measures in Europe and the U.K. as examples of decisive and necessary action. Everyone seems to agree that reducing spending is the way to go.
Has the rethoric got it right? That public debt has increased substantially in the United States is not in doubt, nor is the fact that issuing debt to pay for unproductive spending is a bad idea. But the rise of public debt in the United States is far more due to the unfettered explosion of private debt than to unrestrained and wasteful spending.
Although public debt is usually under the microscope of both the market and the media, private debt often runs under the radar. This is rather peculiar. Private debt is not only business and household debt but also the debt of the financial sector, and given the importance of banks on the functioning of any economy, at least some financial sector debt usually ends up being backed by the government during a crisis. This is the case for the largest, or “systemic”, banks: while small, regional financial institutions are allowed to fail, large national banks are in practice government-guaranteed. Because of the possibility that some private debt may end up owned by the public, a clear picture of a country’s solvency is not possible unless one considers the total amount of a country’s debt.
This is not only true for the United States (witness the bailouts of Citigroup, Bank of America and other giants) but also everywhere else. Ireland, for instance, guaranteed all bank deposits to prevent a run on the banks after concerns that they were saddled with bad assets. This was a costly decision: the bail-out of Irish banks will amount to 15% of GDP, raising its total budget deficit in 2010 to 32% of GDP.
Financial crises usually result in the nationalization of private debt. Households who defaulted on their mortgages in the United States, for example, caused a significant deterioration in the quality of mortgage-backed securities, some of which were part of “systemic” bank portfolios. To save those banks, the government ended up owning those portfolios of toxic assets. This was not cheap and had to be financed by issuing US Treasury bonds. This is one example of how private debt can end up in public hands.
The seeds of the financial crisis in the United States were planted long ago. Financial sector debt increased from about 30% of GDP in 1980 to 120% of GDP in 2008. In hindsight, this should have been exceedingly alarming. But the focus, if any, stayed on Federal debt, which rarely strayed far from 40% of GDP – a mere third of the size of banking sector by 2008.
In the two years after the financial crisis, Federal debt soared from less than 40% of GDP to more than 60% of GDP. But this only mirrors the transfer from the private to the public sector, as financial sector debt declined by an equivalent amount.
Applying the same analysis to Europe is truly terrifying. While banks in the United States are collectively about as large as GDP, Spain’s, Portugal or Belgium’s banks are well over three times their respective countries’ GDP. United Kingdom’s banks are five times as large. Ireland’s bank assets stand at an eye-popping ten times the size of the country’s economy.
The extreme budget tightening that is taking place in Europe may well prevent wasteful spending here and there, but there is no doubt that all those efforts will be of little help if a sizable chunk of the banking sector needs to be bailed out. Budget health matters little in extreme circumstances – Ireland ran ten years of budget surplus prior to 2008, for example, only to face a staggering deficit of 32% of GDP in 2010 when the bailout of its banks is accounted for.
After dodging a bullet with Greece, Europe and the United Kingdom are looking into the barrel of a cannon. It will all depend on how bad European banking assets really are, and whether their proportion grows as a result of widespread austerity measures. Positive results from “stress tests” were not deemed conclusive because they excluded politically charged tests on sovereign debt. Upcoming funding needs for the banks could also prove to be overwhelming.
Investors may well remember that the Great Depression in the United States was painfully prolonged by a European banking crisis that started two years later, sparked by a run on the banks. European politicians surely remember the pain. The question is whether they can find the proper medicine.
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We use quantitative measures to build and maintain portfolios for our clients, which we rebalance every quarter. We described our investment process in previous newsletters. If you would like to know more about how Path Financial’s investment process works, call us or send us an e-mail at the address below. We’ll be happy to set up a confidential meeting to discuss new paths to financial success.
Raul Elizalde | raul@pathfinancial.net | 941-350-7904
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