PART TWO

A WORLD TOUR: WHO WILL FACE ENDGAME FIRST?

From a Bayesian standpoint, if you always observe a certain combination of information when X occurs, and never observe that same data when X is not present, then even if X is hidden under a hat, you would conclude that X is most likely there. If I see clowns walking around the grocery store buying peanuts, and there’s a big top tent with two unicycles in front of it in the middle of what is usually an open field, I’m sorry, I’m going to conclude that the circus is in town.

—John Hussman

In the following sections of the book, we look at some of the more troubled countries in the world. Some of the countries are very small, and you may not know where to find them on the map. Others are large and well known. What they all have in common are extraordinary challenges of too much debt and large imbalances that need to be corrected.

Guessing which countries will have crises in advance is not as hard as it seems. There are a few factors that make countries vulnerable to debt crises and a few telltale signs that a country will have trouble down the line. On their own, each individual sign doesn’t mean much, but taken together, they are always present before financial crises.

Why is it that people are pretty good at spotting problems around them, but economists are very bad at seeing blowups before they happen? Let’s answer this practically. If you had a neighbor who was always running up credit card bills and who constantly borrowed money from neighbors to help pay the credit card bills, would you conclude your neighbor was a high bankruptcy risk? Common sense tells you they’re in trouble. Responsible people don’t borrow and pay back their borrowings with more borrowings. You would be right to guess that they have a problem. People whose finances are in order don’t do those things. Likewise, countries that borrow too much from their neighbors end up in trouble, yet economists never seem to figure out which countries will blow up in advance.

To see how this happens, let’s look at one of the most spectacular (although smallest) blowups in recent years: Iceland.

Iceland has fewer people than Wichita, Kansas, but it managed to accumulate about €50 billion in debts to foreign banks. That was about 10 times its GDP. To put that in perspective, total U.S. debt (public and private) is about three and a half times GDP.

Like many other small European countries, it borrowed money very cheaply from abroad and paid very high interest rates on foreign deposits. Icelanders could borrow Japanese yen for close to 0 percent, and they paid foreign investors very high rates. For instance, Kaupthing Bank’s (an Icelandic bank) Isle of Man subsidiary offered 7.15 percent on one-year deposits denominated in British pounds, and if you deposited money in Iceland as Icelandic kronor, you could get up to 15 percent.

Iceland’s extremely strong currency created tremendous imbalances. The very high interest rate differential, the carry trade, made the krona appreciate. The strengthening of the Icelandic krona meant that Icelanders could buy more and more cars, flat screens, and expensive watches from abroad. The buying spree was so large that Iceland’s current account deficit was 25 percent of GDP in 2006. America’s dangerously large current account deficit was about 7 percent that year, to put it in perspective.

The imbalances were so large that Iceland was an accident waiting to happen. As long as foreign money kept flowing into Iceland to finance the current account deficit and to roll the bank loans, everything was okay. But like any other bubble, as soon as the financing was pulled, the house of cards would collapse. That is exactly what happened right after Lehman Brothers, when all Icelandic banks went bust.

Let’s rewind, though, and see what foreign central bankers had to say about Iceland. None of them saw it.

In 2006, former Fed economist and later Federal Reserve Governor Fred Mishkin co-authored “Financial Stability in Iceland.” The report maintained that Iceland’s economic fundamentals were strong.

[Iceland’s] financial regulation and supervision is considered to be of high quality. Iceland also has a strong fiscal position that is far superior to what is seen in the United States, Japan and Europe. Iceland’s financial sector has undergone a substantial liberalization, which was complete over a decade ago, and its banking sector has been transformed from one focused mainly on domestic markets to one providing financial intermediation services to the rest of the world, particularly Scandinavia and the UK.

There are three traditional routes to financial instability that have manifested themselves in recent financial crises: 1) financial liberalization with weak prudential regulation and supervision, 2) severe fiscal imbalances, and 3) imprudent monetary policy. None of these routes describe the current situation in Iceland. The economy has already adjusted to financial liberalization, which was already completed a long time ago, while prudential regulation and supervision is generally quite strong.1

Talk about the blind leading the blind. Mishkin is a close confidant of Bernanke and worked at the Fed from 2006 to 2008. He even wrote a book with Bernanke on inflation targeting.

Contrast this cavalier approach with what happened back in 2006 when a professor of economics at the University of Chicago, Bob Aliber, took an interest in Iceland. As Michael Lewis brilliantly describes the scene, “Aliber found himself at the London Business School, listening to a talk on Iceland, about which he knew nothing. He recognized instantly the signs. Digging into the data, he found in Iceland the outlines of what was so clearly a historic act of financial madness that it belonged in a textbook. ‘The Perfect Bubble,’ Aliber calls Iceland’s financial rise, and he has the textbook in the works: an updated version of Charles Kindleberger’s 1978 classic, Manias, Panics, and Crashes, a new edition of which he’s currently editing. In it, Iceland, he decided back in 2006, would now have its own little box, along with the South Sea Bubble and the Tulip Craze—even though Iceland had yet to crash. For him the actual crash was a mere formality.”2

How did Miskin totally miss the crisis, and how did Aliber immediately understand what was going on? How did Mishkin—a member of the Federal Reserve Board of Governors, a man who visited Iceland, who was supposed to be charged with guarding financial stability—miss the telltale signs, yet a professor who had never been to Iceland was able to spot the bubble?

Economic Aunt Minnies

The answer is simple. Mishkin failed to spot an Aunt Minnie.

In medicine, an Aunt Minnie is a particular set of symptoms that is pathognomonic, or distinctly characteristic of a specific disease. (The word comes from the Greek pathognomonikos, meaning skilled in judging diseases.) Even if each of the individual symptoms might be fairly common, when you have such a set of symptoms, its presence means that a particular disease is present beyond any doubt.

In the next few chapters, we’ll be looking at countries around the world and spotting the telltale signs of economic disease. We’ll look at what factors make it likely you’ll face a crisis and what factors determine whether a crisis will turn out well. We’ll look at how endgame will work around the world.

The following list comes from Michael Pettis, a very incisive commentator on global economics. It is probably one of the best single pieces you can read on how to identify problem countries in advance. Here is a slightly edited version of Michael Pettis’s five things that matter.3

1. Debt levels matter. The best way to measure them is as total debt to GDP or external debt to exports. As a general rule, the more debt you have, the more difficulty you are going to have servicing it. Coupons matter, too. Low rates are much more serviceable than high rates.

2. The structure of the balance sheet matters, and this may be much more important than the actual level of debt. Not all debt is equal. An investor has to distinguish between inverted debt and hedged debt. With inverted debt, the value of liabilities is positively correlated with the value of assets, so that the debt burden and servicing costs decline in good times and rise in bad times. With hedged debt, they are negatively correlated.

Foreign currency and short-term borrowings are examples of inverted debt. This makes the good times better and the bad times worse. Long-term fixed-rate local-currency borrowing is an example of hedged debt. During an inflation or currency crisis, the cost of servicing the debt actually declines in real terms, providing the borrower with some automatic relief, and this relief increases the worse conditions become.

Highly inverted debt structures are very dangerous because they reinforce negative shocks and can cause events to spiral out of control, but unfortunately they are very popular because in good times, when debt levels typically rise, they magnify positive shocks.

3. The economy’s underlying volatility matters. Less volatile economies are less subject to violent fluctuations, especially if the performance of the economy is correlated with financing ability. This is especially a problem for countries whose economies are highly dependent on commodities. Typically, commodity prices go down in bad times, making it that much harder to export profitably.

4. The structure of the investor base matters. Contagion is caused not so much by fear, as most people assume, but by large amounts of highly leveraged positions, which force investors into various forms of delta hedging, that is, buy when prices rise, and sell when they drop.

5. The composition of the investor base also matters. A sovereign default is always a political decision, and it is easier to default if the creditors have little domestic political power or influence. Unless foreign investors have old-fashioned gunboats or a monopoly of new financing, for example, it is generally safer to default on foreigners than on locals. It is also easier to default on households via financial repression than it is to default on wealthy and powerful locals.

As you can see, the structure and ownership are almost more important than absolute debt levels themselves. This has very important implications, which we will go into as we go country by country around the world.

The insight that it is better to borrow in local currency versus foreign currency is critical. The United States and the United Kingdom, for example, are able to borrow exclusively in their own currency. This acts as an important shock absorber in bad times. It also creates an incentive to use devaluation and inflation as a means of financial repression. Devaluation hurts foreign bondholders, and inflation eases payments in your own currency in the short run.

Smaller countries are less able to borrow in their own currency. In the case of Iceland and Hungary, for example, borrowing large amounts of money in foreign currency means that they are trapped in a vicious circle that is usually only cured by default. For larger countries that can borrow in their own currency, like the United States, we’ll most likely see inflation as central banks come to the aid of cash-strapped governments who insist on spending.

The tour of the world won’t be pretty, but at least we hope it will be informative.