Thursday, June 14, 2012

PART #1 ... Relationship of Debt to Growth ... Size of Government and Individual Freedoms


Greek voters will go to the polls Sunday in large part to express their views about the future of Greece as a member of the Euro zone. But that's not the biggest story coming from Europe these days.

In fact, a much bigger issue is playing out in Spain today as that country is now teetering on insolvency.  Similarly, Italy and Cyprus are getting closer to the breaking point, and Portugal and others may be close behind. And it's all about debt in relation to economic growth, or the lack thereof. So that's the topic du jour.

In this post we'll use Spain as our example.

Spain and the U.S.

So what do the problems in far away Spain have to do with us here in America? Well, just about everything, at least as far as the lessons we can learn.

In the U.S. we're not teetering on insolvency, of course, but neither are we taking the necessary steps to assure our economic future. And in no way are we improving the prospects for future generations of Americans to enjoy the opportunities we've had the past half century or so.

In the past, our ever expanding American economic "pie" has been the envy of the world, and We the People have enjoyed unlimited opportunities. As a result, we've consistently demonstrated by our actions that there is a direct correlation between economic growth and freedom. So far, so good.

Debt Impacts Economic Growth

But what we have yet to internalize completely is the direct correlation between a nation's ability to grow and the size of its debt load. So we'll discuss that topic now.

You see, the size of the economic pie in relation to total debt is of enormous importance to future "pie" growth.  It's the relationship of the two --- debt in relation to the size of the economy --- that matters to growth.

If the pie is growing as fast or faster than the debt is increasing, then we're not losing ground. But if the increase in debt is outgrowing the pie's expansion, we're headed for big trouble. And that's what has been happening around the world, especially in Europe and America as well.

And that's why Spain is such a valuable story for us to study.

We hear about austerity versus growth. Either or is how it's presented. That's a crock.

If we're spending and increasing debt, we're losing. If we're growing and decreasing spending, we're winning. It's that simple.

Shrinking debt while growing the economic pie is great. On the other hand, growing debt while shrinking the economic pie is awful. Numero uno is growing the pie without growing the debt commensurately. Again, it's the relationship between the two that counts.

Spain Has Run Out Of Road

But at some point, if not brought under control soon enough, the amount of debt and the interest charges thereon will kill the economy's pie growing capability in relation to the debt incurred. That's why never letting debt get out of hand is fundamental to successful pie growing economies.

And that's where Spain and other countries are today.  We in the U.S. don't have to end up that way, and my bet is that we won't. But we have to get serious about "pie" expansion and "debt to pie" shrinkage to avoid the really bad outcome that is now befalling Greece, Spain, Italy and others.

Why That's So

How big the pie is in relation to debt directly affects how much future credit will be available to individuals, companies and nations. And there is an enormous difference between borrowing to invest and grow compared to borrowing to spend.

Creditors always want to be repaid and are willing to "rent" their money at a fair rate of interest, but only if the credit risk is deemed to be a reasonable one for the amount of "rent" charged.

To the extent that the potential borrower is a high risk, the creditor insists on a high rate of interest, and perhaps collateral as well, before he will make the loan. And if the creditor believes the proposed loan is too risky, he will  or at least should refuse to make the loan at all.

Today in Spain and Other Countries

And that's where Spain, Greece and many other European countries find themselves today. Either they will be charged really high interest rates or creditors will simply refuse to loan them any more money. As that occurs, they are in essence bankrupt because their economic pie has stopped growing as well.

Then it will be game over unless and until other countries come to bail them out or they default and begin anew. If that happens, the whole interconnected world will be in real trouble. I'm betting that "begin anew" scenario won't happen, but it could.

Thinking and Acting Like a Creditor

Let's approach this from the point of view of the creditor. To the lender, there are four basic types of risk: (1) sovereign or country risk, (2) credit risk, (3) asset or collateral risk and (4) currency risk.

(1) Why loan to Spain if they aren't likely to repay the loan? (2) Why loan to a Spanish company if it's unlikely to be unable to repay the loan? (3) Why loan to a Spaniard to buy a house if the house is likely to decline in value to the point where that collateral wouldn't be worth enough to sell and repay the loan in the event of default? (4) And last, why loan to any of these potential borrowers if the currency used to make the loan won't be the same currency used to repay the loan, or if that currency isn't expected to retain its value during the life of the loan?

One key consideration  in extending credit is the interest rate charged. Today the German government can borrow for ten years at a rate slightly higher than 1%, the U.S. can borrow at a rate of about 1.6% and Spain  must pay ~7%. Italy pays over 6%.  Thus, interest rates are used to offset credit risk, assuming the loan is even made in the first place.

What's Happening Right Now

 Spanish Crisis Deepens says this in part: "The financial crisis threatening the Spanish government deepened Thursday as Spain's borrowing costs surpassed their euro-zone record.

The move followed yet another sovereign credit downgrade and coincided with fresh evidence Thursday of economic and financial stress as the decline of Spanish housing prices accelerated to a 12.6% annual rate in the first quarter and Spanish banks increased their reliance on European Central Bank funding.

Coming just a few days after Spain was forced to seek a European-Union bailout for its banks of up to €100 billion ($125.57 billion), the new raft of bad news sent Spanish borrowing costs soaring. The yield on Spain's 10-year government bond rose to as high as 6.96%, a new euro-era record and a sign that demand for Spanish debt is rapidly drying up. If Spain cannot find enough investors to buy its bonds, it will need to seek a bailout. . . .

That means that housing prices have fallen 26% since their peak in the third quarter of 2007, according to the INE, though some private valuation firms estimate steeper declines.

Spanish housing prices, however, have been slow to correct, largely because banks have been reluctant to unload repossessed properties. Many economists draw comparisons with Ireland, which is grappling with a housing bust of a similar magnitude and where prices have fallen 50%

But the situation in Spain is changing as banks face deepening financial stress and new government regulations force them to unload properties. Robert Tornabell, professor of banking and finance at ESADE business school in Barcelona, said the first-quarter housing price data "is a sign of worse to come."

Separately, data Thursday from the Spanish central bank showed average net ECB borrowings for May for Spanish banks rose to €287.31 billion from €263.54 billion in April, highlighting the growing difficulties local institutions face to obtain financing on international markets."

And Italian Borrowing Costs Surge says the following:

"The Italian government's borrowing costs soared at a bond auction Thursday, a development that will make it more difficult for Prime Minister Mario Monti to avoid having to seek financial help from other euro-zone members.

The souring of investor sentiment toward the euro zone's third-largest member reflects concerns about the knock-on effect of Spain's banking crisis, as well as growing doubts about Mr. Monti's ability to turn around Italy's moribund economy, which experienced the largest contraction among members of the Group of 20 in the first quarter and seems set for a prolonged contraction.

In a fresh reminder of the risks facing Italy, Moody's Investors Service and Egan-Jones Ratings Co. slashed their views on Spain just days after the country requested aid to recapitalize its banking sector. This, along with Sunday's coming Greek elections, helped confirm investors' dismal view of the euro zone's prospects. . . .

Fresh data from the Bank of Italy Thursday confirmed that Italy's public debt rose to €1.949 trillion in April, up €3 billion from March. Italy's government debt amounts to 120% of gross domestic product. The size of Italy's government debt has raised jitters about the country's ultimate fiscal solvency."

Summing Up

In future posts, we'll attempt to apply the lessons to be learned from Spain and similar situations to the U.S. and what we need to do.

We'll also try to make clear why this isn't a Democrat or Republican issue.

It's very much a We the People issue.

If we lead, they'll follow.

If we follow, they'll lead us right off the cliff.

But the good news is that the cliff is still down the road a ways, so there's still time to change course and head down the right road.

In other words, it's up to us, and that's the way it should be.

Thanks. Bob.

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