Dr. Bob Swarup is a respected commentator on international financial markets and financial crisis.† A principal at Camdor Global, an advisory firm that helps financial institutions and investors navigate crisis and these uncertain times, Dr. Swarup was formerly a senior Partner at the Pension Corporation, a $10 billion pension buyout firm. He recently wrote a provocative white paper with Lombard Street Research, Till Debt Us Do Part, which examines the European debt crisis, the socio-political fallout and proposes solutions. He also has a book on the underpinnings of financial crisis over the last two millennia launching in spring of 2014.† Dr. Swarup's central message is that the debt crisis needs to be acknowledged and addressed in real terms if it is to be properly managed.† This interview expresses significant opinions regarding the debt crisis and are solely those of the discussion participants.
Mark Melin (MM): How do you see the markets today?† With the stock market so high, why is this so horrible?
Dr. Bob Swarup (DBS): †What's fascinating about the stock markets right now is that they are really quite dichotomous. On one side, there are people like myself, who look at the fundamentals and are scared by what we see. We see an economy out where the whole landscape is dominated by deleveraging; by disintermediation of banks from large swathes of the population; stubborn unemployment; and so on. We see a lot of the risks out there. At the same time, the S&P would tell you that it is a hugely bullish environment.† For me, it really comes down to human psychology. Consider where we are right now: it is an environment where you have so many black swans passing through in the last few years, I believe people are genuinely going through what I would call "black swan fatigue."
"...people are going through what I would call "black swan fatigue." (Institutional investors) want to be hopeful and optimistic again."
DBS: They (institutional investors) have had enough of the bad news; they really want to be hopeful and optimistic again.† You can see this in the markets.† Markets are nothing more than a reflection of people's emotions.† They are actually a collective noun for the hopes, dreams, fears -- all the emotions of related market participants. What you and I might call "volatility" is nothing more than the outcome of different pools of emotion fighting against each other for supremacy.† When I look at the market right now, I see many people abstaining and others who are tired of being paralyzed. They want to hope the world is getting better. Hope is not a strategy, as we all know.† But I think it certainly makes them feel better in the short-term.
"... it appears that the Central Bank policies undertaken in order to support the markets, have instead effectively hooked markets on these (stimulative) policies."
The second thing I would add, which I think is also very important for the current environment, is that when you look at quantitative easing (QE), it appears that Central Bank policies that were undertaken in order to support the markets, have instead effectively hooked these markets on to these (stimulative) policies. In my simple mind, what we have done to date is to put a very sick patient into an induced coma by giving them lots and lots of morphine-like QE. The problem is that all you've done is stabilize the patient. You haven't actually cured the underlying illness and begun to take him back to any kind of normality. Any time you try and take that morphine away, the patient immediately starts thrashing about violently. As long as people believe the Central Banks are there to provide support and a steady flow of new money into the system, they will continue to hope and continue to believe that we can still muddle through. Don't fight the Fed is the new mantra and it shows in the current trend of low levels of volatility punctuated by sharp spikes, whenever fears arise that policymakers may restrict that free pass.
The second thing, don't forget, is that when you have that much money into the system, it has to go somewhere. This is an expansion of the money supply on a scale that's never happened before. Simple basic mechanisms in the market that we all take for granted, such as price discovery and actually working out what the value of something might be, have completely gone out of the window. If I was to give you the whole balance sheet of Apple, for example, with all of its millions of nuggets of normally useful information, but without any of the price information, could you tell me what the share price of Apple is? Frankly speaking, you could come up with any number at all, if you had no knowledge of the current share price. This is because what goes into this calculation is all your hidden assumptions and biases about long-run interest rates, typical P/E ratios at different points in the market cycle, the cost of refinancing etc. These, however, require stability and a free functioning market. We have neither.
MM: Let's relate this to free markets because what we are addressing is look at the Fed policy of stimulus.† It is repressing a free interest rate market. So, one could say that relative to price discovery, there is no price discovery in the mechanisms of free (interest rate) markets right now.† They (and related asset markets) are being controlled by the Fed and there's just going to be an asset bubble around the corner.
DBS: I think we understand and have learned the markets are as far away from free markets as you can get currently. The problem you have with the sheer amount of money that's gone in there is that it has completely distorted the signals. The money has to end up somewhere. The Fed's thinking is simple. What they're saying is, "You know what, there's a lot of deleveraging happening right now. We need to support the economy through it, ease the pain where we can and so, we should continue to pump money in."
There's a problem though with that perspective. What actually makes an economy go around is transactions. An economy is a living breathing creature that lives on transactions. If transaction's don't occur, the economy dies. The Fed, ECB and others can have a direct impact on the quantity of money in the system, but not the velocity of money in the system - they have no control over this. You can pump as much money into the system as you want but for it to actually have an effect and turn things around not to mention generate that dreaded future inflation, the velocity of money needs to increase.
In other words, where we end up on the recovery (inflation) and stagnation (continued deleveraging) seesaw depends not just on the quantity of money in the system, but also how fast that money is moving through the system. That is determined by the entities that buy and borrow and lend, i.e. banks, businesses and ordinary consumers. In order to have an effect on the economy, the money needs to move through the system and that can only be determined by their willingness to borrow and lend, rather than hoard and save. When banks hesitate to lend, businesses begin to conserve cash and consumers stop buying and borrowing, monetary velocity goes down - even as the money in the system piles up.
A lot of money has gone in, meanwhile, that velocity has completely crashed. So, what you have now is cash piling up on the balance sheets of corporates. You have cash piling up in excess reserves of the Fed via banks.
When you have that much money, it has to go into something and right now, it's all ending up in asset price inflation rather than the wider economy. Money is very cheap today. Some people have lots of money to speculate with, others (such as institutional investors) have large pools of savings that are dwindling in real terms every day - that is all coming through in the markets. At the same time, we have a wider economy that is desperately starved for cash and is continuing to deleverage. That is one of the reasons why this dichotomy exists because when I look at the economy, I see that it is, frankly speaking, in a terrible shape globally. At the same time, financial markets, which in my opinion have always had a pretty tenuous relationship and poor correlation with GDP and the wider economy, are actually having a great time because there is so much money around looking for a home.
MM: Fascinating point! What are the historical parallels and what does that say about the problems today?
DBS: Well, I think the problems are plenty. We've been here so many times before. I think you've mentioned earlier that I was writing a book. In my book, I look at the last two and a half thousand years of financial crises and that's only because our records stopped two and a half thousands years ago, and they hadn't quite gotten round to writing all these things down.
It's human nature. The simple fact of the matter is that we have some very simple psychological biases that will always make us particularly euphoric at times and particularly bearish at other times. And what we call rationality is actually bounded on all sides by our emotions, environment and peers. Like geese flying in formation, we each move individually through the world but never in isolation. If one changes course, his or her actions impede on neighbors affecting their behavior. Our bounded rationalities overlap and cascade through the flock till suddenly, the whole formation changes course - the new order emerging unbidden from the initial random movements of a few.
Our actions are less reasoned and more intuited. There are good reasons for this. We need to take countless decisions every moment of every day and an intuitive approach has served us well in our evolutionary history to date.† Crossing the road, driving a car, tackling my two year old son's logic - life is a continual exercise in instinctive opportunism and risk management. Additionally, social cooperation and harmony depends on shared norms, common opinions and an intuitive grasp of interpersonal skills. But these same virtues also make us susceptible to ignoring fundamentals, running with the herd and convincing ourselves that we are in control - all the psychological ingredients of boom and bust.
"Crossing the road, driving a car, tackling my two year old son's logic - life is a continual exercise in instinctive opportunism and risk management."
And when you throw money and credit into the equation, it becomes a whole new game. What money does is leverage these underlying emotions. If you think of what money actually is and ignore all the economics and finance spiel you were taught, money is a social construct. Money came about because we needed something that was easy to count, portable, divisible and so on to keep tab of the interactions between individuals and store that value for future use. Once created, what money then became was this amazing thread that ran throughout society and bound it even more closely, creating a much bigger, more complex entity through allowing interactions with people you might never meet and for specialized goods or services you could never have possibly hoped to have conceived of.
At the same time, money is a paradox because it also accentuates the divisions between us and brings questions of status and power into play.† Thousands of years ago, I might have thought I was better off than you because my cow produced more milk or I had more worldly possessions or I had more friends. Now, with this new concept called Money, I can actually quantify how much you've got and how much I've got. I can now figure out what the difference in status between you and me is. The point of all that money to me, from a purely social point of view, is actually a way of getting ahead in the perennial rat race that our competitive bias always places us in. The more money I have, the more ability I have to transact with the world and therefore the higher in status I am compared to you on some level.
Now, add in my emotions to that, and we have some very simple biases that quickly begin to emerge. For example, you and I, and everyone is listening to this, suffers from what I would call temporal myopia. In other words, we all have a very short-term horizon. We're not talking about just politicians here, whose time horizon is dictated by the election cycle.
For example, if I offered you $1000 today or $1010 tomorrow, which would you take? What if I offered you $1000 a year from now or $1010 a year and a day from now? Utility theory and its perfect rationality dictate that we would make the same decision in both cases. If you are risk averse, you will always choose the $1000. If not, you will always pick $1010.
But in practice, we are inconsistent. Our bounded rationality creates inconsistent behaviors in response to simple incentives that make complete sense to us. You don't know me. We've only just met and spoken a bit. You don't know if you can trust me. You are more likely to pick $1000 today because the money is here now and you do not know if I will be there tomorrow while the extra amount is tiny in comparison. That uncertainty is enough to bias you to the here and now. So, for you, it's actually better to be short-term in your thinking. However, a year from now, it makes little difference whether you wait a day or not - the timeframes and associated uncertainties are about equal in your mind. Therefore, you are more likely to wait for a year and a day and collect $1010.
However, if I changed the person above making the offer to a good friend, your answers will change again based on your perception of how reliable that friend is. You are not being irrational. In your world, the context always matters and is a key determinant to your rational choice. The nature of the incentive has subtly shifted and, therefore, so has your response.
These are natural survival mechanism that have evolved over thousand of years for human beings. Time is the root of uncertainty. What we sometimes despise as temporal myopia is a natural reaction to the fact that there are large unknowns about the future in the real world. From an economic perspective, it explains why we worry more about buying a house today rather than saving for retirement. The uncertain path of whether we will make it to old age, what our money might be worth that far down the line and what the government or some future economic disaster might do to our little hoard, coupled with our innate optimistic bias that there will be ample time and opportunity to make the money later, mean that we are naturally driven to focus on nearer term needs that can also function as stores of wealth in our perspective.
It explains why corporates and financial institutions are so focused on near-term returns. They drive your share price this year and the next. They know almost every investor - even purportedly long-term ones such as pension funds - has an actual time horizon that usually spans from today to the end of the quarter or year, depending on their reporting cycle. They also know current models of staff compensation are biased towards returns on equity, i.e. returns in the short-term. It explains why governments spend today and hope for growth tomorrow. Their myopia is subtly different in that it is driven by the electoral cycle. However, in their case, it always makes more sense to spend today. In the boom times, this caters to key vote banks and demonstrates affirming progress on social and political agendas to supporters. In the bad times, stimulus increases their chances of economic success in the near-term and the perception that they are doing something. Both enhance the probability of being re-elected. Taking a longer-term view may result in a curtailed career, particularly when you appreciate the shorter time horizons of your electorate. It also casts light on their dynamic inconsistency - fancy words for propensity to disappoint - as they soon learn that expectations management is far more important than actual delivery.
In the financial markets that we inhabit, that temporal myopia becomes all the more acute. Every moment brings a change in that P&L and that little bucket of hoarded status. With advents like mark-to-market positions, our horizons become ever shorter and that drives our decision making all the way through. That inevitably will always lead to huge rises in euphoria periodically because you've extrapolated the very recent past too far into the future. And it is will lea to periodic busts when we suddenly figure out that perhaps that confidence we had was misplaced.
MM: You bring up an interesting point regarding confidence. Particularly on a debt crisis crash, it's really a crash of confidence because the confidence in the bond and currency market erodes. I've seen modeling for debt crisis math, where essentially the currency becomes very invaluable and untransferable. If you look at the 1933 (Germany) issue (when the currency became worthless), the issue was there wasn't (the amount of) money in the system. We could be coming up to the next crash where the problem is there is too much money in the system. What does a debt crisis crash look like to you?
"... A lot of what you and I call 'money' is actually debt by another name."
DBS: Well, we've talked about leverage in the system, and a lot of what you and I call money is actually debt by another name. When you go and look at your bank account and you see whatever is there today, just remember it's not actually there. It's just an accounting entry on some bank's balance sheet and the money has actually been lent out several times over to individuals and businesses or invested in speculative activities.
So, although you think you have cash, what you actually have is a credit note from some debtor(s) on future income and revenues. If you look at the U.S., for example, the actual money supply, the base money supply in U.S. is like $3 trillion. In contrast, the credit markets are about $50 trillion, which gives you some idea of the quantum of illusion out there.
DBS: In a bull market, it's fairly easy to borrow money. People are optimistic about the future and therefore, are willing to be more credulous about lending large sums of money to people for mortgages, businesses etc. It will come good in the end. Moreover, as your collateral grows in value, you feel even richer and by the miracle of credit scores and analysis, you can borrow even more against it. Then, as the debt builds up, there is a growing belief that somehow it doesn't matter how much there is - there will always be a way for us to refinance.
MM: We're coming at the end of that, it appears to me.
DBS: Exactly, and I think the problem is that every time you will eventually reach a saturation level. The system has a large capacity to sustain debt but it is a finite capacity. When you've reached that saturation level, there is only one thing you can do and that is to deleverage. It's also important because then you rebuild that buffer to fund future growth. We are reaching that point. In fact, I would argue we would have reached that point already if the Fed and other Central Banks had not suddenly come in and supported the markets with such force. However, there is good debt and there is bad debt. And when you've reached those upper echelons of capacity, it's worth remembering that a large chunk of the debt is probably junk and will never be repaid.
We keep reminding ourselves of this fact periodically throughout history. Even ancient religious texts such as the Bible talk about the need for periodic debt forgiveness. The Old Testament recommends a Jubilee every 50 years, where all the debts across society would be written off and the slate wiped clean.
MM: Debt forgiveness has been discussed at high levels, by the way. It just seemed so absurd to me. †One outcrop was that absurd trillion dollar coin minting fantasy that occurred maybe three or four months ago in the United States.
DBS: Yes, it was just ridiculous. But I think it just showed how people have gotten so lost in the minutiae and can't see the wood for the trees. It remind of the 1920s during the Weimar hyperinflation in Germany, The Governor of the Reichsbank - their central bank - would stand up in parliament every single day during the episode and with complete seriousness, tell them exactly how many billions of Marks they had printed that day. The next day, the number was inevitably larger and delivered in the same matter of fact tone. It was darkly comical but the problem was that he was completely stuck in his mode of thinking and obstinately pushing the monetary button, hoping for a different better answer every day. He couldn't understand that the system around him may have some serious structural flaws that were not actually being addressed.
MM: Is that the thinking of Central Bankers today? Do they not see this massive potential problem on the horizon?
DBS: Well, I think the problem for Central Banks at the moment is that they see a huge amount of deleveraging that has to occur. This will all be very painful for the economy and for them, it is not an option. For example, as we said, there is $50 trillion worth of credit out there and deleveraging is a fact. We have far too much debt in the system and the only way we're going to get sustainable growth going forward is if people have the capacity to borrow again. In my mind, we need to be realistic and write off large parts of the debt but that's a separate discussion.
What Central Banks have decided is that the deleveraging is because of a lack of demand from consumers and businesses. They firmly believe that if you can support the system long enough, aggregate demand will come back and that we will be back to normal. By putting more cheap money into the system, they are hoping to create incentives for people to borrow and lend. But they have failed to appreciate the debt dynamics at play and that some of the demand will not come back till these are addressed. They also have not appreciated that boom and bust are as natural to people and the economy as breathing is to you and me.
Relative to addressing the problems on the horizon, I would note that policymakers are people too and subject to the same temporal myopia I talk about earlier. It is why policymakers choose to fight the urgent crisis today over the far more important crisis building up in the future. The enhanced risks for the future in terms of high inflation, impaired sovereign balance sheets, the far more crippling costs of paying for a generally aging population and the resulting social tensions are of lesser consequence right now. This is because in their eyes, the overarching need is to preserve the financial system today.
MM: That's the point we're at today. If you talk to people who are concerned about this current equity market run up without fundamental basis, (a crash could be ahead).† It's better to have smaller and easily manageable market crashes rather than one massive crash that could destabilize society.
DBS: I think that's the thing people forget. A lot of people look at the situation only from the monetary point of view and they completely ignore the sociopolitical aspects. Money, as we said earlier, is a social construct. That means, by definition, anything that happens to money and credit has wider ramifications across society. Unemployment, for example, is crippling psychologically as it creates uncertainty, lowers feelings of self-worth and leaves people - particularly younger people - with poorer prospects for the rest of their lives. These drivers are what create social tensions and threaten the sustainability of an economy. If you look at Europe, unemployment is in double digits. It is north of 25% in Spain and over half the youth population is without a job right now. These are all the right ingredients for populist and extremist politicians to come into power, and was one of the areas we highlighted in Till Debt Us Do Part.
MM: Right. That's what hopefully society is trying to avoid. What do you see as some of the solutions?
DBS: Well, I think the simple solution as I've said earlier is to get capacity back in the system. You just basically have to get rid of the debt. This notion that it will all be repaid somewhere down the line - that's, to be honest, bull. It's not going to happen. The simple fact of the matter is you have to restructure a huge amount of the debt out there. However, there are plenty of options here, and many tested throughout history. If you look at Europe again for a moment, they are going through what I would call a tragedy of small decisions. They have a summit and do something small - piece-meal restructuring like the Irish promissory notes. Then they wait, hoping that somehow in six months that it will become better..Then, just as they're ready to move on, whoops, it's not working yet. Cue more hand-ringing, more desperation and another kicking of the can down the road.† The problem is and what they haven't fundamentally understood is that there is simply too much debt in the system, and that this needs to actually be restructured, ideally in one fell swoop. Otherwise, what you are doing through this halting hesitant approach is strangling all the confidence out of the system and doing far more damage. You are making a depression out of a decline.
MM: Is that the reason quantitative easing is less effective with every attempt at it?
DBS: I think in the first instance, it does become necessary because the problem is how to stabilize the patient. However, as we've discussed, you're not actually helping the patient get better. You have to marry that quantitative easing with fiscal and structural reforms. My recent paper, Till Debt Us Do Part, points out that it is never easy but that the alternatives in the long run are far worse. In many ways, the situation in Europe today is reminiscent of the 1920's when they went through a similar extended period of debt restructurings. Back then, it was driven by the burden of reparations on Germany post World War I but critically, it was another unsustainable debt burden with huge socio-political ramifications.
Providing the system with monetary support becomes part of the answer because you want to sacrifice depth of pain for duration. In a credit-hooked society, shutting the banks and financial infrastructure down is not a good idea. However, you alongside have to make some pretty painful adjustments, such as restructuring debt. Our proposed solution was for Europe to implement their version of the Brady bond. Put your hands in your pocket, have an honest rummage round and say to the bondholders, "You know what, guys: We can't pay you back what we promised." Then, you can start focusing on effectively giving back 50 cents on the dollar or whatever is a realistic recovery number. There are lots of ways of achieving that outcome without reducing the nominal number. Extend the duration over a nice long enough period of time. Cut the yield offered. Offer warrants that align repayment to future growth and revenues. Let the market figure out a clearing price. It may not be what was promised in the euphoria of the boom but at least, you and I are both going to get something back, be able to get on with our lives and make some money again in the future. Our temporal myopia will soon take care of any lingering resentment.
"...say to the bondholders, 'You know what, guys: We can't pay you back what we promised."
MM: Has that concept been formally floated between bond holders and governments at any point, do you know?
DBS: Not to the best of my knowledge, though it has happened to a limited degree with odd items like the restructuring of the Greek debt. When we proposed it about a month ago, it was news to many people.
MM: Well, I don't think that the institutional bond holders have the notion in their heads yet that the government is not going to entirely repay them. We're potentially a couple of years away from that.
DBS: I think you're right. People have this huge psychological aversion to losses. We all love gains But the losses wound us far more, which is why every trader out there has a story about the losing trade they stubbornly hung onto for far too long. Emotions get in the way. Bond holders are people and would like to get their money back, even though the prospects in real terms are not great. The problem they face is that unless they comes to this realization sooner rather than later, the less chance they have of seeing sustainable economic growth in the future.
Returning to 1920s Europe briefly, most countries had GDP ratios over 100% because of the cost of the First World War. A lot of this was owed to the US, who had lent the bulk of the money. The US, of course, demanded that all this money get repaid. The Allies didn't have the money and so in turn, demanded that Germany pay war reparations. The result was a huge pyramid of debt claims, which ended up with Germany being required to pay something like 300% of GDP. Over the next few years as it became clear that German growth was crippled and the money was probably never going to be repaid, the US negotiated the Dawes plan. The US government and banks began to lend vast amounts of money to Germany, allowing Germany to pay the Allies and the Allies to then pay the U.S.. It fuelled a private credit boom in Germany, put a rocket under asset prices and GDP, and kept everyone happy for a few more years. But underneath the surface, nothing had changed and no one implemented any of the structural reforms that were needed to create sustainable growth. By 1928, it was clear the Germans were still in trouble and once the Great Crash of 1929 got under way, the system was perfect fragile to transmit contagion all over Europe and trigger the Great Depression.
Unemployment shot up to over 30%, extremist parties became the largest parties in parliament and in 1933, Germany just unilaterally defaulted all of its debts. Other countries followed suit over the next few years and even the US ended up stealthily restructuring the last Liberty loan to its own population.
So, the lesson is that you want to restructure in an orderly fashion because you have the best chance of recovery and keeping the economic† as well as political systems you like.
MM: If you look at debt crisis probability tables, the worst case scenario is a complete debt crisis crash. The smaller manageable crashes are preferred actually to one massive societal crash.
Bob, I've appreciated your time today. It's been valuable. †Best of luck with your upcoming book in spring of 2014. We'll have to keep look out for its publication.
Opalesque Futures Intelligence
Wednesday, May 22, 2013
Institutional Consultant Notes Debt Crisis With Concern