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Sovereign Debt Crisis Nursing the Global Economy Back to Health

Policymakers and politicians are spending their time, energy and OUR money attending to the symptoms of the disease while the disease itself continues to grow. Recessions are a necessary evil, as they serve to eradicate the excess and misallocation of capital that occurs in a growth phase. Once cleared of this excess and misallocation of capital the system is again efficient and free to grow. However policymakers have refused to allow this natural cleansing of the system for too long now and they continue to promote misallocation of capital and mispricing of assets through the use of ultra-loose fiscal and monetary policy. The result is a sovereign debt crisis in the world'

Sovereign debt crises are more common than most people realise. Despite the world having unprecedented levels of sovereign debt, relative to history we currently have a small percentage of countries in default or restructuring debt. This is set to rise sharply in coming years. Reinhart and Rogoff have done an awesome job of documenting the history of sovereign debt crisis, covering 800 years of data (see charts below). Interestingly Spain is the undisputed champion in the sovereign default arena, it has defaulted on its debt 13 times since 1500. Also of interest is that Greece has spent roughly half of the last 200 years in some form of debt restructuring or in default.

Chart 1 shows the percentage of countries either "restructuring" the debt or in default going back to 1800. Notice how default levels remain low for long periods of time and then suddenly surge as default becomes contagious.

Chart 1
Soverign External Debt

Chart 2 shows the link between public sector debt and inflation is a strong one. The quantity theory of money argues that the supply of money and goods are the drivers of inflation. Therefore monetary policy is seen as the panacea with respect to inflation. Chart 2 demonstrates that the fiscal authorities also have a role to play in driving inflation.

Chart 2
public sector debt and inflation

Charts 3 and 4 indicate; capital flight, currency crashes and inflation mark the progression of the sovereign debt crisis. The argument for deflation is very strong, however policymakers stand ready to defeat deflation with their printing presses and I wouldn't bet against them.

Chart 3
capital flight, currency crashes and inflation

Chart 4
Capital Mobility and the Incidence of Banking Crsiis: All Countries, 1800-2007

The progression of the Sovereign debt crisis is an important indicator on the journey back to health for the global economy. Unfortunately it will only be a severe crisis that acts as a catalyst for prudent macroeconomic policy to return. Mr Market has woken up to the Sovereign debt bubble and is now working its way through the guilty from weakest to "strongest". Greece has been in focus for some time, a country whose economy is uncompetitive and has absolutely no chance of generating the growth required to reverse its sovereign debt burden. Spain is now in focus, and the painful adjustment from a socialist/welfare state is underway. The crisis will then make its way through the remaining culprits in Europe before heading east to Japan and finally arrive on US shores. Until the crisis gets to the United States the dollar and treasuries will remain the "go to" assets. The US is by far the most dynamic and competitive economy amongst the major developed nations and it does have the ability to print unlimited amounts of the world's reserve currency.


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