The Debt Crisis - National Balance Sheets - Economist

Jan 16th 2013, 16:08 by Buttonwood, The Economist

MORGAN STANLEY has an interesting (but, alas, privately distributed) research note on the debt crisis arguing that most developed governments are effectively insolvent. It draws up a stylised balance sheet for a government: its assets are the ability to tax (the discounted value of future tax revenues), plus real assets (buildings, equipment), equity stakes and cash. On the liabilities side, there are the market debts (bonds and bills) and the net present value of future "primary" expenditure (items such as pensions and health care). Now, one could surely push tax revenues up a bit in some countries (where they are lower than average) and bring down spending on the health and pensions items. But Morgan Stanley reckons the shortfalls are so large (between 800% and 1,000% of GDP in the US and UK) that the situation is hopeless.

In effect, the public sector must impose a burden on the private sector but the only question is how. Greece has already had to opt for outright default. Those countries that can borrow in their own currencies will opt for financial repression—keeping interest rates negative in real terms. When financial repression was practised after the second world war, there were foreign exchange controls, outright caps on interest rates, restrictions on the ability to buy gold and much besides. At the moment, real interest rates are negative; in part, this is down to central bank purchases of government bonds but it is also the result of investors' desire for safe-haven assets. The paradox is that central banks (and governments) would like risk appetites to return to normal, but not if this means a sharp rise in government bond yields.

As Morgan Stanley points out, financial repression was associated with quite benign outcomes after the second world war. The economy steadily grew its way out of the debt. But the big difference with today is that although post-1945 governments were burdened by war debts, the private sector was relatively unlevered; now both sectors carry high debt. This makes it much more difficult to grow your way out of the crisis. As Japan shows, you can hold rates near zero for ages without prompting companies or consumers to borrow.

The implications for investors, says the bank are that

With fixed income yields at record lows due to financial repression, we prefer equities over bonds. However, with yields likely to stay low for a long time because of repression, we wouldn’t make a major move out of bonds, as significant losses are unlikely.