Michael Surkan of the Optimistic Bear again invited me on his radio show to discuss the ongoing issue with Dubai and its potential knock-on effects around the world. As I mentioned in my technical update on the weekend, this issue itself is not likely large or relevant enough to cause a global bout of deleveraging. But it may contribute to a loss in the prevailing optimistic tone toward the ability of some sovereigns to make good on their debts. The assumption is that any sovereign in trouble will be bailed out or assisted by another sovereign, the IMF, etc.
But this may be a premature assumption. Explicitly guaranteeing the debts of other sovereigns may increase the perception of systemic instability. German finance minister Peer Steinbrueck learned this last year when he blurted something about not allowing any Euro member to go belly up. He later backed away from that statement, surely after being made aware of the implications: if Germany were to guarantee the debts of all euro nations, they themselves would be perceived as ultra high risk. Abu Dhabi is certainly aware of this potential issue, hence their reluctance to immediately back Dubai.
The next assumption is that many heavily indebted sovereigns will attempt to pay off their debts through traditional measures (tax revenues, inflation, austerity, etc). Many times these measures are not politically possible. So strategic default starts to become a legitimate way out. Once this begins, it is difficult to stop in its tracks. Nobody wants to be stuck paying interest on debts while their competitors operate debt-free. Eventually, this will happen. New political parties will be elected and will view the debt burdens as "obligations of previous regimes."
Right now they continue to play extend and pretend. Extend the duration of obligations and pretend that assets are worth more than they really are. That will work only so long as it appears beneficial for everybody involved (ie. rising stock market). Soon, the sheer mathematics overrun the ability to continue this. As Steve Keen put it so well recently, and as Karl Denninger continually posits, the world's debt burden relative to our productive output is too high and is only poised to rise. And the percentage of our incomes required to service this debt is also too high. This has a corrosive effect on our ability to invest in productive capacity which lessens the other side of the ledger (output). All of the above puts upward pressure on risk premiums (ie. interest rates), which self-perpetuates the worsening servicing ratios.
This is the "Minsky moment" we experienced briefly last year. Confidence was high that it could be prevented. We are now in the process of testing that theory. In my opinion it will fail and another Minsky moment will soon occur - this time with dramatically less confidence in the ability of central bankers to postpone its effects, and less political capital to act as they did before.
Listen to the podcast below (run time about 20 mins).
As always, comments are appreciated.
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