But the original problem - too much debt - hasn't gone away. It has just been transferred to government balance sheets.

Time to give up debt addiction

GREG HOFFMAN
May 17, 2010 - 2:12PM

The first week of May's panicked trading on world financial markets was eerily reminiscent of the post-Lehman chaos of September 2008. Equity markets plummeted, debt markets froze and inter-bank lending rates skyrocketed.

The question is not whether Greece can or cannot pay its debts (without dramatic cuts to government spending, it looks nigh on impossible), but which country is next.

With Spain, Portugal and Ireland in the firing line, it's no wonder banks are reluctant to lend to each other. It's also no surprise that the European Union (EU) and International Monetary Fund (IMF) have orchestrated a 750 billion euros ($1 trillion) rescue package.

The Europeans, being European, took their time. But, not surprisingly for students of human nature or politics, they've taken the easy option and kicked the can down the road. For now, another crisis has been avoided.

In hock

For more than a decade, Western consumers borrowed too much money, ably assisted by financial institutions creating financial products they themselves didn't understand. When the consumers couldn't pay and the banks were about to collapse, governments bailed them out. Remember the calls for a "global stimulus package"'?

Well, it worked in as far as we're not looking down the barrel of another Great Depression. Amongst the recent chaos, statisticians announced that the US economy generated an astonishing 290,000 jobs in April.

But the original problem - too much debt - hasn't gone away. It has just been transferred to government balance sheets. Now, one of those governments can't meet its obligations. So what do we do? We just transfer the problem onto bigger balance sheets. In this case, they're the ones owned by the EU and the IMF.

The buck, however, can't get passed any further. Europe and the US are not too big to fail, but they are too big to bail. It is going to hurt but eventually, eventually, the Western world needs to reduce the overall leverage in the system. And what form might that take?

How to deleverage

McKinsey and Co, a consulting company, recently produced an insightful analysis of 45 prior episodes of deleveraging, 32 of which followed financial crises. The authors conclude that there are four ways to deleverage an economy, and only two of those options are available to the West today.

The two options are inflation and "belt tightening". The latter has been the most common tonic to a bout of indebtedness (16 of the 32 post-crisis deleveraging episodes).

This means cutting back on government spending in order to bring spiralling foreign debt balances under control and the result, in all cases, was a substantial reduction in economic growth.

Inflation might seem like a far more palatable solution and, for creditors, there's no doubt it is. Perhaps best described as "default by stealth", inflation erodes the value of debts and, if you're the supposed recipient of those debts, the value of your assets.

Inflation also reduces the value of all other assets in an economy, creates substantial frictional costs and destroys a country's ability to borrow in its own currency again.

It might be the most palatable option for a leveraged electorate, but for the owners of capital, inflation is a disaster. And once the inflation genie is out of the bottle it can be very difficult to get it back in.

As investors, we should be preparing for one or both of these factors to have a substantial impact on our portfolios over the coming decade. In many ways, however, we should welcome it. It's in everyone's interests to unwind imbalances in global trade and fiscal budgets and so begin the process of Western deleveraging. Otherwise we run the risk of a crisis so big it might portend another Great Depression. From my perspective, the sooner the better.

This article contains general investment advice only (under AFSL 282288).

Greg Hoffman is research director of The Intelligent Investor

http://www.smh.com.au/business/time-to-give-up-debt-addiction-20100517-v84t.html

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