The guest commentary below was written by Jeff Snider of Alhambra Investments. This piece does not necessarily reflect the opinions of Hedgeye.
When their paper came out in January 2010, Carmen Reinhart and Kenneth Rogoff put a number on bond vigilantism as it had been known in prior history.
The idea behind investor fickleness was simple and intuitive: profligate governments who finance their ill spending ways by borrowing will literally end up paying the price once the exceed common sense. And when those governments do, the people they claim to represent are those who really end up footing the bill.
The uncontroversial history behind the process is one key reason why this becomes such an emotional topic; the stakes are enormous and, like it or not, they will affect everyone underneath any regime running afoul.
What Reinhart and Rogoff had found was the number 90 (for both advanced and emerging market countries). In other words, when anyone’s central government debt (public) reached 90% of real GDP, this appeared to have triggered vigilantism before then a slew of negative consequences.
Among them, a statistically significant drop off in economic growth and the rate of advance for living standards. It’s that last part which really impacts the average person on the street, and by which the average person actually judges the overall situation and their place in it. Maybe not consciously, but as a group we absolutely “feel” when the rate of change has changed for the worse, and remains worse for a prolonged period of time.
First the statistics behind all this:
[T]he relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of GDP. Above 90 percent, median growth rates fall by one percent, and average growth falls considerably more.
While no definitive explanation is offered, theories connect higher debts with eventually higher taxes and/or spending cuts which, in the authors’ view, is a drag upon aggregate demand (neo-Keynesian framework).
In such a case, then, the number ninety holds special significance for that being the most likely point when vigilantism might be unleashed.
Why are there thresholds in debt, and why 90 percent? This is an important question that merits further research, but we would speculate that the phenomenon is closely linked to logic underlying our earlier analysis of “debt intolerance” in Reinhart, Rogoff, and Savastano (2003). As we argued in that paper, debt thresholds are importantly country-specific and as such the four broad debt groupings presented here merit further sensitivity analysis. A general result of our “debt intolerance” analysis, however, highlights that as debt levels rise towards historical limits, risk premia begin to rise sharply, facing highly indebted governments with difficult tradeoffs. Even countries that are committed to fully repaying their debts are forced to dramatically tighten fiscal policy in order to appear credible to investors and thereby reduce risk premia.
This had appeared to have become the case – as Reinhart and Rogoff had just warned – for much of Europe 2010 moving into 2011 and toward Draghi’s “promise” in July 2012. The weaker Club Med (or PIIGS) members of the EU found their high levels of borrowing pre- and post-crisis were turning off bond investors in droves; or so it seemed.
Whereas interest rates skyrocketed on those specific members’ debt securities, all that turned around in 2012 at the behest of Draghi’s ECB.
This had appeared to have given each country space to sort out their issues, and debts, so as to emerge from the high 90s. Most never did, even as Europe as a whole managed to ride recovery from the 2011-13 recession to just below the paper’s threshold.
One thing is absolutely clear, however; growth rates dropped off as borrowing had skyrocketed, and never came back. What was meant to have been “stimulus” didn’t actually stimulate much beyond the ire of bond market participants if only for those few recession years.
The debt, as well as the lack of growth and inflation, still remain. While on a reflationary track from 2013 forward, overall central government borrowing has slowed and even reversed as a percent of rising GDP, not much has actually changed – just in time for 2020.
According to Eurostat’s figures, in 2019 total European government debt had fallen to around 84% from a high of 92.8% back in 2014. In a few days, the agency will release its estimates for CY 2020 which are undoubtedly going to be somewhere around 115%, give or take.
In current conventional description, this is “stimulus” even powerfully so, and we are told that it should be looked on unquestionably in this way. Not just that, but governments are in danger of having done “too much” in the good sense of inflationary excesses (not paying any mind to the other “too much” in the sense of the borrowing threshold).
Another economic and financial crisis, another peacetime surge in borrowing not having paid off (or grown out of) the last one’s. Should Reinhart and Rogoff’s formulation still apply moving forward, it would suggest even less growth afterward before ever getting to COVID and the governmental overreactions to it which have absolutely destroyed significant parts of the European economy.
Obviously, the neo-Keynesians have all along strenuously objected to these findings, the mere mention that it might be possible for debt levels to subtract from growth rather than add much to it (as mainstream models uniformly assume).
But, and this might be the most important question, aside from the red herring behind the occasional “austerity” criticism, there hasn’t been any work from the usual vigilantism anywhere in Europe. Apart from a hit or miss tax hike, usually having nothing to do with budget deficits (such as France’s riot-inducing climate change fuel tax a few years ago), the vigilantes accomplished nothing for all the 90% violations across the Continent.
And that includes all those right now who remain on the wrong side of the threshold. Put another way, they each felt the sting of the lack of growth usually associated with being on the wrong side of the bond market, but without having undertaken any of the palliative measures intended throughout history to get back on the right side of it (in order to bring borrowing costs back down).
They’ve triggered the thresholds but not the consequences of the triggers. Borrowing costs are low all over the world no matter.
Instead, vigilantism has disappeared from Europe just as it has throughout other high debt countries around the world – notably Japan and the US. Expectations for American debt-to-GDP are similarly huge already, jumping even more in 2020, obviously.
According to US government numbers, debt-to-GDP (gross central government debt; like terms with the paper) surpassed 90% in 2010 as the ARRA worked its way into infamy.
The ratio, unlike in Europe, hasn’t come back down since (106% in 2019) and is now poised to easily surpass our European neighbors.
And like them, no negative consequences from the vigilantes. On the contrary, taxes haven’t changed much (lower, on the whole) and Uncle Sam sure hasn’t gone any sort of spending diet. Yet, also like Europe, growth dropped off significantly anyway.
All the negative effects associated with the 90 trigger, but none of the proposed causes. On the one hand, all this public debt has clearly failed to add much to the economic situation, so the fat model multipliers have proved of limited (read: useless) value.
In short, bond yields down – no vigilantes – but growth down with it anyway just in the way Reinhart and Rogoff had warned if for none of the theorized reasons associated with high debt levels before 2008.
Any seasoned reader (who has come this far) knows where I’m going with this: eurodollars and liquidity concerns are, and must have been, paramount across the whole world.
This is what has robbed it of its growth while simultaneously favoring these profligate central governments who only issue more debt when their prior rounds of borrowing predictably fail to boost anything as expected.
It has become a near-spiral, especially now in the wake of 2020’s big negative contributions on both sides (even less growth and much more debt).
And that’s the problem – there’s no off-ramp. With even less anticipated future growth, the more the bond vigilantes will hibernate, thus ever-increasing levels of government debt confirmed by the lack of growth. The real global phenomenon of the past few years.
This may be why the current reflationary trend has been so thoroughly…underwhelming to the shock and surprise of those both expecting the imminent waking of vigilantism or the inflationary contributions from the debt.
Yields have gone up globally if only a relatively tiny bit (rather than a “historical” rout described in media accounts).
Massive debts aren’t becoming a signal for “too much”, no matter how far above the 90% number; on the contrary they are yet more confirmation for the same environment that sadly favors these “safe” borrowers; sovereign government issuers of bonds that the market will take at near any price (at least when Fedwire might not get in the way).
Jeff Snider is Head of Global Investment Research for Alhambra Investments. Jeff spearheads the investment research efforts while providing close contact to Alhambra’s client base. This piece does not necessarily reflect the opinions of Hedgeye.