Big Debt Crisis

Question 1

If a country has a lot of debt, what 3 factors is the magnitude of this risk dependent on?

Answer 1

1) The ability of that country to spread losses over time (low rates, long terms)
2) Whether or not currency is denominated in currency they control (ability to control rates and/or inflate away debt through printing money)
3) If they can influence how creditors/debtors behave with each other - ?

Question 2

What typically happens in an upcycle?

Answer 2

1) Borrowing (credit) lifts incomes, rising incomes lift spending, rising spending lifts creditworthiness, rising creditworthiness lifts borrowing etc.
2) Rapid growth to fund infrastructure (followed by abrupt decline when infrastructure spending dries) typical of emerging markets

Question 3

What are the biggest risks during a debt crisis?

Answer 3

1) Failure of policymakers to know the right thing to do

2) Political consequences of hurting some/helping others and delay

Question 4

What are the 4 levers policymakers have to pull in a downturn?

Answer 4

1) Austerity
2) Debt Defaults/Restructurings
3) CB Printing Money
4) Transfer of money from haves to have nots (via taxes)

Question 5

What are characteristics of the short term debt cycle?

Answer 5

1) Central Bank can manage with monetary policy
2) Less extreme
3) Self constrained by borrowers and lenders to some degree
4) Debt/Income ratios bottoms and tops are always higher than previous cycle in upcycle

Question 6

What happens during a deflationary depression?

Answer 6

1) Typical when debts denominated in own currency (otherwise likely inflationary)
2) Central bank can no longer lower rates to stimulate growth
3) Debt restructuring and austerity dominate without stimulus at the expense of credit and growth (error)
4) Debt as % of income actually grows as incomes decrease

Question 7

What happens during an inflationary recession?

Answer 7

1) Typical when a countrys debts are denominated in foreign currency they don’t control
2) Capital withdrawal of foreign flows from exogenous factors causes lending to dry up
3) Countries print their own money to fund deficits required to stimulate growth as external lending dries up
3) Currency devalued as money supply increases and foreign investors are no longer buying the local currency (net sellers as they leave)
4) (Above 3 combine to produce price inflation)

Question 8

Deflationary Debt Cycle Phases

Answer 8

1) Early Phase - Debt burden low, goldilocks phase
2) Bubble - avg 3-4 yrs, debts rising faster than income
3) Top - avg 1 year, triggered by CB rates rising or foreign exogenous factors if debt denominated in foreign FX
4) Depression - avg 3-4 years, triggered by policymakers not doing enough quickly enough
5) Beautiful Deleveraging - avg 3-4 yrs
6) Normalization

Question 9

What is typical of the beginning of a bubble?

Answer 9

1) Overleverage, asset/liability mismatch
2) Borrowing short term to lend long term
3) Liquid liabilities to invest in illiquid assets
4) Investing in riskier debt w/ borrowed $
5) Borrowing in 1 currency, lending in another

Question 10

What is typical of a general bubble?

Answer 10

1) Debt to income levels: Avg increase 40%, range 14-79%
2) Debt increase: Avg 32%, range 17-45%
3) Income growth: Avg 13%, range 8-20%
4) Equity market growth: Avg 48%, range 22-60%
5) Yield curve flattening (SR-LR): 1.4%, range 0.9-1.7%

Question 11

What is a fundamental flaw with traditional monetary policy?

Answer 11

1) Reluctant to tighten when some asset prices are booming and inflation (esp core) is OK. Japan 1980’s, world in 1930’s and 2000’s.
2) Some bankers feel it’s not their job to control bubbles, but impact of some bubbles going bust is massive and are always a function of credit and money

Question 12

What to look for to identify a bubble?

Answer 12

1) Prices higher relative to traditional measures
2) Prices discounting future rapid price appreciation
3) Broad bullish sentiment
4) Purchases financed by leverage
5) Buers have made exceptionally extended forward purchases (inventory, supplier contracts etc.)
6) New buyers enter market
7) Stimulative monetary policy adds to bubble

Question 13

What is needed to anticipate debt crisis well?

Answer 13

1) Analysis of debt service abilities of specific sectors
2) Forecast of cascading losses from busts in those specific sectors
3) Even if avg debt/income levels are higher, this is less problematic if spread across multiple sectors

Question 14

What happens during a debt cycle top?

Answer 14

1) % of new borrowing goes to pay debt service, emerges in some sectors 6 mo before peak in vulnerable places
2) Credit spreads tick up (riskiest first)
3) Yield curve flattens or inverts (long down, short up) incentivizing savings and cash
4) Hard to observe, some areas of economy remain fine
5) Fastest rates of tightening typical 5 months before top
6) Unemployment at cyclical lows, inflation rates start to rise
7) Slows demand as items bought on credit more expensive)
8) Short rates peak just before the top

Question 15

What falls first in a bubble burst?

Answer 15

1) Wealth. Stock declines often misinterpreted as good opportunities when asset values decline, but really an early indicator of income decline.
2) Wealth constricts, credit dries up, investment dries up, spending dries up, asset values decline (wealth constricts)

Question 16

What was the major difference between the great depression and the 2008 financial crisis?

Answer 16

1) In great depression, slower to ease monetary policy and create fiscal stimulus
2) In financial crisis, quickly dropped rates to 0 and used other measures to stimulate

Question 17

What issues do depressions cause with institutions, and how are they attenuated by policymakers?

Answer 17

1) Solvency - Accounting rules or equity infusions or MnA

2) Cash Flow - Fiscal or monetary policy infusing cash

Question 18

What happens to the investor class during a depression?

Answer 18

1) Equity prices decrease an average of 50%
2) Taxes increase
3) Earned income falls
4) Become defensive, move money out of country or into hard stores of value

Question 19

What is the problem with austerity during a crisis?

Answer 19

1) Cutting spending further decreases incomes
2) Raising taxes further decreases incomes
3) Both above are always mistakes

Question 20

What must a government do quickly when providing monetary stimulus?

Answer 20

1) Curtail panic and guarantee liabilities
2) Provide liquidity - lending against wide range of collateral or institutions
3) Support solvency of systemically important institutions
4) Recapitalize/Nationalize/Cover losses of systemically important institutions

Question 21

How many bear market rallies occurred during the great depression? What were the gains during the bear market rallies?

Answer 21

• 6 bear market rallies, gains between 16-48%

- Ultimately market declined 89%

Question 22

What happens when policy makers are effectively managing debt defaults and restructurings during a crisis?

Answer 22

• Swiftly recognize magnitude of problem
  
  • Don’t save every institution that is expendable
  • Create or restore robust credit pipes
  • Ensure acceptable growth and inflation conditions while bad debts are worked out
  • SPREAD PAIN OVER LONG TERM WHERE NECESSARY

Question 23

What are the two ways failed lenders assets are managed?

Answer 23

• Transferred to separate entity (Asset Management Company, AMC). Better to isolate problem assets so previous entity can continue.
  
  • Remain on Balance sheet of lender

Question 24

What were the two periods where the wealth gap grew in the U.S. the most based on what measurement?

Answer 24

• Great depression and now (2020)

- Top 0.1% own as much as the bottom 90%

Question 25

What causes problems between haves and have nots during deleveraging?

Answer 25

• Greed and wealth acceleration through bubble causes popular uprising against rich
  
  • Taxation causes mutual anger by the rich, causing them to move money exacerbating the issue
  • Taxes don’t typically have a big enough impact on helping with deleveraging unless there is a massive revolution and associated wealth transfer

Question 26

What does the right government policy do during a deflationary deleveraging?

Answer 26

• Neutralize what would have otherwise been a credit market collapse
  
  • Get nominal growth rate marginally above interest rate to spread out the deleveraging process over time (income needs to grow faster than debt)

Question 27

Why does CB print money during deleveraging?

Answer 27

• Money OR Credit can be used to buy things. In the absence of credit, money must take it’s place.
  
  • This is easier for countries with debt denominated in their own currency because they can 1) monetize the debt and 2) restructure debt more easily

Question 28

When is the printing of money not inflationary?

Answer 28

• If the size and character of the money creation is equal to the size and character of the credit contraction

Question 29

What is the average length of contraction, size of currency decline vs. gold, peak money creation, and peak fiscal deficit during deflationary debt crisis?

Answer 29

• Length of contraction AVG: 55 mo, RANGE: 22-79
  
  • Size of currency decline vs. gold AVG: -44%, RANGE: -58%–37%
  • Peak money creation AVG 5% of GDP, RANGE 1-9% of GDP
  • Peak Fiscal Deficit: AVG -6%, RANGE -14%–1%

Question 30

What is QE?

Answer 30

• When central banks inject money into the economy through government bond purchases, incentivizing banks to loan that money to others creating credit and growing the economy.

Question 31

What does QE do?

Answer 31

• Targets investors and spenders
  
  • Reduces risk spreads, decreasing actual risk
  • Benefits to financial assets, widens the wealth gap
  • What investors buy w/ money is important. Stuff that stimulates spending = good, financial assets = not nearly as good.

Question 32

When does QE not work?

Answer 32

• Over time, QE decreases in effectiveness because asset prices are pushed up to a level beyond where they should be based on historical fundamentals, and the reward/risk ratio starts to suggest cash is a better bet than investing. “Pushing on a string”
  
  • Debt and money are claims on goods and services. If debt/money are too high, it needs to come down to make sure there are realistic expectations of receiving those goods and services. Can be typical of later years in long term debt cycle.

Question 33

What is 3rd phase of monetary policy?

Answer 33

• Direct money to the hands of spenders instead of investors
  
  • Direct payments to less wealthy is more directly stimulative because lower income people have more incentive to spend vs. wealthy.
  • Can be in the form of fiscal stimulus from government programs or CB helicopter money.
  • Year of Jubilee in Roman times was a big across the board debt relief.

Question 34

Why do policy makers almost always print money in the end?

Answer 34

• Austerity causes more pain than benefit
  
  • Big restructurings wipe out too much wealth too fast
  • Transfer of wealth doesn’t happen in a meaningful way without revolutions

Question 35

What are macroprudential policies?

Answer 35

• Strategically assessing health of entire economy

- Strategically target or support one sector vs. another to stimulate economy

Question 36

What are deflationary debt crisis recovery conditions in terms of length of equity drawdown, length of GDP drawdown, and change in debt-GDP cost stimulation

Answer 36

• Length of equity drawdown AVG

Question 37

How does inflation and interest effect bond prices?

Answer 37

1) Rates going up decreases the price of the bond as a price decline must compensate for the new substitute higher yield
2) Inflation going up decreases the price of a bond as future payments have less purchasing power

Question 38

When does a dangerous currency dynamic begin?

Answer 38

• If holder of debt expects interest rates to not compensate for decline in currency in which debt is held

Question 39

What produces inflationary depressions?

Answer 39

1) CB’s can’t keep rates high enough (risk economic disaster) to compensate for currency decline, further expectations of currency decline cause investors to flee to safer wealth stores
2) CB must print money to avoid domestic credit markets from fully drying up, increasing supply and causing more to leave.

Question 40

What are characteristics of a country with currency weakness?

Answer 40

1) Debt denominated in foreign currency
2) High dependence on foreign capital inflows
3) Currency weakness is what causes inflation when there is a depression