Baking the dough of debt into the bread of financial crisis.

Debt seems to be a necessary trigger condition for global economic disasters.

Doesn’t matter if its private (subprime mortgages) or Government (Greek debt).

In the Red

But Japan shows debt is not a sufficient condition for a meltdown.  (Government debt = nearly 200 percent of GDP)

So what is the extra ingredient that turns the dough of debt into the crusty baguette of financial crisis?

The inability to repay is the obvious catalyst to make the loaf rise. But those taking on the debt expect to be able to pay it back. The yeast is dormant until other people decide the borrowers can no longer repay.

What’s often needed is a snap decision that debt can’t be repaid.

This happened for Greece when the EU statistics agency revealed they’d been creatively measuring their budget deficits.  Suddenly these went from 5 percent to 14 percent.

In Thailand, they devalued their currency by 40 percent in 1997.  Their debt (mainly privately held) had to be paid in foreign currency, and therefore nearly twice as much baht was needed to make repayments.  People pulled their money out of Thailand.

The recent GFC seems to have been different, and that’s the scariest thing.   There was no one moment where the yeast was added.  What made the subprime debts go bad was a tipping point in the accumulation of people who thought they would go bad.  These people started betting against the subprime mortgages, their prophecies self-fulfilled, and the rest is Macroeconomic history.

And macroeconomic history is full of reminders that these crises spill over. From one sector to another, then from one economy to another.  Contagion.

Peaks of concern about subprime debt turned out to be mere foothills to the Mountains of Trouble that followed.

Portents of doom. Maybe.

Rogoff and Reinhart have done some work on Government debt. They find that countries with debt over 90 percent of GDP tend to grow more slowly.

The point of taking on debt (in theory) is that it creates higher future incomes that will make paying it back easier.  That’s why we take on student loans, loans for infrastructure investments, etc.  But when that debt gets over 90 percent of GDP, it seems to make growth slower. Slowing growth makes debt even harder to repay!

This list of high public debt countries shows a bundle of economic stalwarts and basket-cases.  But is their future bright?

Not all debtors are in the poorhouse.

(By rights, Nauru should top this list, but sometimes it pays to fly under the radar.)

Importantly, Rogoff and Reinhardt also have something to say about ‘external debt’ which is a combination of all government and private debt owed outside a country.  They find “growth deteriorates markedly at debt levels above 60 percent.”

Australia and the US are certainly in illustrious company!  All those mortgages look a bit more dubious now.  Should we panic? The question of course, is whether there is any risk of that raising agent being added.

What could cause a snap decision that debt can’t be repaid?

For Australia, a crash in the Chinese economy would likely do it.  If one of their insolvent banks was allowed to fail, their economy might stop looking so rosy, and our debt with it. I understand that all of China’s banks have been technically insolvent recently, and that bad loans remain a major issue. The Communist party is propping them up, and arguably thereby propping us up too.

For America, all it might take is China selling Treasury bonds.  The Chinese Government holds at least 23 percent of the external debt that the American Government owes (they lend America the money to buy the cheap exports that keep Chinese people employed).

If China decided to offload these billions worth of Treasury bonds, the value of the US dollar could tumble, and it might find itself feeling like Thailand in 1997…

Worried now?

Published by

thomasthethinkengine

Thomas the Think Engine is the blog of a trained economist. It comes to you from Melbourne Australia.

6 thoughts on “Baking the dough of debt into the bread of financial crisis.”

  1. Americans have been warned plenty of times about the debt held by China, and the warnings are starting to lose force as we come to realize that China is every bit as stuck with us as we are with them. How could China unload all its US bonds without wiping itself out? Can you really sell your entire debt in one transaction, so that no part of your sale causes the price of any other part of your sale to fall? I mean, as a small trader I can liquidate my holdings all at once if I want to, but only because there are buyers who are way bigger than I am.

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  2. I like the parallel the author made between debt and baking. I am not a baker but how true is it that yeast is needed for the bread to rise and in this case if the debt cannot be repaid, then we all know what happens. This article also made it clearer in my mind the difference between the public debt and the external debt with the US not in the list of 12 on the public debt but placed third on the external debt.

    Evelyn Guzman
    http://www.debtchallenges.com (If you want to visit, just click but if it doesn’t work, copy and paste it onto your browser.)

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  3. Great post! I thougth it was really good where you said it is usually when someone else decides you can’t repay is when the trouble starts. Do you think this gives more power to companies like PIMCO and other large bond traders?

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