Can investors adapt to a deleveraging world?

How will widespread deleveraging affect the global economy?

Following the stagflation of the 1970s, the world entered an extended period of growth driven by host of genuine benign innovations. This environment enabled an extended period of leverage and excessive indebtedness by many individuals, corporations and governments. This came to a crashing halt in 2007–2008. We are now several years into what is almost certainly an extended period of deleveraging.

The euro mess

Initially many Europeans felt the global financial crisis would be contained to the US subprime market, but what quickly became evident was that many European banks held huge portfolios of securitised debt. Like the Americans, their governments needed to bail out large financial institutions that were too big to fail.

However, countries in the eurozone have an additional impediment to deleveraging: they do not have the safety valve of their own free-floating currencies. Instead they signed up to a single currency, thereby forgoing the natural balancing mechanism that the foreign exchange markets afford. From day one, the euro was known to be economically illogical. Something has to give if you have (a) different nations with sovereignty over their fiscal arrangements, (b) limited practical mobility of labour (for cultural and language reasons), and (c) no institutionalised, federally directed transfers of wealth. But these economic realities were trumped by politics aimed at bringing the nations together in a close union to promote trade and peace.

As we now know, joining the eurozone was a boon for the peripheral countries (Portugal, Ireland, Italy, Greece and Spain or PIIGS) as they were able to piggyback on the aggregate strength of the eurozone with more or less one interest rate applied to the sovereign debt of each of its countries. Many bondholders thought sovereign default would never eventuate and that, as the only other mechanism for different risk outcomes (that is, currency) had been removed, the same interest rate should apply to all eurozone sovereigns.

They could not have been more wrong. For instance, the private holders of Greek sovereign bonds are being cajoled into accepting a 50 per-cent (or worse) “voluntary” haircut. They may well have to agree to or face a worse outcome. And, even then, Greece will probably still be insolvent.

Greece is smaller than its fellow PIIGS. Ireland will probably renegotiate the bailout that was forced on it last year. Italy and Spain have huge deficits that are impossible to service with the higher interest rates being forced on them.

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