3D View: Debt, Deleverage and Definancialisation

It’s taken me a long time to get round to this post. My eyes have been glued to the train wreck that is European fiscal management. Who could forget the financial gymnastics performed by many EU wanna-bees prior to EMU integration. 3% budget deficit….no problem said Greece….we have some very good accountants in Athens.

So the chickens have finally come home. And now the Euro project is in harms way. Or is this just the next stage in complete sovereign consilience? It’s fiscal consolidation or that’s the end of the road.

The real problem, if you look hard enough under the falling limbs of the EU forest, is simply debt and its modern bedfellow, leverage. The financial binge of the last decade, built upon market deregulation in the 80s, has simply finished. Apres le binge, le deluge as they might say in Paris. A bad hangover is one thing but watching bankers get on the big white telephone is no fun at all.

The debt binge primarily was brought about not so much by low interest rates (though that helped) but by the belief that capital gain was guaranteed. Stocks always go up in the long run, property always goes up in the long run…..don’t worry about income, just borrow as much as you can and buy an asset. These financial assets have become a magnet for all investors and, naturally, sellers of investment products. I wonder how many people are holding derivative products which allow them to catch the upside of the stock market with no risk unless the market falls 50%….oops. Certainly Mr Buffet has a few of those.

The return to a time when people invested in companies based on their fundamental performance and bought houses to live in is long overdue. That people cannot afford to buy a home is without doubt the result of excessive lending by banks over the last 30 years. This is the root cause of the problem. Banks have actually created the inflation we have seen in financial assets….unearned income to be exact. That asset price inflation has seen real wages fall heavily over the years consigning the average wage earner or those unable to access leveraged credit to a lifetime of renting and debt.

The maths of excessive leverage is the simple maths of compound interest….compounded.

As Paul Volcker noted in this recent piece,

“There was one great growth industry. Private debt relative to GDP nearly tripled in thirty years. Credit default swaps, invented little more than a decade ago, soared at their peak to a $60 trillion market, exceeding by a large multiple the amount of the underlying credits potentially hedged against default.”

The bottom line is very simple: we have spent our GDP already….for many years hence.

Now it’s payback time. The payback process could take many forms: bankruptcy, forced asset sales or a slow descent back to a normalized level of activity – actually living within our means. Stripping away the financial sector so it works for people and business rather than conspiring against them will be the first requirement: not so much regulation as reengineering.

Whichever route we take it will be a painful adjustment made worse by the fact that those who are in charge are actually responsible for perpetuating the current system or refusing to question and change it.