Today’s European sovereign-debt crisis has much in common with other seemingly unrelated crises of the past decade. The common element? Too much leverage.
Let’s take a look at the last three major crises we’ve faced. First came the technology, media and telecom bubble of the early 2000s, when corporations took on excessive leverage. We all know how that ended. Next came the overleveraging of financial firms and consumers that led to the unraveling of the US subprime market in 2007 and 2008. And today, we are faced with a sovereign-debt crisis caused by a period of overleveraging by governments.
There are three ways in which an entity can deleverage:
- First, they can pay the debt back, which is generally the preferred choice (especially of debt holders).
- Second, they can default, or as the Greeks have called it, “voluntarily restructure.” Some people, including the economist Carmen Reinhart, include “financial repression” as a form of debt restructuring. This is where a country takes various measures to keep nominal interest rates below what they would otherwise be, effectively coercing captive investors such as savers and pension funds to accept lower returns.
- Third, they can inflate their debt away.
The first road—paying back debt—requires a sustained period of deleveraging, as we’ve seen in the past. Japan’s private sector has been deleveraging since the late 1980s. In the US, companies have taken action to reduce their leverage in the years following the corporate crisis of 2001. In fact, US investment-grade companies today have more free cash on their balance sheets than ever before. Of course, the most highly leveraged entities don’t have the luxury of repaying their debt. Hence, the European high-yield market’s default rate of nearly 40% in 2002.
We’ve seen a similar process at work since the 2008 financial crisis. US consumer debt has come down slightly, and the debt-service ratio—the ratio of debt payments to disposable income—has declined at a more rapid rate thanks to very low interest rates and write-offs. US financial firms, too, have been deleveraging. Many have raised fresh capital, and Tier 1 capital ratios—a measure of capital adequacy—have risen well above precrisis levels.
So, US corporations, consumers and financial firms, in aggregate, are all in better shape today than they were three years ago. European institutions have not fared quite as well, although private sector credit growth is contracting. But government debt growth has been rapidly accelerating. That brings us back to the current European sovereign-debt crisis.
If governments do nothing, debt-to-GDP levels will likely increase. An escalating debt burden can be very detrimental. A study by Reinhart and another economist, Kenneth Rogoff, suggests that once a debt/GDP ratio exceeds 90%, growth tends to fall off meaningfully. Many European countries—most notably as Greece and Italy—have debt levels in this vicinity (Display).
The problems of Europe are complex because of the one-size-fits-all nature of monetary policy in the euro area, but in the end, there are still three potential options with respect to the debt overhang. Two of these—debt repayment and default—will no doubt choke off economic growth. The inflation option appears to be a near-zero probability, because it is anathema to the European Central Bank.
So don’t expect rapid growth in Europe any time soon.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Douglas J. Peebles is Head of Fixed Income at AllianceBernstein