Last month, the world’s biggest hedge fund, Bridgewater, issued a fascinating analysis of deleveraging case studies through the history of the world, grouped by final outcome (good, bad and ugly). As Dalio’s analysts note: “the differences between deleveragings depend on the amounts and paces of 1) debt reduction, 2) austerity, 3) transferring wealth from the haves to the have-nots, and 4) debt monetization. Each one of these four paths reduces debt/income ratios, but they have different effects on inflation and growth. Debt reduction (i.e., defaults and restructurings) and austerity are both deflationary and depressing while debt monetization is inflationary and stimulative. Ugly deleveragings get these out of balance while beautiful ones properly balance them. In other words, the key is in getting the mix right.” Of these the most interesting one always has been that of the Weimar republic, as it certainly got the mix wrong.
The reason why Weimar will be critical, is that at the end of the day, Weimar, unlike some of the other successful case studies, is precisely what the global debt situation will require when all is said and done will be the model to imitate. Why? Because as BCG showed last year, the global debt overhang (on a net blended basis) to reduce global Debt to GDP to a “sustainable” 180%, would require the elimination of $21 trillion in debt, one way or another, with the excess debt concentrated primarily in the US ($8.2 trillion) and the Eurozone ($6.1 trillion).
This is in absolute terms, not relative, as permitted under Keynesian methodology, as relative devaluations simply destroy the “last defector” actor in serial fashion (with benefits accruing to the ‘first to default’), in the process crucifying globalization and consolidated world trade. Which means that a coordinated inflation driven deleveraging is the only possible outcome.
Which is where Weimar comes in. And specifically the following chart from Bridgewater:
The case of Weimar is one of the most extreme inflationary deleveragings ever. At the end of the war, the Reich government was forced to choose between a shortage of cash and economic contraction or printing to stimulate incomes. The government chose to print and devalue to stimulate the economy, beginning with a 50% devaluation at the end of 1919 that brought the economy out of recession. Eventually, a loss of confidence in the currency and an extreme amount of printing led to hyperinflation and left the currency basically worthless. As shown below, the currency fell essentially 100% against gold and printing was exponential. Starting debt of 913% fell to basically zero. Non-reparations government debt of 133% GDP in 1919 was wiped out by inflation. Gold-based reparation of 780% GDP effectively went into default in the summer of 1922 when reparation payments were halted. We summarize this in the table below and then go through the pieces.
Note the shaded red regions.
And this, make no mistake about it, is what is in store.
Continuing from Bridgewater: “The next chart shows the aggregate government obligations owed and its two pieces, the gold-based reparations and other government debt”
Then there is the question of what happens to gold. In Weimar’s case, gold-denominated reparations were simply forgiven.
As discussed, the non-reparations government debt was eroded rapidly through inflation. While the reparations were not techincally imposed until 1921, they effectively existed shortly after the war and it was mostly a question of negotiating how big they would be (the official amount was settled at the start of 1921 and then reduced that spring by about 50%, still a huge sum). Because the reparations were denominated in gold, they held their value until Germany ceased payments in 1922. They were then restrutured several times over the next decade until they were effectively wiped out.
Well, as the Greek case study has shown, this time around the gold will first be confiscated. All of it. Only then will the debt be forgiven. In the form of a hyperinflating of trillions in claims, in a coordinated way across all currencies, and relative to a basket of hard assets.
And going back to the current parallel in which the entire world is now one big Weimar Republic, we return to the BCG study in which the dire conclusion is as follows:
Let’s suppose that the politicians and central bankers acknowledge the hard facts. Agreeing on the starting situation would be a precondition for defining an effective remedy. They might begin by recognizing what many commentators have been pointing out for a long time:
- Western economies, notably the U.S. and Europe, have to address the significant debt load accumulated in the course of 25 years of credit-financed economic expansion. (See Exhibit 1.) And some must address real estate bubbles as well.
- The necessary deleveraging would lead to a period of low growth, which could, given historical precedent, last more than a decade and would be amplified by the aging of Western societies.
- This would have consequences for the emerging markets, with their exportbased growth strategies. Any shift toward more consumption in these countries might not have a substantial stimulatory effect on the economies of the West.
- Efforts by governments to deal with their debt problems would lead to even lower growth and would increase the risk of social unrest. A recent study shows that as soon as expenditure cuts exceed 3 percent of GDP, the frequency of protests increases significantly. The demonstrations that occurred in some European countries this September should therefore not have come as a surprise.
- Banks do not have enough equity to weather further write-downs—and governments are running out of ammunition to stabilize banks should a new crisis hit.
- Central banks may be seen as the last remaining institutions able to stabilize the financial markets and support economic growth. But their efforts are losing effectiveness. In spite of increasing balance sheets by up to 200 percent since the end of 2007, central banks have been unable to ignite sustainable economic growth.2 On the other hand, the monetary overhang could be the basis for significant inflation.
- The longer governments postpone addressing the fundamental problems of the crisis, the deeper and more prolonged the crisis will become.
But even if all these facts were generally acknowledged, there would be no one size-fits-all solution.
Correct, which is why when push comes to shove, the nuclear option will be used.