Feature Article: The Critical Challenges Posed by Leverage and Legitimacy

It is safe to say that the world economy has entered a period characterized by complex and dangerous dynamics that few people even begin to understand. And even fewer people have tried to think more than a few steps ahead, about where these dynamics may take us, much less what those future scenarios imply for asset allocation and risk management decisions today. Finally, it goes without saying that any attempt at such thinking is bound to be imperfect, given the complex and evolving nature of the underlying system that is generating the rapid and often confusing changes we see all around us today. Nevertheless, professionals who have been entrusted with the management of other people's money, and especially those who have a fiduciary duty to their clients, have an obligation to think about these issues. The goal of this essay is to help our readers meet this challenge.

To preview what lies ahead, we will state our key conclusions up front. The world faces two critical challenges in the years ahead. The first is obvious: How to deal with the problems caused by excessive leverage in multiple sectors of the global economy? The second is less obvious, but possibly even more important: Will the legitimacy of current political systems be maintained as the leverage problem is resolved? Broadly, the way in which these challenges are met could give rise to four scenarios; however, we will concentrate on only two: (1) the global debt problem is largely resolved through higher economic growth, and current political systems generally maintain their legitimacy; and (2) the global debt problem is largely resolved through austerity and various types of default, and many current political systems lose their popular legitimacy. However, before we discuss these scenarios in more detail, we first need to look at the underlying issues in greater depth.

Options for Resolving the Global Debt Problem

We are squarely in the camp that believes that the seriousness of the debt problem facing the world economy has not been fully absorbed by most investors. And the problem goes well beyond the building bubble in China, which we analyzed at length in last month's issue. Let us take a fast sector by sector tour, starting with the U.S. household sector. The proximate cause of the 2007/2008 crisis -- excessive construction of, and investment in residential property based on excessive mortgage borrowing and lending, leading to a price bubble that eventually collapsed -- has not been resolved. According to First American Core Logic, 28% of mortgaged U.S. residences still have negative or near negative equity at the end of the first quarter of 2010. As a number of analyses have noted, negative equity makes buyers increasingly unwilling to keep paying their mortgages, and increases the probability that they will "strategically default" on them. At the same time, U.S. unemployment remains stubbornly high (the broadest measure, so-called "U6 unemployment" has been stuck at more than 17% for over a year), which reduces borrowers' ability to make mortgage payments, even if they are willing to do so. Beyond mortgages, and despite net repayments, total household sector debt (which also includes credit card, auto, student and other loans) remains at or near record levels not just in the USA, but also in many other developed countries.

Moving on to the non-financial corporate sector, the two most glaring problems are loans for commercial real estate (CRE) and highly leveraged transactions (e.g., leveraged buyouts and recapitalizations by private equity funds). Just in the United States, the Congressional Oversight Panel (for TARP financing) has estimated that $1.4 trillion in CRE loans will come due between 2010 and 2014. The COP estimated that nearly half of these loans are underwater. Moreover, it did not estimate the future losses that banks will take when they sell the real estate assets they currently hold on their balance sheets as a result of previous foreclosures. With respect to highly leveraged transactions, Bain and Company recently estimated that $460 billion of debt for these transactions will mature between 2012 and 2014. In relation to these exposures, the aggregate capital of many banks is undoubtedly insufficient to absorb the potential losses they face.

To put it differently, marking all their assets to market value would likely reveal many banks (and probably a few insurance companies) to be technically insolvent. As a result, a number of steps have been taken to prevent this from happening, and in so doing to give the banks time to rebuild their capital, hopefully to a level that can absorb future losses without requiring further government support and/or nationalization. The first of these steps was a change in accounting rules that has allowed many dodgy assets to be carried on banks' balance sheets at higher values than those found in the secondary market for the same or similar assets. This "extend and pretend" approach was quite successful in the case of the 1982 LDC loan crisis, in which many large banks were also probably technically insolvent (although secondary markets for loans, as well as the degree of securitization, were both far less developed then than they are today).

The second step that has been taken to shore up bank profits and capital has been the efforts by central banks to hold down interest rates, and therefore bank funding costs relative to the rates being earned on their assets. The third step has been the change in policy that has enabled the banks to sell assets of questionable value to central banks at higher than market values in order to obtain funding liquidity. However, while these steps forestalled the first wave of the crisis, there is no guarantee that they will be sufficient if a second wave strikes.

One of the reasons for this is the rising doubts over the value of the government debt that many banks hold on their books. While Greece is now the best known example of this issue, others are not far behind, including the accelerating doubts about the creditworthiness of other national governments (e.g., Portugal, Spain, Japan, and even the United States) and sub-national national governments -- for example, municipal bond issuers in the United States (e.g., see "State Debt Woes Grow Too Big to Camouflage", by Mary Williams Walsh in the March 29, 2010 New York Times; "Beware the Muni-Bond Bubble" by Nicole Gelinas; "Public Pension Deficits are Worse Than You Think" by Andrew Biggs in the March 22, 2010 Wall Street Journal; "States are the Canary in the Fiscal Coal Mine" by Josh Barro; "Next Big Crisis is Unfoding in Muni-Bond Markets" by Joe Mysak, published by Bloomberg.com on April 9, 2010; and many excellent articles on this issue by Steve Malanga, including "The Beholden State"). Many governments came into the crisis of 2007/2008 in questionable financial shape, due to high levels of outstanding contractual debt relative to national or state output (i.e., the debt/GDP ratio) as well as high levels of unfunded liabilities for future pension and healthcare commitments (e.g., Social Security, national health care, and public sector employee pensions -- regarding the latter, see "Public Pension Promises: How Big Are They and What Are They Worth?" by Novy-Marx and Rauh). The arrival of the 2007/2008 crisis, and the subsequent downturn in the economy, then made this fiscal situation worse in three ways. First, it reduced government tax revenues. Second, it increased government transfer payments (e.g., unemployment benefits). Third, it increased the outflow of government resources that were used to shore up the financial system and, in some cases (e.g., GM) non-financial corporations. The net impact of these changes was an explosion in government debt/GDP ratios around the world.

The net result of all the changes we have seen across multiple sectors was well summed up in a recent commentary by John Hussman ("Greek Debt and Backwards Induction", www.hussmanfunds.com). "Looking at the current state of the world economy, the underlying reality remains little changed: there is more debt outstanding than is capable of being properly serviced. It's certainly possible to issue government debt in order to bail out one borrower or another (and prevent their bondholders from taking a loss). However, this means that for every dollar of bad debt that should have been wiped off the books, the world economy is left with two -- the initial dollar of debt that has been bailed out and must continue to be serviced, and an additional dollar of government debt that was issued to execute the bailout. Notice also that the capital that is used to provide the bailout goes from the hands of savers into the hands of bondholders who made bad investments. We are not only allocating global savings to governments. We are further allocating global savings precisely to those who were the worst stewards of the world's capital. From a productivity standpoint, this is a nightmare. New investment capital, properly allocated, is almost invariably more productive than existing investment, and is undoubtedly more productive than past bad investment. By effectively re-capitalizing bad stewards of capital, at the expense of good investments that could otherwise occur, the policy of bailouts does violence to long-term prospects for growth."

Let us now turn to the options that are available for dealing with excessive debt, relative to income. In broad terms, there are three choices: (a) Increase income. This requires no cut in current consumption, while the additional income is used to pay down debt. (b) Reduce consumption in order to pay down debt. (c) Reduce the amount of debt via some type of default -- e.g., bankruptcy, debt/equity conversion, etc. How do these options apply to each of our overleveraged sectors of the economy?

Obviously, like every other sector, households would prefer to repay debt out of increased income. Yet how realistic is it to expect such an increase? On the one hand, real incomes have been growing over the last twenty years for the top quintile of U.S. households (though this was often the result of a second earner entering the workforce). On the other hand, this has not been the case for other households -- and those are the households that hold the majority of U.S. household debt. Unfortunately, this phenomenon has not been limited to the U.S., but rather seems to characterize income dynamics in many OECD countries. Multiple studies have examined the underlying causes of flat real household income growth -- globalization, the impact of technology, growing skills mismatch, weakened unions, etc. -- none of which is easy to quickly reverse. Bottom line: for the household sector as a whole, repaying debt out of rising income does not appear to be an option. That leaves austerity (reducing current consumption to repay debt) and/or default, in one form or another. Both trends are clearly underway, as evidenced by historically weak personal consumption expenditure data, rising personal bankruptcies and, particularly in the U.S., a growing number of "strategic mortgage defaults." Thus far, political elites around the world have not taken steps to shift the balance of debt adjustment from austerity to making default easier for household borrowers. To cite one example of this, the attempts thus far by the U.S. government to facilitate mortgage restructurings have generally been judged failures -- because they have not significantly reduced the net present value of the amount owed, or shifted its mix from all debt to a combination of debt and equity -- as evidenced by the relatively small number of homeowners who have pursued these options, as opposed to defaulting.

Turning to the non-financial corporate sector, we find that once again rising income is the preferred but unlikely to be realized solution to the debt problem. In this case, rising income means rising revenue for borrowers, whether they be real estate developments (e.g., rising rents) or heavily leveraged companies. In both cases, rising income would logically result from an economy whose growth is based on something other than continued government support financed by increasing levels of sovereign debt and a rising debt/GDP ratio. To be sure, such a positive scenario could conceivably come to pass -- provided that China and other Asian countries quickly reorient their economies from export to domestic consumption led growth while also allowing a rising level of imports from OECD countries. However, as we described at length in last month's issue, the odds against this scenario seem very high. Once again, this leaves borrowers with a choice between austerity -- i.e., cutting costs to free cash flow for debt payments -- and default. The available evidence shows that non-financial businesses have been aggressively cutting costs and paying down debt -- though this results in higher unemployment, with knock-on negative effects for the household sector (and, later on, reduced revenues for non-financial businesses).

However, the evidence also shows a rising tide of bankruptcies and defaults -- with perhaps the most visible example being the decision on the part of a number of large investment banks to walk away from some very large commercial real estate loans owed by their subsidiaries. Again, this has knock on effects, as default and foreclosure saddles lenders' balance sheets with commercial property assets that are most likely worth much less than their carrying value. In turn, this reduces banks' willingness to extend risky loans to other borrowers -- indeed, the evidence suggests that it is small businesses, which historically have created the most new jobs -- that are bearing the brunt of this growing credit crunch. What we have yet to see in this crisis is the same degree of bankruptcies and debt/equity exchanges that we have seen in other serious debt crises, such as Latin American in the 1980s. Instead, we appear to be going down the same road that Japan did in the 1990s, dragging out the resolution of our current debt crisis, and in the process causing a high level of growth depressing uncertainty to persist.

Unlike other sectors, financial businesses have squarely focused on rising income -- due to widening spreads between funding costs and portfolio returns -- as the means to work their way out of their own excessive leverage (and asset quality) problem. In so far as austerity has been used, it has largely taken the form of cost reductions due to industry consolidation (e.g., layoffs following the acquisition of Bear Stearns and Lehman Brothers' failed businesses), rather than sharp reductions in employee compensation costs. And rather than lenders to financial institutions bearing a share of leverage reduction costs (e.g., via debt/equity conversions), what we have seen instead is taxpayers bearing most of the burden (via government absorption of bank failure costs and provision of funding at below market costs).

This brings us to the options facing governments, as they attempt to mange the debt problems brought about by both the crisis and the actions they have taken to respond to it. In the case of sovereign debt, the underlying math is straightforward (as described 22 years ago by Tim Congdon, in his book, Debt Trap, or, more recently, by Willem Buiter in his outstanding Citicorp Global Economics research report, "Sovereign Debt Problems in Advanced Industrial Countries"). In order for the debt/GDP ratio to remain stable, the public sector balance (i.e., the budget balance before interest payments) as a percent of GDP must exactly offset the difference between the real rate of interest on government debt and the rate of GDP growth. For example, if the real interest rate is 2.5% and real GDP growth is 3.0%, the public sector deficit can be no greater than .5% of GDP, else the debt/GDP ratio must increase. Now consider a more realistic example today: if the real interest rate on government debt is 4.0% (because of some risk of default), and forecast real GDP growth is only 1.0%, the public sector must run a surplus of 3.0% if the debt/GDP ratio is to remain constant, and an even larger surplus if the debt/GDP ratio is to decrease (note that we have slightly simplified these calculations; to be technically correct, the difference between the real interest rate and real GDP growth should be divided by 1+real GDP growth -- however, that isn't necessary to develop a basic understanding of the underlying math).

Last but not least, it important to understand another bit of math that is also critical to the resolution of the debt problem facing many governments today. As we have repeatedly noted over the years, a nation's current account deficit (as a percentage of GDP) by definition must equal the sum of its private sector deficit (total output less the sum of private consumption and private investment) and its public sector deficit. To carry on the example used above, if, in order to maintain the government debt/GDP ratio a nation must switch from running a public sector deficit to a public sector surplus, either the private sector balance and/or the current account balance must also change. For example, assume a nation is running a public sector deficit equal to 7% of GDP, with a private sector surplus of 4% of GDP, and a current account deficit of 3% of GDP (4% + negative 7% = negative 3%). If the public sector balance must shift to a surplus of 5% of GDP, that swing of positive 12% must also be reflected in the private sector and/or the current account balance. For example, this could be accomplished by the private sector going from a positive 4% to a negative 5% (e.g., because of an increase in private consumption and/or investment) and the current account going from a negative 3% to 0% (e.g., due to a sharp increase in exports, or a sharp fall in imports). In reality, however, changes of this magnitude are extremely difficult to make -- yet that is the challenge facing many governments today. Now that we understand the math, let's move on to the policy options governments confront.

As in every other case, governments would prefer to grow their way out of their debt problem. So let's take a closer look at the underlying drivers of GDP growth. At the highest level, GDP growth reflects three inputs: labor, capital, and productivity (i.e., the efficiency with which labor and capital inputs are used). Hence, a change in GDP must reflect some combination of a change in the labor force, a change in the amount of capital employed, and/or a change in productivity. Changes in the labor force usually reflect a combination of demographic and social factors, including birth and death rates, immigration and emigration rates, and the percentage of potential workers who choose to seek work. Changes in the amount of capital employed is a function of the after tax return that can be earned on it use, as well as its cost, which in turn depends on the savings rate, competing capital demands by other sectors (e.g., government) and the level of perceived uncertainty and risk. Finally, changes in productivity (also known as total factor or multi- factor productivity) also reflect a range of factors, including the rate and quality of research and development spending, the quality of the educational system (for example, see "The High Cost of Low Educational Performance" a recent report from the OECD), the quality of infrastructure (see "International Productivity Differences, Infrastructure, and Comparative Advantage" by Yeaple and Golub), the quality of different national institutional contexts (see "The New Kaldor Facts: Ideas, Institutions, Population and Human Capital" by Jones and Romer), and the variation of management practices across firms, sectors and countries (see "Why Do Management Practices Differ Across Firms and Countries?" by Bloom and Van Reenen, "Micro Efficiency and Macro Growth" by Nallari and Bayraktar from the World Bank, and "Cross Country Comparisons of Industry Total Factor Productivity" by James Harrigan of the Federal Reserve Bank of New York).

A common way to sum up these growth drivers is by showing a country's rate of labor force growth and its rate of labor productivity growth, which captures increases in both the amount of capital per worker and in total factor productivity (though in the long run, the marginal return to more capital per worker declines to zero, and labor productivity growth solely reflects TFP growth). The following table (based on data from the OECD) shows how these vary across a number of developed countries that are faced with rising debt/GDP ratios. Where possible, we have also broken out the change in total factor productivity.

*Country*	Annual Labor Force Growth 2000-2008	Annual Labor Productivity Growth, 2000-2008	Apparent Potential Annual GDP Growth	Note: Annual TFP Growth 1999-2007
*Australia*	2.01%	1.03%	3.04%	0.59%
*Canada*	1.78%	1.01%	2.79%	0.66%
*United Kingdom*	1.00%	2.01%	3.01%	1.40%
*United States*	1.00%	2.07%	3.07%	1.50%

*France*	0.67%	1.54%	2.21%	1.04%
*Germany*	0.69%	1.40%	2.09%	1.02%
*Italy*	0.71%	0.34%	1.05%	-0.08%
*Spain*	2.97%	0.79%	3.76%	0.02%
*Eurozone*	1.25%	1.16%	2.41%

*Sweden*	1.30%	1.93%	3.23%	1.94%
*Switzerland*	1.32%	1.26%	2.58%	0.70%

*Japan*	-0.22%	1.94%	1.72%	1.54%

This table highlights a number of important points about the potential for nations to grow out of their debt problems. First, developed countries have taken different routes to growth over the past decade. For example, the UK and US has slower labor force growth rates than Australia and Canada, but higher rates of labor productivity growth, which was largely driven by improvements in total factor productivity (TFP) rather than higher amounts of capital per worker. Sweden and Switzerland had comparable rates of labor force growth, but the former was able to achieve a much higher growth rate because of superior TFP performance. Japan actually saw a fall in its labor force, which it offset with impressive TFP growth as well as higher capital per worker. Finally, among the four largest nations in the Eurozone, there was a significant difference in productivity growth between France and Germany on the one hand, and Italy and Spain on the other.

So what does this tell us about the chances a country will be able to grow its way out of its debt/GDP problem? It appears there are two main strategies that could be used: increasing labor force growth (e.g., via skill-based immigration, as Australia and Canada have done), and/or increasing total factor productivity growth (via such policies as infrastructure investment -- e.g., the internet or smart-grid, improvements to the educational system, and/or improvements to business management practices). Going back to our public sector math discussion, higher GDP growth would likely bring two additional benefits. The first would be a reduced probability of sovereign default, and hence a lower real interest rate on the nation's debt. The second would be higher government revenues and a reduce need for government deficit spending to support aggregate demand and economic growth. Unfortunately, there are two critical obstacles to implementing this "grow our way out of the debt problem" strategy. The first is a timing problem: both increases in skilled immigration levels and implementation of reforms to increase TFP both take time and are likely to face opposition from interest groups that believe they will be adversely affected by such changes (e.g., in the U.S., look at the way teachers unions are resisting the Obama Administration's proposed education reforms). The second obstacle is a free rider problem -- countries have an incentive to let other nations undertake these painful reforms, hoping that they can avoid them and simply increase their exports to grow their way out of their debt problems (in fact, the United States, many Eurozone countries, and China all seem to taking this path, which is obviously an unsustainable situaiton). Given this, it seems likely that a nation attempting to grow its way out of a debt problem would also have to increase its level of protectionism to ensure that the job creation and economic demand benefits that result from its painful reforms actually accrue to its own residents.

Is there an alternative to this depressing scenario? Perhaps, at least for some countries. As we saw in our discussion of the mathematics of the problem, a country that needs to achieve a substantial swing in its public sector balance from deficit to surplus must simultaneously achieve some combination of (a) an increase in private sector consumption spending; (b) an increase in private sector investment spending; (c) an increase in exports; and/or (d) a decrease in imports. Given the already high levels of household debt in many OECD countries, increasing consumption spending would seem to be out of the question, at least as a primary target of policy (though it might later increase, as a second order effect in an improving economy). Similarly, significantly increasing exports would also seem to present an insurmountable challenge in a world with flat or negative economic growth and shrinking credit availability. That leaves increasing private sector investment and decreasing imports in a relatively quick time frame, in a manner that results in an increase in domestic employment without recourse to protectionism and a global trade war. In our view, the only strategy that meets these requirements would be a change in regulations in the United States that forced a substantial increase in private sector investment and employment in the environmental and energy sector. For example, a sharp increase in both domestically produced biofuels (e.g., cellulosic ethanol, and other fuels derived from algae and bacteria) and incentives to help electric vehicles gain market share would reduce oil imports. At the same time, an explicit price on carbon emissions would encourage higher investment in natural gas production, carbon capture and storage, and other technologies. Whether this would result in sufficient changes in the private and current account balances to achieve the required change in the public sector balance remains to be seen. However, as we look over the current options, this appears to be the best hope for the U.S. growing its way out of its burgeoning government debt/GDP problem. Hence, from our perspective, a key indicator to watch is the progress of the so-called Kerry-Lieberman-Graham environment and energy bill that has been introduced in the U.S. Senate. If it gains traction and is eventually passed, that will be a hopeful sign. If this fails to happen, the odds of going the default route would significantly increase, in our view.

What about the second option -- austerity? In the case of government, this involves shrinking the debt/GDP ratio by running a fiscal balance that more than offsets the difference between the real rate of interest on the nation's debt and its rate of GDP growth. At the aggregate level, in the absence any offsetting measures to stimulate either exports and/or private sector consumption and investment, a sharp swing from government deficits to surpluses would lead to a sharp contraction in aggregate demand (i.e., negative GDP growth). In terms of our economic balance equation, this would cause a sharp fall in imports, which would result in a large improvement in the current account balance. However, in a slowing economy, there would be even lower levels of private sector consumption and investment, so the private sector balance would also likely increase. Of course, this also assumes no trade war or knock on effects abroad, that would cause a fall in exports. Were that to occur, the amount of painful domestic adjustment would be even higher.

Let's look at the austerity option from another perspective. Today, with real interest rates in many cases higher than real GDP growth rates, austerity means making very large shifts from government deficits to government surpluses, at a time when government spending has been critical to maintaining aggregate demand. In short, in the absence of renewed private sector growth (e.g., due to changes in labor force and TFP policies), reducing debt/GDP ratios via government austerity is likely a recipe for global depression (particularly given the rising probability -- as we examined last month -- of a collapse in Chinese growth rates). This is not to say that some steps towards government austerity cannot and should not be part of the medium term solution to national debt problems. There are obvious opportunities for improving government finances in the medium, if not the short term (e.g., raising retirement ages, changing Social Security cost of living increase formulas, implementing consumption taxes, taking a different approach to medical cost containment, etc.). However, it seems clear that a sharp change from government deficits to government surpluses is not in the cards in the short term.

This brings us to the third option: reducing government debt/GDP via some type of default. As shown by Reinhart and Rogoff in their excellent book (This Time Is Different: Eight Centuries of Financial Folly), sovereign debt defaults have existed for almost as long as people have made loans to governments. Outright sovereign debt repudiation is quite rare; rather, default more commonly takes one of two forms -- either exchange offers that reduce the real net present value of the debt, or increased rates of inflation that have the same effect. Since the Latin American debt crisis in the 1980s, sovereign defaults have been more common than most investors realize, and an entire industry cluster has developed to manage them (indeed, one of us started out in this business way back when, and some of our colleagues are still at it almost 30 years later). In fact, that industry has been hard at work preparing for an eventual Greek exchange offer, which they regard as inevitable at some point in the future, due to the mathematical challenges facing that country (including a very high debt/GDP ration, real interest rates made extra burdensome by a high default risk premium, a deeply distorted economy that virtually guarantees low GDP growth over the next few years, and the political impossibility of implementing a radical change in the government's fiscal situation and/or structural economic reforms that are needed to raise the potential growth rate). So default via an exchange offer is a viable course of action for many countries, particularly since repeated studies have shown that the long-term consequences of default have usually not been severe for the governments in question (see, for example, "The Costs of Sovereign Default: Theory and Reality" by Borensztein and Panizz). However, questions have been raised about how applicable the experience of past sovereign defaulters may be under the different conditions we face today. For example, past sovereign defaults were in countries that were relatively small compared to the size of the world economy, which was enjoying strong growth when the defaults and recoveries from them occurred.

As for the default-via-inflation option, as Buiter shows in his Citi report, in most cases it is less attractive than it first seems. The reason for this is that defaulting via an unexpected (by creditors) increase in inflation works best under a limited set of circumstances, including (a) a large amount of fixed rate debt; (b) that has a relatively long maturity/duration; (c) which is held by foreign investors. Currently, the nation best positioned to undertake a default via inflation is the United States -- yet going that route would seem sure to raise tensions with foreign parties holding U.S. government debt, particularly China.

Finally, a recent paper by the Bank for International Settlements makes a critical point about default on sovereign debt. In "The Future of Public Debt: Prospects and Implications", Cecchetti, Mohanty and Zampolli begin by noting that "since the start of the financial crisis, industrial country public debt levels have increased dramatically, and are set to continue rising for the foreseeable future. A number of countries also face the prospect of large and rising future costs related to the ageing of their populations." The authors' broad conclusion is that "the [current] path being pursued by fiscal authorities in a number of industrial countries is unsustainable. Drastic measures are necessary to check the rapid growth of current and future liabilities of governments and reduce their adverse consequences for long-term growth and monetary stability." Specifically, the authors of the BIS report focus on two scenarios. The first is a so-called "sudden stop", in which investors, faced with high fiscal deficits and a rapidly rising debt/GDP ratio, stop buying a country's new debt issues. As the authors note, this would almost certainly force the nation's central bank to purchase (i.e., monetize) the debt, leaving it "impotent to control changes in inflation expectations." A sudden stop would likely trigger a sharp fall in the nation's currency, which in turn could lead other nations to impose trade and or capital controls (to limit the adverse impact on their own trade balance and employment). The second scenario is one in which a nation's central bank gives in to pressures to undertake a partial default via inflation. The risk here is that "inflation expectations would become unanchored" by such a move, which would logically lead to a sharp increase in the yield demanded by investors in the inflating nation's debt, which would at minimum trigger a slowdown in GDP growth (and a worsening of the government's fiscal balance), and quite possibly a "sudden stop."

So where does this leave us? Clearly, the first preference of every sector we have examined -- households, non-financial corporates, financial institutions, and governments -- would be to resolve their current debt problems by increasing their income -- i.e., "growing their way out of it." Indeed, a recent paper ("Great Depressions of the Twentieth Century", by Kehoe and Prescott) reinforces this point, concluding that "government policies that affect productivity and hours worked per working age person were the crucial determinants the great depressions of the twentieth century." However, we have also seen that increasing income is much easier said than done, particularly in the short-term. In the best case, a short period of austerity and reduced consumption would be able to keep the debt problem in check long enough for growth oriented reforms to be implemented and take over the debt reduction burden.

However, the combination of a high degree of political factionalism in many countries, as well as the temptation to be a free rider on growth reforms undertaken in other nations leaves us pessimistic about the likelihood that this scenario will materialize. It therefore seems inescapable to us that a substantially higher level of defaults of various types, across all sectors, lies ahead in many nations. As we have long expressed in our Economic Updates, rising defaults are likely to be accompanied by greater deflationary pressures in the short term, but greater inflationary pressures thereafter, particularly if we experience a sudden stop in one or more major countries. We also continue to believe that it would be impossible for a rise in defaults to take place without rising protectionism, and possibly capital controls that would collectively lead to a world that, as we have repeatedly described in our Conflict Scenario, is much more organized on the basis of different blocs (e.g., the Anglosphere, Europe, Sinosphere, etc.) as well as some "wild card" countries, including Russia and Iran.

The Slowly Building Legitimacy Crisis

Let us now turn away from the debt problem, and towards the second crisis facing the world today: the accelerating erosion of political legitimacy. A number of writers have remarked on this, but we don't believe the majority of investors (or even a significant minority) have yet absorbed the full implications of their observations. For example, in his article "Greece is the Welfare State's Death Spiral", Robert Samuelson notes that "virtually every advanced nation, including the United States, faces the same prospect. Ageing populations have been promised huge health and retirement benefits, which countries haven't fully covered with taxes. The reckoning has arrived in Greece, but it awaits most wealthy societies...Countries cannot overspend and overborrow forever. By delaying hard decisions about spending and taxes, governments maneuver themselves into a cul-de-sac...The welfare state's death spiral is this: Almost anything governments might do with their budgets threatens to make matters worse by slowing the economy....Cutting welfare benefits or raising taxes would, at least temporarily, weaken the economy, and perversely, make paying the remaining benefits even harder...[But] by allowing deficits to balloon, they risk a financial crisis as investors one day -- no one knows when -- doubt governments' ability to serve their debts and refuse to lend...If only a few countries faced these problems, the solution would be easy. Unlucky countries would trim budgets and resume growth by exporting to healthier nations. But developed countries represent about half of the world economy, and most have overcommitted welfare states...What happens if all these countries are thrust into Greece's situation?"

Gideon Rachman's recent column in the Financial Times offers a blunt answer: "Europe is Unprepared for Austerity." He begins by noting, "I used to think Europe had got it right. Let the U.S. be a military superpower; let China be an economic superpower -- Europe would be the lifestyle superpower...Life for most ordinary Europeans has never been more comfortable...It was a great strategy. But there was one big flaw in it. Europe cannot afford its comfortable retirement...Europe's existence as a lifestyle superpower has depended on an ample supply of credit...While Europeans no longer fear foreign armies, they are starting to fear foreign bondholders." To be sure, Rachman offers a glimmer of hope: "the citizens of Latvia and Ireland have already swallowed actual cuts in wages and pensions. But these are both countries that have experienced real poverty in living memory, followed by massive and unsustainable booms. They know that the past few years have been a bit unreal...[But] as the riots on the streets of Athens illustrate, not all Europeans will react so stoically to deep cuts in spending. Many have come to regard early retirement, free public healthcare, and generous unemployment benefits as fundamental rights. They stopped asking, a long time ago, how these things were paid for. It is this sense of entitlement that makes reform so very difficult. As the British election has just amply illustrated, politicians are extremely reluctant to confront voters with the harsh choices that need to be made. Yet if Europeans do not accept austerity now, they will eventually be faced with something far more shocking."

And it is just not the Europeans who are struggling with the need to simultaneously rein in government spending and raise revenues. Most American states are required by law to balance their budgets each year. Yet achieving political consensus on the means to achieve this goal has proven to be extremely difficult, as evidenced by the fiscal crises now facing California, Illinois, New York, New Jersey, Rhode Island and many other states. As Anatole Kaletsky noted in a recent column in the Times of London, in virtually all democracies, the major parties lack a narrative that can both explain how we got into the mess we're in today, and mobilize a majority of voters to make sacrifices in support of a plan to get us out of it. As Kaletsky notes, if ever there was a need for a "third way" it is now; but as yet, it is lacking, which creates an opening for political leaders who hold more extreme and populist views -- a situation which, throughout history, has often led to trouble.

In another FT column ("Irish Treat Pain of Crisis Like a Hangover"), Gillian Tett notes that "there are two other, less tangible factors that appear to have played a role in the Irish story...One of these is the issue of political infrastructure or, more specifically, whether a country has the decision-making machinery in place to cut debt. The second...is social cohesion, and whether a government is able to impose tough choices on a society without sparking political instability, social turmoil, or worse." Along similar lines, other analysts have noted that two other late 20th century national turnarounds (Canada and Sweden) both benefited from high levels of social cohesion and trust in national political institutions.

In essence, the underlying issue is as much whether nations have the willingness to solve their debt problems through means other than default, as whether they have the capacity to do so. Unfortunately, there is growing evidence that in many countries (and in the case of the Eurozone, regions), the social cohesion and trust that seems critical to this willingness is either at low levels or in rapid decline. For example, in countries around the world we repeatedly see public sector employees refusing to accept any reduction in their pay and benefits, and often turning to the courts to back their demands with judicial decisions. Unsurprisingly, this behavior is provoking a growing backlash (see, for example, "The Crippling Price of Public Employee Unions" by Mort Zuckerman, and "Do You Have to Love Labor Unions to be a Good Democrat?", by Mickey Kaus). However, the fact that in many cases these same public sector unions have a very strong impact on elections (in effect, voting into office the people with whom they negotiate), is increasingly leading more and more citizens to question the underlying legitimacy of the current political system.

Similarly, in the U.S. pollster Scott Rasmussen (www.rasmussenreports.com) has repeatedly documented the very wide difference in views between the political and business elite (what he calls the "Political Class") and the rest of the nation. We don't doubt that similar polls in Europe would produce similar results. As Rasmussen notes, "Most Americans trust the judgment of the public more than political leaders, view the federal government as a special interest group, and believe that big business and big government work together against the interests of investors and consumers. Only seven percent (7%) share the opposite view and can be considered part of the Political Class. On many issues, the gap between the Political Class and Mainstream Americans is bigger than the gap between Mainstream Republicans and Democrats." In this regard, we note again a point we made last month in our analysis of conditions in China: researchers have found that a key indicator of future political instability is the extent of factionalism in a society (see "A Global Model for Forecasting Political Instability" by Goldstone, Bates, et al). We also note that the Economist Intelligence Unit has adopted this model, and added to it worsening economic conditions as an important trigger event -- and their "Political Instability Index" shows a rising likelihood that such instability will occur in multiple countries. In this regard, we cannot help but see rising factionalism in Europe and the United States as very worrying signs. Other writers have concluded that the evidence shows that protracted downturns in economic growth and extended periods of unemployment undermine people's support for democracy, while increasing the attractiveness of leaders with more extreme views (e.g., see two recent papers on these issue: "Economic Growth and the Rise of Political Extremism" by Bruckner and Gruner; and "Joblessness and Perceptions About the Effectiveness of Democracy" by Altindag and Mocan).

In the United States, if not to the same extent in other developed countries, the negative impact of the mainstream/elite gap has been further reinforced by the wave of conspicuous consumption that has swept American in the past twenty years, led by the top quintile of households who benefited from globalization, and causing many others to take on loads of debt in an ultimately unsuccessful effort to keep up external appearances and internal self-images. We believe that some very basic neurobiological forces are at work in our society today. To begin with, fear is increased by the experience of loss and by a rise in uncertainty. However, it is also increased by envy -- when others are perceived as more successful and attractive, one experiences a feeling of social loss. In turn, heightened primary feelings of fear have been shown to trigger a secondary reaction: a heightened fear of social isolation, and a stronger desire to stay with a group. It seems obvious that all of these reactions, which research findings suggest are hardwired into the amygdala region of our brains, were highly adaptive when small groups of humans first roamed the east African plain ages ago. They may prove much less adaptive today, especially given the frequently observed tendency for people and groups to react to fear with anger and aggression when they cannot flee from its source. Unfortunately, there is no doubt that there are a lot of fearful people out there today. Far too many households have seen the core elements of a middle class existence slipping from their grasp, including a sense of employment security, retirement income security, healthcare security, housing security, and confidence that their children would be able to attend college or university. Moreover, in Europe there is the additional pressure created by cultural challenges posed sizeable and rapidly growing domestic Muslim populations. In comparison, the United States' difficulties in absorbing large numbers of Hispanic immigrants (or similar challenges in Australia and Canada) pales by comparison.

Recent events have no doubt caused an increasing number of already fearful and angry members of the OECD middle class to question the legitimacy of the system that has produced the situation they face, and which seems unwilling (e.g., via passage of a mortgage restructuring program in the U.S. that actually provided some cash flow relief) or unable (e.g., stemming the offshoring of jobs) to help them.

As George Friedman recently wrote ("The Global Crisis of Legitimacy", www.stratfor.com), "the state both invents the principle of the corporation and defines the conditions in which the corporation is able to arise. The state defines the structure of risks and liabilities and ensures that the laws are enforced. Emerging out of this complexity, and justifying it, is a moral regime. [Investors'] protection from liability [via the creation of the corporation] comes with a burden. Poor decisions will be penalized by losses, while wise decisions are rewarded by greater wealth. Because of this, society as a whole will benefit...The greatest systemic risk, therefore, is not an economic concept, but a political one. Systemic risk emerges when it appears that the political and legal protections given to economic actors, and particularly to members of the economic elite, have been used to subvert the intent of the system. In other words, the crisis occurs when it appears that the economic elite used the law's allocation of risk to enrich themselves in ways that undermined the wealth of the nation...with the political elite apparently taking no action to protect the victims." Friedman concludes with the observation that, "in extreme form, these crises can delegitimize regimes. In the most extreme form...the military elite typically steps in to take control of the system." We do not believe we are near this point today in most developed countries (see, for example, "American Coup D'Etat: Military Thinkers Discuss the Unthinkable", Harpers, April, 2006); however, we also note that we have seen coups happen plenty of times during three decades of work in emerging markets, and that Rasmussen and other polls regularly find that, in the United States, the military is held in much higher regard than virtually all other institutions today.

In sum, in May 2010, we see a building crisis of political legitimacy in many developed countries, perhaps most dangerously in the Eurozone and the United States, regions that are increasingly fractious, and where there is no clear consensus on the need for change, nor a clear desire to achieve a shared vision of a better future, nor an understanding of what sequence of changes must occur to get there, nor any sense of how these changes could be achieved. Meanwhile, as debt crisis pressures increase, and the majority of households and businesses see their situations becoming more desperate, and as political elites only seem to protect the interests of the favored few, the overall legitimacy of the political system in the eyes of the many continues to corrode. We do not know what form the future will take if a tipping point is reached; however, in a recent essay ("Complexity and Collapse"), Niall Ferguson reminds us that fundamental change can happen far faster than most people realize, once the underlying level of tension within a system has reached a critical threshold. We have long believed that the new system that would emerge after a crisis of legitimacy would be one organized around blocs, with far lower levels of global trade, labor, and capital flows. We also rather strongly suspect it would be a world in which conspicuous consumption is far less prevalent, the financial system far more regulated, government spending and economic growth lower and inflation and taxes higher than is the case today.

Implications for Asset Allocation

At the outset, we proposed two scenarios that describe the way our Conflict Scenario could further evolve in the years ahead. In one, current debt problems are resolved through an uncertain and unstable mix of austerity, renewed growth, and a limited number of defaults in the household, corporate and financial sectors, but generally (apart from some sub-national governments) no major defaults at the national government level. Under this scenario, the current political elite and political system largely retain their legitimacy, though some rough patches are inevitable. In our alternative scenario, both austerity and the changes required to increase GDP growth are blocked by political opposition, forcing a growing series of defaults across all sectors, including national governments. This scenario could also be triggered by a collapse in China, which we discussed last month. It includes a sharp period of debt deflation, followed by sudden stops, monetization of debt, and a sharp increase in inflation. Politically, elites lose their legitimacy, significant political changes occur, global flows of trade, people and money sharply contract, and the world system reforms into a series of blocs, including the Anglosphere, Europe, and Sinosphere. The following table describes the implications of these scenarios for various asset classes:

*Asset Class*	Scenario 1: Muddle Through Scenario	Scenario 2: Default Into Competing Blocs
*Real Return Bonds*	Under either scenario, demand for real return bonds will increase, generating falling yields and positive returns (that said, there isn't much more room to fall from currently low levels).	Real return bonds may also become subject to concerns about government defaults. Hence, discrimination in country quality will be critical under this scenario, in addition to the ability to repatriate funds invested outside a given bloc. We continue to favor Australian and Canadian RRBs, as well as those issued by Sweden and Germany.
*Nominal Government Bonds*	Default premiums on government bonds will spread, making good credit analysis important -- e.g., monitoring government debt/GDP ratios, policy responses, and the evolution of the inescapable math of government debt and the economic balance equation. Even the countries we consider most attractive still face challenges (e.g., Australia's GDP is heavily dependent on Chinese growth; Canada's reliance on oil sands and U.S. growth, and significant household debt problems; Sweden and Switzerland's dependence on the Eurozone's health, etc.).	Timing will be critical, as nominal government bonds, in the absence of default, will do well during the initial deflation, but will then suffer as inflation and/or defaults increase. Similarly, repatriation of capital will become an issue in a world of blocs. On balance, in this scenario we prefer Anglosphere government bonds, as the flexibility of these economies promises a quicker recovery and fewer defaults. Similarly, in the Eurozone we prefer Sweden, Switzerland and Germany.
*Nominal Credit Bonds*	Careful credit risk analysis -- not simple dependence on ratings -- is critical. Bond issued by companies in sectors with more stable cash flows -- e.g., staples, utilities, energy -- are likely to perform best. In the U.S., even in the absence of a deeper crisis, we still expect to see higher defaults by municipal issuers, with knock on implications for banks and insurance companies who hold this paper.	Careful credit risk analysis -- not simple dependence on ratings -- is critical. Bonds issued by companies in sectors with more stable cash flows -- e.g., staples, utilities, energy -- are likely to perform best. The potential exists for very sharp and sudden losses as confidence is lost and many investors attempt to exit their fixed income positions. Lower quality issues -- both private and public -- are most at risk.
*Commercial Property*	Returns will suffer as defaults on commercial mortgage backed securities increase (one high visibility REIT bust will shift psychology); however, this will likely also trigger an overreaction on the downside.	In countries where bubbles may still exist (e.g., Australian and Canadian residential property), they will burst. REITs will suffer due to concerns with underlying leverage. Offsetting this may be inflows driven by inflation hedging -- however, there will be competition for these from other asset classes. On the other hand, in regions (e.g., Europe, UK) where property has been a traditional refuge in difficult times, prices of directly owned investment property with solid tenants and modest leverage levels will increase.
*Commodities*	Industrial metals likely to underperform relative to the past because of lower GDP growth. As corn ethanol is displaced by newer fuels, agriculturals' correlation with other commodities should fall, increasing their portfolio benefits. Energy as a sector should do well, but could experience a major shift driven by changes in energy and environmental policy.	Performance of different sectors is likely to widely diverge. Industrial metals will likely suffer. Agricultural commodities may be hurt by trade restrictions; careful analysis will be critical, but so too will be capital controls. In the energy space, oil may underperform, due to declining demand and substitution on the supply side; gas may outperform due to higher use in electric generation. Energy MLPs may become an attractive alternative for traditional fixed income investors.
*Gold*	Continued weak GDP growth and high uncertainty should hold down real bond yields in the US, which will support positive returns on gold. Returns on gold will also depend on the effectiveness of policy choices in the US -- the less effective default and austerity policies, the higher the returns on gold.	Gold will do well; however, coins may outperform gold based ETFs in a world of capital controls and declining faith in financial instruments.
*Timber*	Continuing problems in the housing market will keep putting downward pressure on timber prices and returns. The price of timber investment vehicles will likely vary with changing inflation expectations. However, timber prices could receive a significant upward boost if environmental legislation allows timber operators to recognize the value of the CO2 sequestration benefits provided by forests.	As in the case of physical gold and property, investment in physical timber will be attractive as a store of real value in highly uncertain and likely highly inflationary times.
*Developed Country Equity*	At best, prices in defensive sectors like stapes and utilities could benefit from outflows from fixed income as defaults mount. Depending on legislative changes, the energy sector could also benefit.	Cross border investments will be affected by restrictions on trade and capital movements, and the differing fortunes of emerging blocs. Defensive sectors could benefit from a flow out of fixed income (remember, the size of fixed income markets dwarfs equities, and most issues are nominal, not real returns).
*Emerging Equity*	Emerging markets may well see an even bigger bubble develop than exists today.	Emerging markets will be negatively affected by trade and capital controls. Worsening conditions will also put pressure on local institutions, which could lead to deteriorating treatment of foreign portfolio investors (e.g.. look at the recent history of Venezuela, Russia or China).
*Volatility*	Will continue to provide valuable benefits to investors' portfolios.	Will continue to provide valuable benefits to investors' portfolios.
*Uncorrelated Alpha Strategies*	High level of uncertainty suggests that strategies without consistent long or short exposure should perform relatively better -- e.g., equity market neutral and global macro. Some event driven strategies may do well -- e.g., distressed debt, assuming highly skilled managers.	Global macro and currency strategies will be negatively affected by trade and capital controls. Equity market neutral should, assuming skilled manager, do well within a given bloc. Ditto for event-driven strategies - there will be no shortage of distressed debt, though recoveries are likely to be highly idiosyncratic, and less reflective of historical averages -- hence, there is heightened risk for model driven strategies.