Investing in the Age of Sovereign Defaults

How to Preserve your Wealth in the Coming Crisis

Peter T. Treadway

• Publisher: Wiley
• Year: 2012
• ISBN:
  9781118247228
• Edition: 1
• Topic: Personal Development
• Subtopic: Personal Finance

Acclaimed investment experts Peter Treadway and Michael Wong explain how to protect your investments—and even profit—from the coming sovereign default crises

A major sovereign default crisis is looming for the so-called developed economies of the world. The result will be a major redistribution of economic wealth and an overhaul of the international financial system on an epic scale. Investing in the Age of Sovereign Defaults: How to Preserve your Wealth in the Coming Crisis explains what lies ahead, and offers invaluable suggestions to help investors avoid massive losses.

• Explains why the West is headed for a major default crisis and how investors can protect themselves
• Contends that the value of gold will continue to rise and that sooner or later government debt, including that of the U.S. and Japan, will be shunned
• Written by investment experts Peter Treadway and Michael Wong

The days of the economic status quo are coming to an end. Investing in the Age of Sovereign Defaults shows investors what's coming and what investors must do if they want to escape unscathed.

Chapter 1

Democracies’ Fatal Attraction of Populism

When national debts have been accumulated to a certain degree, there is scarce, I believe, single incidence of their having been fairly and completely paid.

—Adam Smith, The Wealth of Nations, 1776

Democracy is two wolves and a lamb voting on what to have for lunch.

When the people find that they can vote themselves money, that will herald the end of the republic.

—Benjamin Franklin

The United States shall guarantee to every State in this Union a Republican form of government.

—United States Constitution, Article 4, Section 4, Paragraph 1

I think when you spread the wealth around it’s good for everybody.

—Barack Obama

The central theme of this book is that the so-called advanced nations are rapidly moving toward a broadly defined “default” on the many obligations they have accrued over the last hundred years. This defaulting is not some kind of historical accident but results from the underlying fatal attraction of populism in democracies with universal suffrage. This broadly defined default along with supply-side/structural reforms will be necessary for the advanced nations to reestablish themselves on the path of human progress.

Let’s start with a definition of populism. Look it up and you will find a variety of definitions. The majority defines the word as policies benefiting the common people at the expense of the rich or the elite. But as a free market economist, I have my own definition, which is the meaning of the word the way it is used in this book. As used here, populism is a political strategy ostensibly targeting the wealth and income of the affluent elite and based on a calculated appeal to the interests or prejudices of ordinary people regardless of the economic rationality of this strategy. As an investor, you are categorized as belonging to the rich or the elite. So populism basically is a set of programs that are ultimately aimed at reducing your wealth.

Now back to our theme. Government defaults are an old story going back to antiquity. But the susceptibility of modern advanced democracies to default may come as somewhat of a surprise to most of us for whom democracy is truly a sacred concept. The idea, that democracy with universal suffrage may at times be inefficient but in the end the people always “get it right,” is embedded in Western—indeed, global—political DNA. Suggesting that democracy has any serious faults is blasphemy. But the current reality is that, at least when it comes to fiscal probity and managing fiat paper money, the people don’t always get it right.

This chapter will present a theory of why democracies with universal suffrage and well-developed political institutions will tend to eventual bankruptcy and default and why lenders in particular will be at risk. My reasoning will draw, in part, on many thinkers, including those as diverse as James Madison, the Father of the American Constitution, and Hyman Minsky, whose financial instability hypothesis has come from obscurity to receive much attention in recent years.

I want to be clear. This book is not advocating alternatives to democracy. Like Winston Churchill—who famously said (Churchill said many things) that democracy was the worst form of government devised, except for all the others—I am not suggesting a better idea. I will discuss, however, that America’s Founding Fathers were afraid of universal suffrage democracies and preferred a more limited suffrage republic.

Default, an Expanded Definition

In its strict legal sense, default means the failure to perform a legal obligation specified in a contract or by law. Countries have frequently legally defaulted on their debts over the course of the centuries.

But the text of this book uses the word default in the broader sense of a sovereign government failing to meet any formal promise or obligation. In the sense used in this book, a default could be:

1. A legal default under the legal system of the borrowing country or a recognized international legal system such as that of the United States.

2. A restructuring of outstanding loans on a “voluntary” basis.

3. A situation where a loan can only be repaid or serviced with the assistance of bailout money coming from an external entity like the International Monetary Fund (IMF).

4. A reneging on promised entitlements, including those for medical or pensions for retirees. This type of default will actually be good for investors. Unless of course they are also recipients. Call it a benign default.

5. A default by inflation whereby a defaulting country prints money and destroys the value of its currency, which happens to be the currency in which it has incurred the obligation.

6. Financial repression whereby a sovereign nation takes measures that essentially confiscate money from its financial system via excess reserve requirements on its banks, interest rate caps on savers, and prohibitions on investments outside the home country.

All these types of defaults are on the horizon for advanced countries, with the exception that countries that can borrow in their own currency (e.g., the United States will choose the option of printing money and inflation rather than legally defaulting on their government debt).

From investors’ viewpoint, default on promised entitlements is a good thing. This type of default reduces tax burdens. If investors are also relying on one or more government programs that are being defaulted on, then as beneficiaries they will feel some pain.

Debt Default in History—A Recurring Theme

“Countries don’t go bust,” famously remarked by Walter Wriston, a famous CEO of Citibank.1 But they do. And often. According to Carmen Reinhart and Kenneth Rogoff in their now classic work This Time Is Different, Eight Centuries of Financial Folly,2 countries have been going bust as long as there have been countries. Way back in the fourteenth century, England’s Edward III defaulted on his debt, contributing substantially to the demise of the Italian Bardi and Peruzzi banks who were his lenders.

Many countries at one time or another have been repeat offenders (i.e., serial defaulters, in the words of Reinhart and Rogoff). Greece, the current poster child for bankrupt sovereign debt, was in default more or less continuously from 1800 to the end of WWII. As Reinhart and Rogoff have so meticulously recorded, the list of sovereign defaulters is a long one and, going back over the last five hundred years, includes the majority of countries on earth. Reinhart and Rogoff record at least 250 sovereign external default episodes over 1800–2009 and at least 68 cases of default on domestic public debt.3

This book will not recite this list. Anyone seriously interested in this subject should read Reinhart and Rogoff’s book, which is probably the definitive historical record on this subject.

However, contrary to the views of some American politicians, the United States is no exception. It has defaulted on more than one occasion. Three instances deserve special mention. First, the American states. A number of American states defaulted in the 1840s and again after the American Civil War in the 1860s. Second, in 1933 the United States refused to honor its obligation to pay in gold on its bonds held by US citizens. Third, in August 1971 the United States defaulted on its obligation under the Bretton Woods Agreement to redeem in gold dollars presented by central banks. (The Bretton Woods Agreement, along with the entire international monetary system, will be discussed in Chapter 4.)

With such a record, one might ask why anyone or any institution in their right mind would loan money to a government. History repeatedly shows that governments regularly default, then they promise never to do it again, then lenders lend once again, and governments default again. Incurable recidivist behavior on both sides is the norm.

Nobody Likes a Lender

Historically, investors and lenders have gotten little sympathy. Money lenders, as the hapless Jew Shylock in Shakespeare’s Merchant of Venice can attest, are generally depicted as the bad guy. Lending at interest was banned by the medieval Christian Church in Europe and is still banned today under prevailing interpretations of the Koran. Jews in Europe, as nonbelievers, were confined to moneylending as an occupation. It turns out that moneylenders tend to get rich.4

The nineteenth century success of European Jews in this profession was to evoke the jealousy of their goy neighbors and serve as a foundation of Hitler’s murderous National Socialist anti-Semitism. The Rothschilds, in particular, who played a major role in financing the British victory in Waterloo and had gone on to become the preeminent banking family in Europe, were the epitome of evil Jewish money lenders and the object of hatred by various non-Jewish deadbeats and defaulters. Alexander G. McNutt, governor of Mississippi, a US state that defaulted on its Rothschild-owned loans in the 1840s, said of Baron Nathan Rothschild: “The blood of Judas and Shylock flows in his veins.”5 McNutt went on to say that the Rothschilds might hold a mortgage on “the Sepulcher of our Savior” but “they will never hold a mortgage on our cotton fields or make serfs of our children.”6

But it’s not just Jews who have been singled out. Any group that specializes in lending and making a return on capital will not win a popularity contest. In South India, there is a group called the Chettiars who for centuries have specialized in moneylending and finance. Modern scholars have concluded that the Chettiars were important innovators in banking and that they financed the creation of a modern economy in several territories of the then British Empire, notably Burma and Ceylon, as they were then called. But in Burma, when the worldwide Great Depression came, the Chettiar lenders operating under British law foreclosed on property that had been pledged as collateral for loans in default. As a result, the Chettiars came to be hated by the indigenous population as well as the British colonial administrators. In bad times, when defaults rise, the underlying dislike of lenders rises to the surface.

Interestingly, intergovernmental institutions such as the International Monetary Fund (IMF) and now the European Central Bank (ECB) refuse to accept defaults on their troubled loans. Just why they should be in this preferred position is unclear. Private lenders somehow are always judged less noble than their governmental counterparts, and from time to time they must take haircuts on bad debts. Hedge funds and banks are bad guys; the IMF and the ECB are, at least in their own estimation, the good guys. This is a problem, for example, in the case of Greece, where the IMF and the ECB own a substantial portion of Greek obligations. In the case of default, a disproportionate share of the default burdens therefore has fallen on the private holders.

Looking at the history of debt, what you see, in the words of anthropologist David Graeber, is “profound moral confusion . . . the majority of human beings hold simultaneously that 1) paying back money one has borrowed is a simple matter of morality, and 2) anyone in the habit of lending money is evil.”7 Graeber is a scholar of somewhat leftward leanings. (He’s a self-described anarchist who managed to get himself unhired as a member of the Yale faculty. Imagine, an American academic institution kicking out a professor for being too far left!) Graeber goes on in his five-hundred-page book Debt, The First 5000 Years to argue that not paying back money one has borrowed can be okay. (Graeber even goes so far as to express sympathy for the “non-industrious poor.”8) President Barack Obama now seems to be in agreement, at least with regard to mortgages and student loans.

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Congratulations to Students Who Can’t Pay

The Obama administration, with Congress’s cooperation, has proposed a form of debt relief for student loans that is unique in that it disregards market signals in favor of what could be called government signals. We will discuss government versus market in this chapter. The government signals, of course, are rooted in populism. Obama is essentially proposing to require that debt collectors let student-loan borrowers make payments based on what they can afford, rather than on the size of their debt. According to the financial media, the US Education Department, which hires private collectors, said it would mandate that the companies use a standard form to gather debtors’ income and expenses. If borrowers protest, they would be offered an income-based formula, which can result in payments as low as $50 a month for an unmarried person with $20,000 in income and $20,000 in loans.

This effectively discriminates against brighter, more ambitious students who go to the top schools and/or choose fields of study that will lead to jobs that bring them higher incomes. On the one hand, these students will be forced to repay their loans. On the other hand, less-bright, less-focused students or students who choose fields of study that lead to jobs with lower remuneration will be favored. This is an interesting policy, given that the Obama administration has spent time lamenting the fact that American students are avoiding the science...

Table of contents

• Cover
• Contents
• Title
• Copyright
• Dedication
• Acknowledgments
• Preface
• Chapter 1: Democracies’ Fatal Attraction of Populism
• Chapter 2: The Sorry Fiscal State of the Advanced Countries
• Chapter 3: A Diversion to India and China
• Chapter 4: The International Monetary System—In Desperate Need of Repair
• Chapter 5: The Road to Worthless Paper Money
• Chapter 6: An Overall Assessment of the Current Investing Scene
• Chapter 7: Investment Survival in the Age of Defaults
• Appendix A: A Quantitative Approach to Sovereign Risk Assessment
• About the Author
• About the Contributor
• Index