To those who know, hedge fund manager J. Kyle Bass needs no introduction.
In the following “must watch” keynote lecture delivered in October 2012, in his usual calm, matter-of-fact, pragmatic and incisive style he shared his thoughts on a number of key issues facing the world over the next few years. These include the inevitability of a major war, escalation of social unrest and food riots, and why our governments will never tell us the truth about the nation’s financial situation:
Highlights (with comments from your humble blogger)
4:00 – Largest peacetime accumulation of debt in world history … ends through war
“Something that I think is really important to pay attention to; in the last ten years, debts around the world… has grown from $80 Trillion to just over $200 Trillion. So debts have grown, at almost an 11% compound annual growth rate, over the last ten years. We sit today at the largest peacetime accumulation of debt in world history.
One of the things we talked about in the back after the last panel – and very few people are willing to go out there and say this – you know how this ends, right? This ends through war…
We don’t have a playbook for the enormity of debt at 340% of global GDP, and that’s why we have such a hard time thinking about how this plays out. But I can tell you that – again, I don’t know who’s going to fight who – but I’m fairly certain that in the next few years you will see wars erupt and not just small ones.”
8:00 – Deficit spending going into a war
“If you think about what’s happened in the past; if you study history, you see that when sovereign nations get to 250% total credit market debt to GDP, they’re both deficit spending going into a war. And at the conclusion to the victor go the spoils and to the loser go defeat and default. That’s the playbook that we’re actually familiar with.”
9:00 – Central banks have created $10 Trillion out of thin air
“Central bank balance sheet expansions are really important. We talk about money printing; today… the four largest central banks in the world have $13 Trillion on balance sheet. From the beginning of the [GFC] crisis to today, they’ve expanded by $10 Trillion. Ten trillion dollars has been created out of thin air. How are we supposed to think about that? Well I know we are all worried about it… You are starting to see the first signs of what happens when you expand central bank balance sheets limitlessly.”
13:00 – More worried about the sovereign balance sheet
“I went and met with (Kenneth) Rogoff in February of 2009 and delivered our work here to him, and I said to him: “I’m looking at this and it’s really, really worrying me” – and if you remember, in February 2009 we (financiers, traders) were mostly focused on which bank is going under, and who was going to bail this bank out and that bank out and how the financial system is going to stay together, but I was more worried about what was going on on the sovereign balance sheet – when your banking system gets to ten times your GDP, and you lose 3% of your banking system, you’re finished. And that’s what’s happened; Iceland, it’s what happened to Ireland, it’s really what happened in a number of different nations…
So at the top of what’s going wrong with the world, no one was paying attention to how large these systems were getting. You know, in February of 2009 when Rogoff looked at this he said to me: ‘I can hardly believe it’s this bad,’ and I was thinking: ‘Oh shit, who’s paying attention to the size of those countries’ banking systems, because if you, the father of sovereign balance sheet analysis isn’t, then I know who isn’t’.”
This observation serves as solid justification for the concerns that Senator Barnaby Joyce has, for some years now, been expressing (to much derision by “experts”) about ever rising sovereign debt – the “trajectory”, as he calls it – in the USA, Europe, and in turn, here in Australia.
Moreover, Bass’ observations about the dangers of an expanding financial sector ring out like the tolling of funeral bells when one considers the size of ours. In late August 2012, the Bank of International Settlements (BIS) issued a warning about the size of Australia’s banking sector:
Finance has grown too big around the world and cross-border lending too large, according to BIS chief economist Stephen Cecchetti.
“Experience shows that a growing financial system is great for a while — until it isn’t,” he told the BIS annual conference in Switzerland, arguing there is an optimal size beyond which the financial industry drags down the rest of the economy…
In Australia, the finance sector accounts for 11.5 per cent of all industry value added, having doubled its share of the economy since the mid-1980s.
This compares with the 2008 peak of 7.7 per cent in the US and 10.4 per cent in Ireland…
The extraordinary dimensions of Australia’s banking sector were highlighted by Bank of America Merrill Lynch research last week showing that Australia has the second-largest banking system in the world by market capitalisation, surpassing those of the eurozone, Japan, Britain and China.
It is absurd for a nation of 22 million to have a banking sector that represents more than 8 per cent of the world banking industry by market value. Banking now represents just under half Australia’s listed market.
Back to Kyle Bass:
12:00 – GDP is a homogenizing denominator, we use government tax revenue as a better denominator
“When we think about private sector leverage becoming a public sector problem, back in 2008 when we were trying to understand this transference of risk from the private balance sheets to the public balance sheets, very few people – in fact, I couldn’t find it when I went out looking for it – had done the work to try to understand On Balance Sheet debts, and then the acuity of the banking system problem. So when I was thinking about how to get my arms around how this is going to go forward, we were saying, ok let’s forget about contingent liabilities, let’s forget about social welfare, let’s forget about promises that had been made to various people in various nations; let’s just look at On Balance Sheet obligations. Let’s just look at how big banking sectors are in relation to GDP – and actually, GDP is a pretty good homogenizing denominator; we tend to use central government tax revenue as a better denominator, because certain countries are much more productive than others, in our opinion…”
There are two important observations here that I wish to highlight.
The first is Bass’ concern over private sector (ie, banking system) “leveraging” (ie, mega-debt) being transferred on to the public (taxpayer) sector, in a banking system crisis. This is the #1 reason why, even though it is true that private debt is much worse than public debt, I believe that Barnaby Is Right in constantly expressing concern over the rapidly rising trajectory of public debt in Australia. Because, regardless of whether or not you agree that our public debt is “low compared to other OECD countries,” the undeniable fact remains that our rapidly rising government debt does represent a weakening of the government’s balance sheet… even before any banking crisis arrives! Foreseeing that our banking system was, just like the rest of the West, our key vulnerability, and that weakening the government balance sheet unnecessarily would only make our future problems far more calamitous, was one of the main reasons why I launched this blog in early 2010. When you hear some distinguished-looking, eminent economic “expert” – or politician – reassuring us that Australia’s public debt is “low”, just keep one word at the front of your mind. Ireland. And remember what happens to the public debt level, when a government with previously “low” public debt suddenly finds itself borrowing to the stratosphere – often from the IMF – in trying to bail out an over-leveraged banking system.
The second important observation – on GDP as a “homogenizing denominator” – is one that thrilled your humble blogger, and made him feel a lot smarter than he actually is. How so?
For years I have argued that using “GDP” as a measuring stick is bogus, and deliberately misleading, because:
(a) “Gross Domestic Product” (GDP) is really just a blunt measure of total volume x notional “value” of transactions in the economy… irrespective of whether those transactions were actually a result of “productive” activities or not; as such
(b) it only serves the purpose of helping politicians and bureaucrats to obscure the truth about the economy, and the government’s financial management; and so
(c) governments should be required to report key budget figures like government spending, and public debt, as a percentage of government tax revenue instead.
Bass is both subtle and brilliant, in describing GDP as a “pretty good homogenizing denominator”. One definition of that word is: “to form by blending unlike elements”.
That’s exactly what the GDP figure does – it blends unlike elements. It is a meaningless quantitative measurement, that simplistically blends together every transaction in the economy in one huge number (all the better for making things like government spending or debt “as a percentage of GDP” sound like a small number). In so doing, it obscures any qualitative measurement of activity in the economy. That is, unlike “GDP”, a qualitative measurement would distinguish between the volume x value of transactions resulting from real, productive activities, versus that which resulted only from (eg) non-productive money-shuffling between financial institutions. In theory, an economy could boast a China-like level of annual GDP “growth”, while actually producing nothing. All it takes to achieve that, is a sufficient increase in the volume x notional “value” of electronic digits that are transacted each year. “GDP” as a measurement is utterly ridiculous, once you see it for what it is.
This blogger can greatly appreciate the wisdom of Kyle Bass and his hedge fund team, in choosing to assess economies based on a recognition that “certain countries are much more productive than others”, and that GDP as a measurement does not help to identify which countries have quality (ie, productive) activity, and which do not.
15:00 – We think inflation causes default 90% of the time
“When your debts get to be 20, 25 times your central government tax revenue, a non-linearity develops between your revenues and your expenses. So if you try to inflate your way out of this problem which – again, the academics, the central bankers of the world believe that when you get to this proverbial fork in the road, that fork is either inflate or default, and those two roads are mutually exclusive of one another – we tend to think that 90% of the time one causes the other. And when you develop this non-linearity… when your debts are 20 times your revenues and you try to inflate your way out of this through revenue, it moves your swaps curves or your debt costs, ok? Your expenses grow exponentially while your revenues grow in a linear fashion … it just makes sense, this is logic.
So when you think about Japan, they’ve got 24 times their central government tax revenue in debt. If Japan ever moves to an inflationary bias, they’re finished.”
Oh dear. Remember, this talk was given in October last year. As of March this year, the government of Japan has moved to an inflation bias, after 15 years of deflation. They have set the central Bank of Japan a 2% target for inflation, to be achieved within two years.
19:00 – More social unrest
“You’re going to see more social unrest. You saw huge riots in Greece and you’re seeing huge riots in other parts of the world over food, and lack of food, and those are actually tertiary and secondary derivatives of the financial problems, in my opinion, that we’re exporting inflation to some other nations. So going forward it’s going to be a problem.”
24:00 – They’re not going to tell you when this happens… Their job is to promote confidence, it’s not to tell you the truth
“They’re not going to tell you when this happens, you’re going to have to see it for yourself. How many of you remember Mexico in ’94 when we had the ‘Tequila Crisis’? The government gave affirmative determinations that they would not devalue, they would not default, almost daily. And the day after they said we won’t devalue, they devalued 60%. The government’s never going to tell you that it’s going to happen. (Greece’s) Yunker, when asked in 2010 if there was a secret meeting to discuss restructuring Greece, he said: ‘Oh no, there’s no meeting’. And then they talked to two other Finance ministers the next day, and they said: ‘Oh yes, we had a meeting and Yunker was in there’. And so the press went back to him and said: ‘You told us there wasn’t a meeting’, and he said: ‘Look, when it becomes serious, you have to lie’.
You have to realise that these guys are never going to tell you the truth, because they can’t tell you the truth. Their job is to promote confidence, it’s not to tell you the truth.”
26:00 – There is no chance the Japanese can ever repay their debts
“We all know Japan’s On Balance Sheet situation is now 240% debt to GDP, 25 times central government tax revenue; they have over a quadrillion Yen of debt, On Balance Sheet. That’s a one with fifteen zeros after it. If you were to try to count to a quadrillion, and if every number only took you one second to get there, how long do you think it would take you to get to a quadrillion? Thirty-one million years. There is no chance the Japanese can ever repay their debts. Plain and simple. And they will have a crisis. They will have a bond crisis in the next two or three years, in our opinion. It will be a big one.”
Japan is our second largest trading partner, last time I looked.
42:00 – Global sovereign restructurings … people are going to lose a lot of money
“What this means, is that the globe is about to enter into a period of sovereign restructurings. And what does that mean to you? Well, to me it means people are going to lose a lot of money.”
54:00 – Gold is not the panacea that people think… Currency system should be linked to population growth
“It (gold) is not the panacea that people think… Having our entire currency system tethered to something that’s either convertible into a fixed asset or – I think something that’s better, maybe, tied to population growth – makes a little bit more sense. But limitless credit creation is probably a bad idea.”
This too, impressed me. And made me feel smarter than I am. How so?
Fundamental to my own alternate currency system idea, is the view that gold (or any other ‘commodity’ whose stocks, supply, or public reporting of reserves can be manipulated) should not be used as the basis for a future currency system. And – per Kyle Bass – my idea ties currency issuance directly to population size.
Watch the whole talk, on Youtube. Highly recommended.