I recently re-visited the book This Time is Different by Ken Rogoff and Carmen Reinhart. See Amazon here . This book is back in the news lately due to the discovery of a cell error in a spreadsheet. See here. In case you are unaware this book became an economic sensation after the 2008 credit crisis. The book goes back in history and compiles an enormous amount of country specific data on GDP and debt. There is also the research paper Growth in a Time of Debt published by the same authors in 2010. There have been many books published on asset bubbles but this book appears to be unique due to the volume of data analyzed.
One of the conclusions that the authors reached is that economic growth slows down after the 90% debt/gdp threshold is reached. This is generally welcome news to conservative economists who favor reducing the size of government. On the other hand liberal economists are probably ticked off since they generally recommend increasing government spending (Keynes) during recessions.
Why does this all matter? How does it affect my investments? In my opinion it matters mainly due to the situation in Europe. In case you have not noticed Europe is in rough economic shape. Last week the Euro area reported GDP and it was down again making it down in the last 6 quarters. The only good news is that so far the declines have been relatively modest. See reports here:Euro Stats . I have been following the situation on and off over the last 3-4 years since mainly the Greece crisis took off. The problem, in my opinion, is not really Greece. Greece alone has a very small GDP relative to the Euro area. The main concern seems to be Italy and Spain followed by France. (One way to follow the latest news on the Euro crisis is to go here). So, what to do? If we were to follow Rogoff and Reinhart Europeans are due for a long period of low/no growth.
Another significant problem is the European banking system. According to Europe and the Financial Crisis by David Beim - Columbia Business School - 2009 many of the European banks were over-leveraged. Leverage ratio's over 30 times against owner capital for both France and Germany. Banks have bought European government bonds on the assumption that they are risk-free. They are not risk free and the banking system has required a re-capitalization. The European Central Bank (ECB) has stepped in to essentially bail the banks out (Do Whatever it Takes). This is essentially printing money (cyber money) which worries a great deal of people - especially in Germany.
The European situation is very complex both economically and politically. While I am not an expert in these matters it would seem that the Europeans need to consider debt forgiveness as a solution. Thisis the main take I get from This Time is Different. Sort of a Marshall Plan for debt management. I don't really see what else to do. Lately there has been some of talk of setting up a universal deposit insurance program but it is far from being approved. Socialization of losses is not pretty but it may be the best option out of many bad alternatives. Squeezing debtor countries with austerity is like trying to get blood from a stone. So far it seems that the Northern countries are against this idea since it essentially gives the Southern countries a free lunch. This is, of course, moral hazard here but the alternative might allow political extremism to take hold.
When the crisis was going full blast a couple of years ago I followed the Italian and Spanish 10 year bond rates here and here. If trouble is coming you will probably see it in the bond rates very quickly. Obviously you would follow the Euro currency as well. Lately the Euro is modestly weak against the dollar. See here:
The whole debate above assumes as an investor you would buy/sell securities based on economic information and interventionist policy. I am not really worried about modest declines in GDP - if that was the concern I would not be posting. The REAL concern for Europe is an economic implosion of debt deflation similiar to what we had in the great depression. So far they have avoided the worst.
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