Posts Tagged ‘Default’
Guest Post: The Real Story Of The Cyprus Debt Crisis (Part 1)
Monday, 17 June 2013 12:19
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Submitted by Charles Hugh-Smith of OfTwoMinds blog,

I highly recommend this deeply insightful two-part series on the banking/debt crisis in Cyprus.

 
I am privileged to present a comprehensive yet succinct two-part account of the banking/debt crisis in Cyprus, prepared by a knowledgeable resident of that nation. Why do the debt crisis in Cyprus and the subsequent "bail-in" confiscation of bank depositors' money matter? (Read more…) They matter for two reasons:
 
1. The banking/debt crisis in Cyprus shares many characteristics with other banking/debt crises.
 
2. The official Eurozone resolution of the crisis–the "bail-in" confiscation of 60% of bank depositors' cash in an involuntary exchange for shares in the bank (which are unlikely to have any future value)–may provide a template for future official resolutions of other banking/debt crises.
 
In other words, since the banking/debt crisis in Cyprus is hardly unique, we can anticipate the resolution (confiscation of deposits) may be applied elsewhere.
 
Readers may recall that the initial resolution in Cyprus called for all depositors to accept a "haircut" (the harmless-sounding vernacular for confiscation). This triggered widespread outrage, and was soon amended to exempt the first 100,000 euros on deposit. 60% of the remaining "uninsured" deposits would be confiscated and involuntarily exchanged for bank shares, in two tranches of 37.5% and 22.5%: Bank of Cyprus starts process of turning uninsured deposits into stocks (April 29, 2013)
 
In sum, it's extremely important to understand the real story of the Cyprus Debt Crisis to be able to sort out which features of the situation may be considered unique and which ones are shared by other banking/debt crises.
 
We are fortunate to have this on-the-ground account by a longtime resident of Cyprus, John H. Morgan. Here is Part 1 of his report.
 
The story of The Republic of Cyprus’ descent into bankruptcy is a Greek tragedy of epic proportions.

The Cyprus Political Crisis post-1974

In July 1974, in the face of an airborne invasion backed by the armour of NATO member Turkey, 200,000 Greek Cypriot citizens ran from their homes with only the clothes on their backs. The Greek Cypriot armour and infantry were no match for the second largest standing army in NATO, equal in size to the British and French forces combined. The Greek Cypriots were easily routed. The victors conducted summary executions of thousands of their prisoners and threw some of the bodies down wells to hide their crimes.

History, geography and economy of Cyprus (Wikipedia)

37% of the island of Cyprus was taken; 50,000 Turkish Cypriots fled north and took shelter in the homes abandoned by the Greek Cypriots; 200,000 Greek Cypriot refugees fled south and were housed in tents, in the same way that hundreds of thousands of Syrian refugees are now sheltered by the Turkish Government in 2013.

Yet so began the housing boom in Cyprus. Refugees in the Turkish-occupied North had the pick of thousands of abandoned homes. Refugees in the South had to build their own. The Cyprus Government parcelled out plots of government land. The banks would not give mortgages on state land so the Cyprus Government stepped in and funded the construction industry.

Political opportunism was not far off. During his election campaign Former President Glafcos Clerides allegedly promised to give Greek Cypriot refugees temporary title to thousands of Turkish Cypriot homes and land. Once he was elected, the programme was halted. He handed out 8,000 Government jobs to party cronies in his 10 years as President, perhaps by way of consolation.

Patronage, cronyism and clientelism have been the hallmark of government control in both the South and occupied-North of Cyprus. Since the Turkish occupation, employment in the State sector in Cyprus has been used to reward party loyalty (and to incentivise elections). The civil service in the free Republic of Cyprus has grown from 18,000 workers in 1978 (costing €36 million in annual salaries and benefits), to 70,000 workers in 2012 (costing taxpayers and business €2.8 billion per year).

One in six workers out of a total workforce of 440,000 are employed in the public sector. The government controls an empire of 63 Semi-Government Organisations (SGOs) plus the Cyprus National Guard, an army of conscripts headed by a permanent officer corps. Officials in charge of the SGOs are appointed by party affiliation. SGOs are monopolies and can set their own tariffs.

State teachers have become the highest paid in Europe, with top teachers earning almost three times (282%) the salaries of their counterparts across Europe. In January 2013, state teachers went on strike because they were required to work one extra lesson per week, 40 minutes. Electricity prices skyrocketed to the second highest in Europe, to fund the pensions of the broader state sector. Between 2009 and 2011, the price of domestic electricity doubled. A clerk in government with a High School Certificate could earn the same salary as a Professor in a private university.

In December 2012, the pension funds of the Telecommunications, Electricity and Ports Authorities were raided to pay State workers their 13th cheques. In May 2013, the workers of the Ports Authority downed tools because their 14th cheque was reduced by half.

All political parties have been complicit in the transfer of wealth from the private sector to the public sector. In 2009, 98 shipping containers of Iranian armaments on their way to Syria, were intercepted by the US Navy. On 11 July, 2011, they exploded while being stored at the Cyprus naval base. The island’s main power station was destroyed and 13 lives were lost. Insurance companies paid out the first claims within weeks. The Cypriot Parliament charged the taxpayers €99 million to cover claims for “Public Liability”. The item was slipped in as the last entry of the 2013 State Budget.

The DIKO Party is the government’s coalition partner (and coalition partner of most of the previous governments). While in power from 2003 to 2008, is alleged to have amassed €18 million of Party funds by endorsing a contract to buy two additional Airbus planes for the loss-making Cyprus Airways.

In 2007, the DIKO government asked parliament to approve the construction of a multi-billion Euro offshore floating Liquefied Natural Gas (LNG) terminal. The gas was meant to be used to power the Vassilikos Power station (destroyed in July 2011, as mentioned above). Parliament questioned why such a massive construction was needed when a few storage tanks would suffice. The government failed to tell the nation that trillions of cubic feet of gas had been discovered offshore. Politicians had set up a front company to take a cut of the billions of Euros taxpayers would contribute to build the plant and to ensure they received an annual dividend from the profits of selling millions of cubic feet of LNG to Europe.

Government debt has been compounded because Cypriots generally avoid paying taxes. Indeed, there are only 52 tax inspectors in the whole country. In her report to Parliament in April 2013, the Auditor-General noted that Cypriots owed their government €1.6 billion in back-taxes and fines, enough to pay off all Eurobond debt due in 2013. She pointed out that failure to collect taxes meant that €300 million of State revenue had been irretrievably lost.

At the end of December 2012, ex-President Christofias vacated the rotating Presidency of the European Council. For 6 months work, he would receive an EU pension estimated at €10,000 per month, courtesy of European taxpayers. For his 17 years as an MP and 5 years as President of the Republic of Cyprus, he would receive a State pension of €22,000 per month, a brand new BMW limousine costing €43,000, a driver, a secretary and 15 body-guards, courtesy of Cypriot taxpayers.

Just one month before Cypriot Presidential elections of February 2013, the Trade Union-backed Communist regime of ex-President Christofias was assiduously appointing party apparatchiks to all key State posts, such as to the Central Bank of Cyprus and the newly-formed State Hydrocarbons Company (theoretically a private company). This guaranteed that the looting and pillage of the Cyprus economy could continue, long after President Christofias had left power.

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The Cyprus Banking Crisis

Corruption was also endemic in the Russian Federation after the fall of the Soviet Union. The chaotic privatisation during the Yeltsin years from 1992 to 1999, made a selected few Russians very wealthy. Many of the new Russian oligarchs wanted to safeguard their money and moved their operations to Cyprus. The country offered a low tax regime. Few questions were asked. The island became a favoured tourism and business destination. The debt overhang which had accrued from rebuilding the Cyprus economy became manageable. There was a plentiful supply of homes and offices, a legacy of rebuilding the devastated island.

In 2004, the Republic of Cyprus joined the European Union. A new wave of investors brought great wealth to the island. House prices in the United Kingdom had been heavily inflated owing to short supply and easy credit. 60,000 Britons chose to buy affordable second homes or retirement homes in Cyprus. Between 2004 and 2007, fueled by a housing bubble, the Cyprus economy grew at 4% per year. At the end of 2007, the State Budget was showing a 3.5% surplus. Public debt was less than 60% of GDP. Cyprus qualified to join the Eurozone.

In 2006, attracted by the huge wealth deposited in Cyprus Banks by British and Russian investors, an innovative salesman managed to sell two insolvent Greek banks to the island’s second largest lender, Cyprus Popular Bank. He became chairman of the enlarged bank, which was named Marfin Popular Bank or Laiki Bank.

After Cyprus joined the European Monetary Union in January 2008, he was able to move €5.1 billion of Cyprus bank deposits to a company he set up in Athens. He used equity in his new company as collateral. This substantially weakened the balance sheet of Laiki Bank. €500 million was lent to a Greek Monastery to buy shares in his company. The Vatopedi monks swapped state land they laid claim to, for prime real estate in Athens. Greek politicians facilitated the deals in return for kick-backs. The scandal brought down the Greek government in 2009.

To cover their capital shortfalls, Cypriot banks invested in Greek Government Bonds which offered very high interest rates. Cypriot banks were also heavily exposed to the Greek property and commercial markets. When the local banks could no longer finance Cypriot Government spending, the Christofias government "borrowed" the €7 billion which had been built up by the Social Security Fund.

The Greek Government applied for a financial bailout in 2010. Cypriot banks held €5.3 billion of Greek Sovereign Debt and a total of €23 billion of Greek assets. Cypriot banks suffered heavy losses in the Greek financial meltdown. Laiki Bank alone endured a €2.4 billion write-down on the value of its Greek Government Bonds. The 80% “haircut” on bonds was proposed by German Chancellor Merkel and French President Sarkozy to make Greece’s debt burden manageable. Other losses by Cypriot banks were estimated at 25% of their total Greek loan book.

The country’s largest bank, Bank of Cyprus, had been affected by a €2 billion write-down of Greek Government Bonds during the Greek PSI, but its directors had made provisions. One of the provisions, used by both BoC and Laiki Bank, was to offer €1.8 billion of Contingent Convertible Bonds to the public. This was preceded by intense marketing.

Sixty thousand customers transferred funds from low-yielding deposits to take advantage of the promised high-yield bonds. In the end, their money was converted to worthless bank equity. The depositors claimed they had been tricked. There were public protests. When auditors reviewed the records of BoC during its subsequent restructuring, 28,000 computer files relating to the purchase of Greek Government Bonds had been deleted by special software.

The Cypriot Banks applied to the Central Bank of Cyprus for support. The state nationalised Laiki Bank and injected €1.8 billion (10% of GDP). The state was then shut out of the international bond markets.

Laiki Bank was technically insolvent. There were rumours that the bank would default. Depositors had already withdrawn €3.3 billion of deposits by July 2012. The Central Bank of Cyprus propped up the ailing bank with billions of Euros of Emergency Liquidity Assistance (ELA).

In July 2012, the Christofias government turned to the rest of Europe for a bailout. President Christofias tried to dictate conditions to the Troika of lenders, the European Commission (EC), the International Monetary Fund (IMF) and the European Central Bank (ECB). He wished to avoid the political cost of signing the Memorandum of Understanding. This called for massive restructuring of the economy of Cyprus in return for a bailout. He had decided to pass the problem on to the next President.

Up until January 2013, a month before the Cypriot Presidential elections, German Finance Minister, Wolfgang Schäuble, denied aid to Cyprus by insisting that Cyprus did not qualify for European financial support. All the while, the Cypriot commercial banks were bleeding heavily in the Greek economic meltdown and were posting their best Greek assets as collateral for emergency funding from the Central Bank.

Furthermore, Schäuble told German voters, Cyprus should not receive German-guaranteed loans as it was an offshore tax haven and Germans would not want to risk their money to bail out wealthy Russians who had hidden their ill-gotten gains in Cyprus. (In a report commissioned by the Troika of lenders, European fraud agency Moneyval and Deloitte Financial of Italy reported a widespread lack of due-diligence, but could find little direct evidence to support such claims.)
Summary of Main Financial Report by Moneyval and Deloitte

Tomorrow: Part 2: The Cyprus Bank Deposit Bail-in and the Economic and Political Prospects for Cyprus post-2013

    



 
Guest Post: Developing Crisis In The Developing World
Saturday, 15 June 2013 19:16
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Submitted by John Rubino via The Dollar Collapse blog,

Things have been a little erratic lately here in US, but not really headline-worthy. The economy continues to grow, sort of, houses continue to sell and stock and bond prices fluctuate but can’t seem to follow through in either direction. We are not, in short, engulfed in any kind of crisis.

(Read more…)

But out in the world, especially in once-hot emerging markets like Brazil and China, the story is very different. As Prudent Bear’s Doug Noland explains in his most recent Credit Bubble Bulletin:

Meanwhile, the “developing” market Bubble continues to unwind. As leverage comes out of the commodities, currency “carry trades” and developing stocks and bonds. And as capital flight becomes a more serious issue, the marketplace must ponder the consequences not only of what a faltering Bubble means for scores of markets and economies, there is as well the issue of developing central banks having to sell from their trove of Treasuries and bunds and such to finance a surge in outflows (“hot” and otherwise). There’s even this new dynamic where Treasury yields rise on days of global currency and equity market tumult. It’s been awhile…

 

I suspect that the global jump in yields (and CDS and risk premiums) has more to do with de-leveraging than it does with tapering worries. This dynamic has caught many by surprise. The speculators anticipated cleverly exiting their leveraged MBS and other trades based on their expectations for Fed policy. Now, there’s a tremendous amount of unanticipated market uncertainty.

 

Japanese policymakers have really mucked things up. The Nikkei sank 6.5% Thursday and was down 1.5% for the week. Perhaps it’s a little early to pronounce the BOJ’s “shock and awe” monetary experiment a failure. The yen rallied 3.5% this week against the dollar. Against the Philippine peso it was up 4.5%, versus the South Korean won 4.1%, the Indian ruppee 4.3%, the Malaysian ringgit 4.0%, the Indonesian rupiah 3.2%, the Argentine peso 3.9% and the Brazilian real 4.2%. Indonesia raised rates to support its weak currency. The yen “carry trade” (sell yen and use proceeds to buy higher-yielding instruments globally) is doling out painful losses – forcing the unwind of leveraged trades across many markets. I wouldn’t be surprised if the yen short is the largest short position in modern history. The yen bears are now running for cover – causing all kinds of havoc in the currencies and securities markets.

 

“Emerging” Asian markets are in the middle of an unfolding financial storm. Friday’s 2.1% gain cut the Philippine equities loss for the week to 9.2%. Even with Friday’s 4.4% recovery, the Thailand stock exchange ended the week down 3.4%. South Korea’s Kospi dropped another 1.8%.

 

Latin America is as well caught in troubling dynamics. Brazil’s currency (real) traded to a four-year low against the dollar this week – despite currency interventions and the removal of taxes on financial flows and currency derivatives. Brazilian equities were hit for 4.4% this week, increasing y-t-d losses to 19.1%. Mexican stocks dropped 2.4%, boosting y-t-d losses to 10.2%.

 

The Shanghai composite dropped 2.2% in a holiday-shortened week. China pegs its currency to the U.S. dollar, so we can’t look to the performance of the renminbi for much of an indication of flows or mounting financial market stress.

 

I have posited that China is in the midst of an historic Credit Bubble. I have over the years tried to explain how interrelated their Bubble is to ours. Our mismanagement of the world’s reserve currency led to 20 years of huge Current Account Deficits. A significant portion of the Trillions of associated IOU’s have made it onto the balance sheet of the People’s Bank of China, especially over recent years. And no Credit system and economy has gone to greater excess during the post-2008 global reflation. It was the “fledgling” Credit Bubble spurred to “terminal phase” excess.

 

If the “developing” economy Bubble has passed an important inflection point, then China is vulnerable. If “hot money” is leaving EM [emerging markets] then China should be susceptible. And, let there be no doubt, when China finally succumbs global economic prospects really dim – and prospects for some fellow EM economies turn downright dismal. Recall how the tightening of subprime finance gravitated to “Alt-A” and then worked its way to the “conventional” core. And when housing in general began to falter the bottom fell out of subprime.

 

This week provided a bevy of notable China-related headlines: From the Financial Times: “China Debt Auction Failure Raises Liquidity Fears;” “Fresh Data Highlight China’s Sluggish Growth.” From Bloomberg: “China Debt Sale Fails for First Time in 23 Months on Cash Crunch;” “China Local Debt Audit ‘Credit Negative,’ Moody’s Says;” “China’s Leaders Face Test of Growth Resolve After May Slowdown;” “China Export Growth Plummets Amid Fake-Shipment Crackdown.” From Reuters: “Fitch Warns on Risks from Shadow Banking in China;” “China Estimates Fake Trade Invoicing at $75 billion in Jan-April;” “China State Auditor Warns Over Local Government Debt Levels.”

 

The price of Chinese sovereign Credit default swap (CDS) “insurance” jumped from 92 to 113 in three sessions, before dropping back down to 98 on Friday. Chinese interbank lending rates have recently spiked higher – and there were even reports of several borrowers forced to pay up for increasingly scarce liquidity. There were debt auctions that did not go smoothly. The currency forwards market is showing some atypical downward pressure on the renminbi.

 

Many believe this newfound tightness in Chinese money markets can be easily resolved by liquidity injections from the People’s Bank of China. And perhaps Chinese monetary and economic managers still have things under control. If so, the same clearly cannot be said for many of their fellow “developing” policymakers. Capital flight is always extremely difficult to manage.

 

I worry that the world has never faced the possibility for such destabilizing flows and speculative de-leveraging. To be sure, global markets have never been as dependent upon the power of central bankers. And in my mental tallies of risk and complacency, I never envisaged they could so elevate in tandem.

So can the US stay placid when the rest of the world turns chaotic? Highly doubtful. There’s a market phenomenon in which one investment play blows up and forces those on the wrong side of the trade to dump their liquid assets to raise cash. Which causes the high-quality assets to fall as much or more than the junk. As Noland notes, the world’s premier liquid asset is the Treasury bond.

If the developing world’s need to raise cash is a factor in the recent spike in US interest rates, this implies a feedback loop in which rising US rates further destabilize emerging markets, forcing the sale of more Treasuries, and so on. Can the Fed stop this? Not unless it wants to buy up not just the newly-issued Treasuries as it does now, but the trillions of dollars of bonds that might be dumped once things really get going.

It’s important to understand that we’re here because for years the developed world in general and the US in particular have been exporting their problems to the developing world via monetary policy. We fund our overspending by creating a bunch of new dollars,  many of which flow beyond our borders looking for higher yields. They land in, say, Brazil, pushing up both local asset prices and the exchange rate of the real. So individual Brazilians see their cost of living rise while Brazilian exporters are priced out of global markets. This is the currency war that Brazil’s government has been complaining about.

Then the hot money flows back out, causing a different set of problems for a country that has spent the past decade trying to adjust to excessive capital inflows.

 

The result: some seriously fragile banks and over-leveraged companies and investors, any of which could trigger a nationwide crisis.

The same general process is at work in other major emerging markets, with each in its own way now posing a threat to the global financial system — at the pinnacle of which sit the S&P 500 and the Treasury market, looking an awful lot like Southern California real estate circa 2007.

    



 
Stanley Druckenmiller On China’s Future And Investing In The New Normal
Friday, 14 June 2013 18:38
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From Goldman Sachs

Stan Druckenmiller is Chairman and Chief Executive Officer of Duquesne Family Office. He founded Duquesne Capital Management in 1981, which he ran until he closed the firm in 2010. Previously, he was a Managing Director at Soros Fund Management, where he served as Lead Portfolio Manager of the Quantum Fund and Chief Investment Officer of Soros

Interview with Stan Druckenmiller

(Read more…)

Hugo Scott-Gall: What are the risks of investing in China that are not well understood in your view?

Stan Druckenmiller: The growth in credit at a time when GDP growth is slowing is a problem for China. And I think this is the 2009-11 stimulus coming back to bite. I understand that it had to be done to fund entrepreneurs and the private sector, but it’s easier said than done if you’re channelling funds through local government investment vehicles. I’m a believer in markets. A few men sitting around a table and deciding how to allocate capital goes against everything I’ve ever believed. Not only are they not great at capital allocation, such an exercise also needs to deal with a lack of property rights and corruption. In essence, the frantic stimulus China put together at the end of 2008 sowed the seeds of slower growth in the future by crowding out more productive investments. And now, the system’s building enough leverage and misallocation of resources to warrant risks of a financial crisis, but the timing of that is still uncertain in my mind. What we’ve seen in China since 2009 is similar to what happened in the US in 2005, in terms of credit growth outpacing economic growth.

I think ageing demographics is a bigger issue in China than people think. And the problems it creates should be become evident as early as 2016.

You also need to keep in mind that for China to grow and evolve further, it will need to compete with a more innovative Korea and now a more competitive Japan. I don’t think China can do that with where its exchange rate is today. I think productivity is a key concern too. And I think that could be one of the reasons why the US has been so supportive of Abenomics.

People mention lack of infrastructure as a constraint. But when I go over there, it looks like they have a lot of infrastructure. It seems ahead of the population, not behind. I see expensive apartments in empty cities that 300 mn rural Chinese are expected to migrate to.  That looks very unbalanced to me. Nobody’s ever had investment to GDP at 47%. Japan and Korea peaked at 36%-38%, so as a result I think capacity is way ahead of demand in some areas in China.

Hugo Scott-Gall: If China slows its fixed asset investment, will that have a knock on effect for its commodities demand and thus commodity prices?

Stan Druckenmiller: When I started in 1976, I was taught by my mentor that when cash flow rises equities go up. But commodities are driven by the cost of extraction 90% of the time, and over the long run, technology makes extraction cheaper, pushing the cost curve down and with it commodity prices. But that hasn’t always worked, if I’d followed that advice over the past few decades, I’d be in trouble.

About five years ago, I bought into the peak oil thesis. But then, along comes shale oil and shale technology, reminding me of what my old mentor said 35 years ago. Now I’ve come to think that the oil price is not as vulnerable to China slowing down as it is to ongoing shale supply growth. I regard the ramp up in investment by China as a 10-year aberration, making the last two years more normal and more representative than the previous decade.

I do think China is serious about rebalancing, which means infrastructure investment is going to slow. And obviously, there’s been a huge ramp-up in supply around the world in response to the 2009-11 stimulus, which in my view is a massive misread by the suppliers of these commodities. So that’s not good for commodity prices. And then you have innovation. Can technology progress in iron ore and copper, the way it has with shale energy? My guess is it will.

If you look at food, there’s now technology that allows seeds to be drought-proof and disease proof. Yes, there is a demand-supply argument for food prices rising, but the impact of technology on food supply is greater than you think. On the other hand, we are using up more and more good arable land to build cities in China and there is a water problem in China too.

Hugo Scott-Gall: Do you think we underestimate the role of innovation in resolving these global constraints?

Stan Druckenmiller: Even with all the progress we have made in technology in the recent past, I think we are only scratching the surface in terms of innovation. We haven’t seen half of the practical applications of big new technologies yet. And the cost of these technologies will come down too, whether it’s robotics or driverless cars. That has to provide a productivity boost.

But there is a downside to technology-driven productivity surges too. There is improved efficiency, but at the cost of fewer jobs. I think the impact of technology on manufacturing jobs is easy to overlook because of the huge surge in services jobs. But we’re now at a point where the impact of technology is hitting the services sectors too. And not everyone understands this. I recently brought up the possibility of driverless auto technology resulting in zero jobs for truck drivers within the next 20 years and there were gasps of disbelief from the audience of investors. When I mentioned it to a high-tech company CEO from Silicon Valley a few days later, his response was exactly the opposite. The point is that the problem with a tech-driven productivity surge is that the benefits of that are going to accrue to a smaller, narrower group. Already, computer engineers have benefitted from computing and the internet a lot more than the broader population.

You could draw similar conclusions on the impact of technology and automation on investing. I believe that good investors are successful not  because of their IQ, but because they have an investing discipline. But, what is more disciplined than a machine? A well-researched machine can make many average investors redundant, leaving behind only the really good human investors with exceptional intuition and skill. And what happens when machines really take over investing? Do the markets get really efficient? Or will there be competing systems trying to outdo each other? All of this is depressing because there won’t much left to do for humans once machines start doing more and more.

If machines do everything well, including allocating capital and resources efficiently, can that be deflationary, can that eliminate poverty? I don’t know. It’s hard to be very optimistic if you look at how humans have behaved historically. All in all, I don’t think robots and greater automation can bring about a utopian world as I imagined it would as a kid 50 years ago.

Hugo Scott-Gall: If you combine the prospect of fewer jobs with an ageing population, it doesn’t look very good for many economies…

Stan Druckenmiller: Apart from India, most of the other major economies have worsening demographics to worry about. It’s a big problem for the US too, especially given that relative to many other economies, including Japan, its fiscal gap is much wider. All in all, I don’t think robots and greater automation can bring about a utopian world as I imagined it would as a kid 50 years ago.

You can look at the US debt stock in a few different ways. The official estimate of the total debt may be US$11 tn, but if you include what the Fed has bought (which you should), then the number if closer to US$16 tn. But a better measure of US debt would include some of the off balance sheet items. Laurence Kotlikoff, who is one of the top economists in his field of generational accounting, estimates the present value of US debt including what has been promised to senior citizens, adjusted for the projected tax revenues and the fiscal gap, to be about US$211 tn. That’s staggering.

The US needs to resolve its debt problem politically, otherwise it is headed towards default. I believe the estimates suggest that the US needs to raise all taxes by about 64% in order to be able to support its older population. That’s raising payroll, capital, dividends and income taxes by 64%. The other option is to cut all government spending by 40%. Neither one is a viable option and a combination is not easy either. In 20 years, those numbers will become even tougher. The US will need to raise taxes by 75% or cut spending by 46%.

There has been vigourous debate on the veracity of Rogoff and Reinhart’s research on the consequences of countries exceeding 90% debt-to-GDP. But it doesn’t take away from the fact that historically, such levels of indebtedness has resulted in extreme implications.  Countries tend to go into a full-blown monetisation or a default or inflation on average 23 years after they cross the 90% threshold according to their research. So these debt levels are less relevant for you and me today, but will be extremely crucial for our children. If we continue to borrow and spend like we do now, this can become a serious problem in 15 years.

If machines do everything well, including allocating capital and resources efficiently, can that be deflationary, can that eliminate poverty? I don’t  know.

I understood the need for QE1 because the US economy faced a potential meltdown then. But further easing brings problems of its own, that only come to light in hindsight. All that easing and prolonged negative real interest rates have gone beyond resolving the core issues the economy faced and has led to re-leveraging. I’m not worried about inflation as much as misallocation of investment.

Another consequence of today’s monetary policy is that the US government is not getting any price signals. In any other society, at some point in the next 15-20 years, the markets will give a price signal and the politicians will need to respond. But currently, there is no such impetus for politicians to act. What adds to the problem is that young Americans don’t vote. Old people not only vote, but also have incredibly powerful lobbying groups behind them. Entitlements in 1960 were 28% of government outlays, today it is 67%. And the baby boomers have only now begun to retire. Another debate is that this is a huge reason to accelerate immigration, but current policy is moving in the opposite direction. But even with immigration, the US needs to fix this pay-as-you-go system or the consequences could be quite drastic.

Hugo Scott-Gall: Do you think investing is becoming harder now with more government intervention and regulation interfering with market price signals?

Stan Druckenmiller: It has become harder for me, because the importance of my skills is receding. Part of my advantage, is that my strength is economic forecasting, but that only works in free markets, when markets are smarter than people. That’s how I started. I watched the stock market, how equities reacted to change in levels of economic activity and I could understand how price signals worked and how to forecast them. Today, all these price signals are compromised and I’m seriously questioning whether I have any competitive advantage left.

Ten years ago, if the stock market had done what it has just done now, I could practically guarantee you that growth was going to accelerate. Now, it’s a possibility, but I would rather say that the market is rigged and people are chasing these assets, without growth necessarily backing confidence. It’s not predicting anything the way it used to and that really makes me reconsider my ability to generate superior returns. If the most important price in the most important economy in the world is being rigged, and everything else is priced off it, what am I supposed to read into other price movements?