Is “Extend and Pretend” the Only Answer?

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“China orders banks to keep lending to insolvent provincial projects.” That front page headline in the May 16-17 weekend edition of The Financial Times shines a spotlight on one of history’s most perilous financial conditions. Since the end of the 1990’s, we have been warning of the extreme danger posed by excessive debt. In this century’s first decade, the world suffered two painful recessions, and domestic stock markets twice declined by 50% or more.

According to former Fed Chairman Ben Bernanke and former Treasury Secretary Hank Paulson, the United States was headed into a depression following the Lehman Brothers bankruptcy, necessitating what has become the most massive financial rescue in history. In this country alone, the Federal Reserve has created about $3.5 trillion since 2008, in the absurd, but ironic, attempt to solve a problem precipitated by excessive debt by creating even more egregious levels of new debt. That effort has succeeded in levitating stock, bond and home prices, although the broader economy has made only meager progress. With no dire consequences so far attending the “money for nothing” approach, the central banks of Japan, Europe and China have decided to follow the U.S.’s lead in supplying unprecedented levels of monetary stimulus.

One need only reread the headline at the top of the page to view the logical extension of this misguided policy. The U.S. banking system has become expert at the “extend and pretend” approach to excessively indebted borrowers. The European Central Bank continues its ongoing charade with Greece over debts that will never ultimately be repaid. Now China has reached the point at which numerous local government projects can’t meet principal or interest deadlines. Again, the solution around the world is not to stop borrowing but rather to borrow more, ultimately creating a bigger problem but deferring the day of reckoning.

In February, the McKinsey Global Institute highlighted the dangers of the expanding world debt burden. Their report warns that the $200 trillion global debt, much of it recently accumulated, “poses new risks to financial stability and may undermine global economic growth.” Former Fed governor and close personal friend Martha Seger stopped by our offices recently, where she was once Mission’s first Vice Chairman. Martha confessed her concern that someday she’ll awake in the middle of the night, turn on financial TV and learn that the over-indebted world financial system has unraveled.

None of that seems to bother equity investors, who have bid prices in most of the world close to all-time highs. There is a remarkable complacency that central bankers have the situation under control. History disagrees. As Carmen Reinhart and Kenneth Rogoff point out in copious detail in This Time Is Different, debt levels even less onerous than today’s have been severely punished with regularity over many centuries. With central bankers building the debt edifice ever taller, investors are betting either that they’ll be able to time a prudent exit or that this time is truly different.