After the outbreak of the 2008 credit crunch, stimulus packages and a range of budget deficits were implemented, as recommended by several economists, in order to revive the Western economies. They thought that the “resulting higher levels of government debt surely would pose no danger.”

In 2012, the European debt crisis started to erupt. The question that was on everyone’s mind; how are we going to get out of this? Politicians responded with a policy of austerity.

The economists whom previously argued for stimulus packages now screamed blue murder; the reduction in overall demand would strangle the European economy, knowing the background of the Mediterranean countries, these would surely collapse under their high levels of indebtedness.  

However there were also economists who formed an opposition, especially thanks to the Harvard economists Carmen Reinhart and Kenneth Rogoff, who pointed out the dangers of excessive sovereign debts. 

In 2009, Reinhart and Rogoff published a book which detailed over 800 years of financial history, and wrote an IMF research report that had a major impact among economists.

The essence of their IMF report was to bust two widespread myths:

1. A debt crisis in a developed country is impossible!
2. Large sovereign debts pose no danger to economic growth.

These myths are not only a hindrance to sound economic policy making, but it can also, without them being aware of it, burden investors with a sword of Damocles hanging over their investments.  

According to Reinhart and Rogoff, the Western world is in a collective state of denial with regards to the (un)feasibility of the current trend in public finance. With the motto 'This time is different,' economic laws and examples from our Western financial history are discarded as irrelevant.

A banking crisis was something only seen in the banana republics. And according to them, Greece couldn’t go bankrupt, considering such a thing couldn’t possibly happen to a modern industrialized state.

And yet, people haven’t woken up. The fault for the Greek bankruptcy is attributed to particular circumstances in the country, such as: corrupt politicians, a dysfunctional tax system, and the fact that government officials could enjoy an early retirement (at 53 years old). “It is different in the rest of the Western world!”

However, Reinhart and Rogoff convincingly show how the current trend of public finances is untenable, for nearly the entire industrialized world. We will need change course in order to avoid a 'Greek tragedy.'

This will mean a set of painful measures, especially for investors. More about this in a second.  

The underlying belief of this myth is reflected in the popular cliché arguing that the level of government debt is irrelevant because “after all, we owe it to ourselves.”

First, this assumes that everyone is on the same financial terms with their government. Or in other words, everyone holds the same amount of government bonds, pays (and has paid) the same amount of taxes, will retire at the same time, makes use of social security to the same extent, etcetera.  

In reality, sovereign debt repudiation completely disturbs the relative financial positions of the citizens of that country.

Secondly, this myth assumes that imposing taxes and the absorption of savings by the Treasury, which would otherwise have gone to businesses, have hardly any impact on economic growth.

However, its most important assumption is that investors will naively continue to invest their capital in countries that are on the brink of a debt crisis. And that doesn’t only pertain to the governments of said countries – retail investors had already stopped investing in Greek government bonds from 2012 onwards – but also its businesses.

The problems that the private sector faces require some explanation. The headlines always stated that there were “problems facing Greece.” However, it is important to understand that the Greek government was facing bankruptcy, and not necessarily the Greek businesses.

So why do government insolvency issues lead to the collapse of an economy of that country, or in other words, of the businesses therein?

Reinhart and Rogoff’s IMF report guides us towards an explanation. When the government is on the brink of insolvency, a 'package of measures' will need to be implemented, involving a mix of:

1. Austerity and tax hikes
2. 'Restructuring' debt or a default
3. Surprise inflation
4. “A steady dose of financial repression accompanied by a steady dose of inflation.” By the way, financial repression is a euphemistic term for policy-induced low nominal and real returns on the financial markets

If option 2 and 3 are used, current investors will pay the price. Option 1 and 4 will hurt future investors. This provides us with a fundamental problem; why would investors invest in the private sector of a country if they can expect future tax hikes or 'financial repression?'

According to economists, that is the reason why these kind of measures need to be introduced at an 'unexpected point in time.'

However, investors are generally quicker in anticipating future developments than policy makers are; they will postpone investments in those types of countries, or preventively move their investments to other countries. This kind of mechanism,  help us to understand why the Greek economy collapsed.

(Re)investments in the Greek private sector collapsed, as a Greek swords of Damocles was hanging over every investment. Furthermore, the absence of measures taken by the Greek government provided major uncertainty concerning future policies. Declining employment by Greek businesses was the unavoidable accompaniment.

It also sealed the fate of the Greek banks; their demand deposits, redeemable on demand at par value, were primarily backed by Greek government bonds and loans to Greek businesses.

The only reason why banks didn’t have to close their doors was due to the 85 billion euro of emergency funding provided by the ECB (approximately 50% of Greek BBP in 2014!).

So we have seen that an excessive level of indebtedness is devastating for a country. But when are sovereign debts, like in Greece, 'too high?' That’s hard to say.  But the effect is relative; the higher sovereign debt is, the more problems it causes. And as Reinhart and Rogoff show, the levels of indebtedness in the Western world are at such high levels that there is no easy way out. 

Enough about public finances, what does this mean for your investment?

It means that investors can expect several painful measures in the coming years, and that economies with relatively high levels of government debt may be faced with sluggish economic growth.

Therefore, it is important to take the level of public indebtedness of the countries where your capital is invested into account, in order to avoid a surprise by measures that are intended to provide a healthy boost to the local Treasury. 

Of course, this is easier said than done. There is no simple measure or ratio that will give you an unmistakable insight to the level of performance  of the public finances of a country. And luckily, a redirection to credit rating agencies will only give you a good laugh.

The list of things to take into account is long: public assets, future pension liabilities, the employment rate, a tax system’s efficiency, etc.

The figurative sword of Damocles hanging over investments is, unfortunately, not as clearly visible as it was in Greek mythology. 

Besides carefully studying  the public finances of a country, you can also avoid risks by investing part of your capital in assets that function as stores of value such as: precious metals, jewelry, and valuable art.

Precious metals are less vulnerable to the 4 aforementioned 'solutions' for public insolvencies than regular investments are, partly because they are easy transportable, and retain their value during inflationary periods. Because of this, precious metals like gold, silver and platinum can help to strengthen the resilience of your portfolio, and thereby provide an essential and valuable diversification.

The most important argument against holding stores of value (like gold) is that they do not pay dividends. However in times of financial repression, this argument loses much of its relevance. Or in other words, diversifying and protecting your portfolio with precious metals only bears a small opportunity cost at a time that – as Reinhart and Rogoff show – this is highly relevant.

And we haven’t even looked at the upward potential of the gold price during financial repressions. More on this next week. 

Being aware of the risks that high sovereign indebtedness in the Western world may pose to your investments in our time is a precondition of taking risks consciously.

It is crucial for ensuring that you only run the risks which you can afford and are willing to take. It also starts one to think about what options are available to hedge unwanted risks.

By this, you can avoid an unconscious and undesirable sword of Damocles hanging over your investments.

With all of this information in the back of your head, the summer time might provide an excellent time to reflect your asset allocation.