Aftermath Of 2008 Crisis: Can Greenwood’s Model Tell Where We Are Heading To?

Herzliya, Israel - August 31, 2015: Microsoft corporation office building facade with logo in Herzliya, Israel. Microsoft Corporation is an American multinational technology company.

Who’s John Greenwood? Back in 1983, China was negotiating with the UK over the sovereignty of Hong Kong; the city’s economy and currency were toppling. As an editor of the Asian Monetary Monitor, John Greenwood published a proposal on how to rescue the Hong Kong dollar, which formed the basis of the Hong Kong government’s scheme to link the HKD to the USD. For this feat, John Greenwood is dubbed the Father of the Linked Exchange Rate System. Greenwood has formed a model for debt crisis recently, and that framework is now predicting credit and monetary contraction in the U.S. economy. Look out, world!

Foolish Explainer: Greenwood’s model of a debt crisis in three phases

The above graph encapsulates the basic of the model. In the first phase, public debt stays flat and private debt piles up; total debt rises till an unsustainable level where debt crisis and default occur. The second phase is the crisis period, during which private debt decreases and public debt shoots up to take its place; it represents that the government is assuming the debt in the private sector in an attempt to restore confidence in the economy. Thus, finally in the third phase, the government is unwinding the heavy debt load it assumes during the crisis and hence public debt falls while private debt stays flat.

The model in real action

Consider the following graph of U.S. private and government debt data from 2000 to 2018:

Source: CEIC, Federal Reserve Bank at St. Louis

We see that from 2000 to 2008, the real data fit the first phase of the model where private debt climbs excessively; though public debt is not flat as the model suggests, it rises at a much slower pace. From 2009 onwards, the real data fit the second phase of the model where public debt overtakes private debt with the former rising and the latter falling.

Since 2015, both private and public debts have stabilized somewhat. This signals that the U.S. is ready any minute to enter into phase three of the model, during which deleveraging of public debt leads total debt level to decrease.

What next?

As leveraging goes down and the monetary conditions contract, the market can experience a sharp correction in the following stage. Though the Fed is careful to slow down the downsizing of its balance sheet, such a high level of public debt is after all unsustainable and will call for an ultimate unwinding.

Since the monetary conditions in the U.S. easily find its way to Hong Kong through the Linked Exchange Rate System, There might be a rough outlook ahead for Hong Kong investor!


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