The reason I came to think about this subject is the conundrum of zero, or even below zero, central bank funding rates that we are seeing. This subject has preoccupied me for a very long time. It has also baffled me that markets are still very complacent and do not seem to fret that the Fed has no more possibility (other than a symbolic 0.50%) to lower rates in case of an economic slowdown, which is just a matter of time. The market doesn't seem to grasp the gravity of the situation. Why interest rates have reached this point today?! We have never had near zero Fed rates in a growing economy, and since our current economic and financial system is something quite new from a historical perspective - ever since the official abandonment of the Bretton Woods system - we can't really make any serious analogies to past experiences. In my analysis - since the US dollar has been, and still is, the world's only real reserve currency - I will be using the realities of the US as default, whenever not mentioning the exact name of the country or the central bank.
First we shall take a look at inflation, and deflation, from a historical point of view. Aggregate price changes during the gold standard did not move far from zero-change. Whenever prices went up for a while in an inflationary environment, deflation would soon follow, and aggregate prices tended not to change much over time since the quantity of gold did not change significantly (chart below). But things did change, as it can be seen in the chart, after the Great Depression. We have never witnessed persistent deflation since. We seemed to be on the verge of deflation in the early 70s, but Nixon administration exchanged that (abandoning Bretton Woods) for much higher inflation for more than a decade. However, even without deflation, unemployment still went up, though not as suddenly as it did in the 30s. Unemployment went up, steadily, for about a decade after the abandonment of Bretton Woods in 1971. The private sector still suffered and shrank (second chart below).
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There are a few important developments in the economic world today, which are crucial to understanding why central bank rates are at rock bottom levels now, and where we are headed. The most important reality is that the steady fall in Fed rates that has occurred since 1980 (chart below) has coincided with a steady rise in total debt. What is very important to note here is that, as it can be seen in the first chart below, after each economic cycle Fed rates go below the previous low by almost 3 percentage points, except after 2008 when they couldn't go any lower as they hit zero. I will come back to this very important point (that Fed rates have tended to be pushed much below their previous lows after each economic slowdown) later on with further explanations and correlations. Total US debt started to rise precipitously after 1980, not just in nominal terms but exponentially, much faster than GDP, reaching more than 360% of GDP in the middle of the financial crisis just after 2008 (second chart below). Although total debt is important, the real issue is total private debt rather than total public debt. Public debt (government debt), in a fiat currency system, can eventually be rolled forever, or partially or entirely taken over by the Central Bank (as it has already happened during QEs in various countries), which is essentially equal to be written off. This subject will be amply developed later on.
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It is clearly noticeable that total debt in the US was unable to make new strides after the crash of 2008. The obvious reason has been household deleveraging, as government debt ballooned in a much faster pace than before, and non-financial corporate debt soared too, because of historically low interest rates (two charts below). Apparently home owners, having been through a housing crash, did not want to take on the risks they used to, and banks after having lost hundreds of billions of dollars in risky mortgages, did not want to repeat the same mistakes again either. However, after 2008, non-financial corporate debt survived the crisis unscathed, and corporations piled on debt much faster than before, making the judgment that historically low interest rates cannot be around for too long, and that it is best to borrow as quickly as possible while rates are still low. Low interest rates also offered another incentive for corporations to borrow, and that was to buy back their own shares, or other companies' shares in mergers and acquisitions. Shares yielded better than corporate bonds, or the interest they would pay for bank loans, so corporate bosses decided to buy shares using borrowed money. The chart below (Goldman Sachs Research) shows how fast corporate debt has gone up since the financial crisis.
Another important component to total debt, which is essential to my thesis, is of course government debt. It is not important as a risk factor, but rather as the counter-balance for the private sector risk factor. US government debt has risen every time there has been economic trouble, and not necessarily a full-blown recession. The pace of government indebtedness went up much faster after 2008 than in previous times of slowdown (chart below). And this coincides with the fact that the crash in 2008 was the first time when the Fed reached rock bottom interest rates and could not go any lower. Theoretically they could go below zero, but it would not have had the same effect. Therefore a new measure was deployed, called Quantitative Easing. Also the government had to absorb a much bigger blow and take on much greater losses, hence the much faster growth in the budget deficit and eventually government debt. Apparently the inability to take interest rates much lower than the previous lows meant that additional stimulative steps were required to get growth going again, and avoid deflation.
All these coincidences show that lowering Fed rates since 1980 after each economic cycle gave the private sector confidence, each and every time, that economic slowdowns are going to be short and mild, and that it is safe to pile on debt. Although there have always been short-term excesses that have caused some investors pain, the over-whelming investor feeling has been that if you think long term and do not borrow beyond a certain level (so that short-term blips don't wipe you out), the economy will grow and everything will be taken care of. It may be more a matter of philosophy to approve or disapprove this belief, but the reality is that if too many think that doing exactly the same thing will make them all richer, then it will most probably not. And more and more investors (whether active or passive) came to believe, starting from 1980 until today, that having debt is OK, whether it is in properties or in businesses. Hence private debt reached levels not seen even after the great depression (chart below, showing aggregate debt to GDP).
One thing is quite different, in the chart above, between what happened after the crash of 1929, and what happened after the crash of 2008 - after 1929 total debt to GDP shot up shortly after the crash because there were a few years of deep deflation which reduced GDP dramatically, while in 2008 total debt to GDP actually managed to shrink a little bit shortly after the crash. Deflation was brought under control after 2008 thanks to interest rate cuts, QE, and government intervention to stabilize the financial system. Although GDP did not shrink that much in 2009 and deflation was very short-lived, as it can be seen, government debt went up faster than any time since World War II.
Interest rates are still at rock bottom levels. Although the Fed raised its funding rates by 0.25% in December last year, Fed rates are still at historically low levels. There are real reasons behind this. The economy simply does not seem to be able to manage higher rates. Of course there are also external factors playing in to this dilemma, affecting the whole interest rate, and growth, environment. In today's globalized financial system, historically low interest rates in the US after the crash of 2008 caused a worldwide decline in interest rates. And private sector borrowing reached unprecedented levels in Emerging Markets. The most important contributor to this phenomenon was China, where government policy to inject cash (in yuans with semi-peg to the US dollar) into the economy, to prevent an embarrassing economic under-achievement (Chinese politics, and culture), pushed total debt from around 150% in 2007 to almost 300% of Chinese GDP (probably higher) today (mckinsey.com). And most of that went to the private sector, as government debt to GDP ratios have not changed significantly ever since. China, thanks to the huge amount of stimulus it provided, not only provided growth for its own economy, but also for much of the rest of the world for a few years. That stimulus, coupled with China's strong natural growth pattern, plus US stimulus, may have been behind the growth, associated with moderate inflation, that we witnessed pretty much all around the world until 2011, when the effects started to wear off, first in commodities exporting countries and then after 2014 everywhere else. Also came two consecutive blows, first from Japanese QE, and then from Europe with QE and negative ECB rates. These two actions which caused heavy currency devaluations practically exported some of their own deflation to the rest of the world, especially to China and the US.
In this globalized world, economic cycles are also bound to be somewhat correlated. And China has played a more important role in the world economy, and most probably US growth, and inflation, than many believe. China's economic growth (more than 7% of GDP) has in recent years been greater than that of the US (2% of GDP) in absolute numbers, even if Chinese economy is still smaller in dollar terms. And this Chinese growth has also been associated with debt accumulation and in a much faster rate than any other major economy in the world, or perhaps in modern history. China, not being a democratic or even a transparent, country, does not have to face a financial crash, but it cannot escape external realities. One major external factor for China is its semi-peg to the US dollar. Most of China's gigantic debt carry interest rates above 6% while, and thanks to yuan's semi-peg to the dollar, China's inflation rates have fallen below 2% (chart below). But producer prices have seen quite a serious fall below zero (second chart below). The deflationary impact of this price drop has been mitigated by a fast growing consumer economy inside China, but it has not been mitigated by China's trading partners, who are already suffering from a mature and indebted consumer base. Nonetheless, such falling prices inside China are simply because of the US dollar peg, which is causing the Chinese debt burden to be extremely difficult to service, if not impossible. China, in slightly more than one year, has reduced its currency reserves from around $4 trillion to $3.3 trillion in December last year, just in an attempt to defend the yuan's peg to the US dollar. And it hasn't succeeded (third chart below). Now that the world has been on yet another expansionary, growth, binge for almost seven years since 2009, it is about time to see a slowdown. A slowdown would reduce demand for China's indebted exporters. Could China hold its debt from blowing, and its currency peg to the US dollar, at the same time, while confronting another global economic slowdown? Very difficult, and very unlikely. In any case, with time passing, China's debt becomes bigger as older debt is replaced with new debt with accrued interest. And a slowdown in external demand, coupled with much better domestic demand (fourth chart below) (currently at over 50% of GDP) than after the shock of 2008, will provide the Chinese leadership with a much easier choice between two possibilities - protect external markets at the expense of bankrupting domestic banks and producers, or protect the domestic economy at the expense of causing havoc in the rest of the world. The obvious choice is to protect the domestic economy first, and let others handle their own affairs. This will anger China's trading partners and they might start imposing higher tariffs on Chinese goods. It's still quite dangerous for China to ignore the importance of its trade with the rest of the world, as its services sector is still comparably small, but if faced with the choice between external trade or saving its banks and producers from disappearing, it will make the rational choice and let its dollar peg go to save its domestic economy. And China knows very well that its future lies with its domestic economy. China's next devaluation round may bring the final blow to the financial markets as they are now, and provoke a serious panic.
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The presentation of the Chinese situation is of paramount importance, as China's debt accumulation now is something far bigger than the sub-prime debt that kick-started a relatively small crisis in 2007 ending in what we call the Great Recession nowadays. It is extremely unlikely to see a financial crisis first happening inside China, but it is quite likely for the rest of the world to fall into a deep financial crisis because of China (this in turn would damage Chinese domestic economy too). China's semi-peg to the dollar does not only pose a potential threat to its almost $1 trillion net debt denominated in US dollars but rather a much greater threat to China's trading partners who could (in the event of a de-pegging) encounter a massive deflationary pressure coming from China. As things stand now, there are two major currencies in the world actively exporting deflation all around the world. Two other larger economies, US and China, up until recently, had the unspoken roles of absorbing all that deflation. After-all it was America who started QE in the first place (after the crash of 2008), so it would have rather been futile, and hypocritical, of the Americans to complain to the Japanese or the Europeans. Something that changed last summer, and has been going on since, rattling financial markets (for good reasons), was the accelerated depreciation of the yuan (third chart above). This meant that America became the only major economy in the world taking on the role of absorbing all the deflation that was apparently being exported from Europe, Japan, and now also China. Market turmoil returned in January this year, with exactly the same occasion, when China decided to let its currency slide further, though this time in a somewhat slower pace. The market panicked, and the Chinese authorities intervened again. All the depreciation since the beginning of last year, causing all the turmoil, twice until now, has been around 6%. That is not going to balance China's currency squeeze. China in reality needs much higher inflation to be able to manage the servicing of its huge debt. China needs to be able to print a lot more money. The problem, obviously, is the dollar peg. Of course, some growth from the rest of the world would be welcome, but there isn't much. And with the Europeans and the Japanese having already received American (and market) blessing for their money printing, China is cornered. Or rather, China's currency is cornered.
Nevertheless, the real, fundamental, problem for the world right now is not China, but rather the inability of the world's central bankers to create demand (because interest rates are already at zero). How did we end up here? It has all started since the end of the Bretton Woods system, which linked the US dollar (hence also other major currencies) to gold. It took the Fed a while to take control of the fiat currency, but after 1980, things started to go very well for the Fed. Inflation no longer ran uncontrolled. The Fed, through a tightening monetary policy, brought inflation under control. It was probably an unintended consequence of this success that businesses and households became ever more comfortable with debt. And this comfort has not really been shaken yet, even after the crash of 2008. Although many suffered at that time, the recovery was swift, and reinforcing. Up until 2008, creating additional demand was easier, and mostly (though not entirely) left to the private sector. The government, and the Fed, conveniently ignored the fact that economic growth coincided with growing debt levels, and not on a nominal basis, but exponentially, to the GDP. However, we haven't had the reckoning yet! After each economic slowdown, the Fed lowered rates, government debt naturally went higher, and inflation picked up as economic growth gathered steam. But each economic slowdown required an ever stronger stimulus from the Fed. Achieving desired economic activity required rates to go far below previous lows (third chart). Just like in the case of an addict who gets used to the drug and needs bigger and bigger doses to feel 'the stimulus'. And when interest rates could not go below zero, the Fed, together with the government, had to do more than just lowering the rates. They came up with the QE. And of course, this time, government debt ballooned in a much faster rate (sixth chart). Not many people talked about the real problem, that we have been accumulating private debt for decades! The main reason behind the accumulation of this huge amount of debt is the (artificially) stable and calm business environment that the government, together with the Fed, have fostered. During the gold standard debt accumulation could not go on for so long and so far. Even after the crash of 1929, total debt never reached current levels (seventh chart). Government debt is not a major problem, as the US government nowadays can practically go on borrowing forever without being asked to pay back anything, but private debt is far higher now than ever before. But is this huge private debt any problem? Maybe, since we have come this far, we can go much farther! Why not? Who knows how far we can go! There isn't really anybody asking us to pay it back! Or is there? There is a lot of asking in the private sector. Banks and corporate bond holders are always asking. We have reached a point in which there is practically not enough demand for new private debt to meaningfully mitigate the impact of the natural course of older debt maturing. This may seem a bit complicated, but in fact it is not only very simple to understand, but also very easy to observe. How can we observe that not enough private debt is being issued? Well, first of all you can look at statistics, but it is most easily visible in interest rates that are unable to go up. Because there isn't enough demand from commercial banks to issue quality loans, that they feel comfortable issuing, interest rates are not going up at all. By contrast, interest rates, despite Fed posturing, are creeping downwards. Don't get me wrong, there is a huge amount of debt issued, all around the world, especially in China, but the amount is not enough to keep the debt wheel rolling. There have been so much debt accumulated over time that there is simply not enough demand for quality debt that banks can willingly issue, in order to meaningfully absorb the negative economic impact of older debt maturing. Instances like this have happened before as economic slowdowns have sapped business confidence, and significantly reduced issuance of quality loans. But in previous cycles the Fed stepped in and cut interest rates so dramatically (by several percentage points within a few months) that not only public confidence suddenly improved, but even some of the previously less desirable demand for loan suddenly turned out to be 'quality'. One is to ask a shaky business to pay 10% per annum interest, and you know it's unlikely to succeed, yet another is to ask the same business to pay 5% interest. The odds that the business will be able to pay improve significantly. This has been the real trick behind Fed easing for so long. The Fed successfully extended debt accessibility by pushing rates lower and lower after each economic cycle, until it ran out of ammunition. And this is how, over and over again, for more than three decades, debt accumulation became the norm, and not many people noticed. Currently, the whole world economy is founded on debt accumulation. It is similar to a Ponzi scheme in which first entrants, who take on debt, are paid by later entrants, and the scheme can go on so long as there are significant numbers of new entrants to enable older entrants get paid. When older entrants don't get paid the scheme starts to unravel. The payment of older entrants is in the shape of debt getting matured without going into default. And of course the debtor enjoys the prosperity of his/her businesses, or the consumption of the products and services (including housing), that he/she pursued.
The clear sign that we have reached the limit of our ability to influence debt levels within the private sector is central banks' inability to go below zero. Central banks can indeed go below zero (as the ECB and other smaller European ones have already done), but it's no longer as effective. After-all central banks need to work with the private economy, through commercial banks. Commercial banks cannot 'charge' their clients below zero interest rates. They cannot even go for zero. They need to make a profit. Otherwise they would not lend any more. The only impact of a below zero interest rate would be to encourage (or rather force) savers to get into risk assets. This is indeed an additional measure, but it is not significant (let alone risky). And it is a one-off measure. You cannot go below zero far. Previous slowdowns necessitated huge interest rate cuts. How far can central banks go below zero? Can they go 5% below zero? Can commercial banks then 'lend' money to willing people, and pay (as opposed to charging) them a few percentage points interest for every year they keep the 'loan'? This would theoretically be the end result of deeply negative interest rates. The central bank would practically pay commercial banks 5% for every loan they can successfully make, and commercial banks would cut their share, giving the remaining (perhaps 3%) to the 'debtors'. This would indeed create inflationary pressures, and in case the newly paid money would exactly look like the old ones they would all become pretty much worthless instantaneously. It is not only completely against Capitalism, it is even against Communism! It's just absurd. So, taking interest rates below zero is useless, and not worth the effort, unless you simply want to discourage foreigners from buying your currency! And that cannot be a good option for the US dollar, as the reserve currency of the world. Negative interest rates haven't done much to the EU economy either, other than probably helping (along the QE) to devalue the euro. But in case everybody would start using QE, or negative interest rates, for devaluation there wouldn't be any sense in that either. It would only mean a currency war.
There will be an end to our current economic boom, just like all the other ones in the past. This time around there is no Fed rate left to be cut (other than a symbolic 0.50%). What will happen then? Our current economic growth cycle is almost 7 years old, which is a respectably long one. Although some may argue that it has been too mild to be called an economic cycle, it does not necessarily require a cycle to be bombastic to be called a cycle. A cycle starts with growth, whether mild or strong, and ends with a slowdown, which can also be mild or harsh. Looking at the chart below, economic growth over the past 7 years doesn't look markedly different from previous growth cycles. So I don't see any rational reason why we would not be near, or at, the end of the current growth cycle.
What is indeed very different this time, and very ominous for any rational economist, is that there is no rate left to be cut! The Fed will just have to do with QE. Last time, when the Fed could still cut rates, though not enough because they reached zero rather quickly (compared to previous rate cut cycles), they still needed QE. How big a QE will the Fed need this time? This can be anybody's guess, but most likely next QE will have to be much bigger than the previous round. And it can be. The Fed can buy treasuries of all kinds and maturities and push yields toward zero. The Fed can also buy debt directly from the government for zero interest, which would equate to government printing money directly without Fed intermediation. But since the Fed, legally and physically (or digitally), does the money printing, the government will just have to go for the fictitious intermediation for now. The private sector is awash with debt, all around the world. Central banks are unable to push them toward more indebtedness because they have been left with no more efficient ammunition. All this private debt, coupled with excess capacity accumulated in years and decades of expansion, is creating a very toxic deflationary environment. As the current economic cycle comes to an end, deflationary pressures will increase, just like in previous economic cycles. How will central bankers keep the economy going, and inflation above zero? As already explained, our current economic system is built (probably inadvertently) on the basis of ever growing debt. As long as total debt can grow exponentially (in US dollar terms, but not necessarily inside the US) to GDP, the economy will keep growing, and inflation will stay above zero. But when that fails to happen, the natural tendency is to go toward deflation, as private debt bears interest, and debtors need to find a way to produce at least the interest payment. This is extremely deflationary, as it can not only cause products and services to get cheaper, but it can also depress asset prices as debtors may end up having to sell assets to be able to service their debts. And asset price falls in a deleveraging environment can easily get out of control and create an economic depression, just like the one in the 1930s.
Our current economic system needs total debt (in the world) to grow meaningfully (exponentially) in order to achieve positive inflation and economic growth. When interest rates fail to encourage private debt to grow meaningfully, government spending must increase to outpace private slack. It is an open question though whether the government can actually spend fast enough to do that. Government in the US (including all governmental entities) is much smaller than the private sector. Debt accumulation doesn't necessarily need to happen inside the US. Debt growth in China, and its semi-peg to the US dollar, has probably been the most important catalyst for world growth ever since the crash of 2008. Our current economic system desperately needs total debt, public and private, to grow all the time, to achieve the inflationary growth we have got used to. Although no Fed, or government official, has ever accepted this reality about debt accumulation, it really isn't difficult to observe. Most of them have been unaware though. Sometimes heavy fog of our hopes and fears make observing even some of the most obvious very difficult.
In the coming period of time, with the final breaths of this maturing economic cycle (or old bull market), deflation will start to bite harder, and some kind of a catalyst is always found to be blamed for another big, or small, panic. The Fed will get its acts together, preparing for another QE, though we cannot know how big the starting QE will be. They may keep on hoping that there will not be a need for a big QE. If history is of any guidance (third chart and chart above), economic slowdowns of early 90s, early 2000s, and then late 2000s were met with ferocious rate cuts, and also QE for the last one. This time around no rate cut is left, so it would be understandable to go for a much bigger QE. But will QE be able to replace a ferocious rate cut? The reality is that some very large QEs haven't helped the Japanese or the European domestic economies that much. QE has only helped Japan and Europe export some of their deflation to the rest of the world. But this time around the US cannot use QE for exporting its deflation to other countries. It would start a currency war. China, Europe, Japan, and other smaller economies, would easily copy the US in QE and it would no longer have any impact on the US dollar. They could come together though (and they probably will) and do QE in a coordinated way, so that its purpose would no longer be devaluation but rather lower longer term interest rates. Here of course Europe and Japan would lose out as their current QE programs would not be as effective as before.
What we don't know yet is the magnitude of deflation that we are going to face. Since there is no efficient monetary policy (QE hasn't worked very well so far) left to push for more indebtedness, or stimulate economic growth, as central bankers put it, the government will have to take over more from the Fed, increasing spending so that it can replace at least some of the deflation caused by a deleveraging, troubled, private sector. The longer the anticipation of inflation fails the more desperate the private sector will become. And the government will have to increase spending significantly to add to the money supply. The equation is that a private sector deleveraging must be matched with a public sector (government) leveraging, so that we don't have deflation. It still wouldn't create inflation, but it would prevent deflation. It would, theoretically, keep total debt levels stable. Public sector leveraging must equal private sector deleveraging dollars in order not to get deflation, which could lead to asset price crashes and mass, sudden, unemployment. It is not possible to get it exactly right and it would all depend on the magnitude of the deleveraging. But the magnitude of deleveraging can also be contained to some extent with Fed intervention by lowering longer term interest rates (using massive QE). Since total government spending is less than 40% of the economy in the US, it can theoretically go much higher over time as a deleveraging private sector would retreat. The government would have to borrow more, and spend more, to compensate at least for some of the deflationary pressures from the private sector. The Fed would use QE to buy as much government debt as possible, therefore practically offering the government free money. This simply means that only the sky is the limit for the government to borrow. Government debt can go up, theoretically, forever and to any levels currently unimaginable. You cannot encourage the private sector to take more debt beyond a certain point as Fed ammunition for that encouragement reaches its limit when Fed rates reach zero. But the government can (and since it has never been tried before, I don't see why it cannot) borrow indefinitely, as much as it wants, from the Fed, for zero interest. The government would only need to find ways to spend the money without causing serious financial, social and political upheavals. And that's easier said than done. The government would just need to push its spending forward as long as private sector deflationary pressures are stronger than the inflationary pressures caused by its own spending. At some point inflationary pressures caused by government spending would replace deflationary pressures caused by private deleveraging. We just don't know when that might happen. The issue is that private sector deleveraging will create unemployment. Can the government employ all those people without losing credibility? There are serious limits to what the government can spend on. The government cannot spend money at the expense of losing credibility. That would cause hyperinflation, which would be even worse than some levels of deflation. Deleveraging will cause unemployment in the private sector, and the government will not be able to create new jobs for all the unemployed. Therefore, some degree of deflation simply seems to be unavoidable. We just don't know how much and for how long.
Private deleveraging does happen every once in a while when there is an economic slowdown. As long as there will be deflationary pressures (as opposed to inflationary pressures) from the private sector, that will simply mean private deleveraging. Increased money supply, thanks to lowering interest rates for more than 35 years, has caused a national, and global, private leveraging. A rather tedious period of deleveraging seems to be a sensible way of balancing an over-stretched private sector. It can of course continue to stay a highly leveraged private sector, even after decades from today. The level of total private indebtedness (businesses and households) will eventually balance itself without any need for further central bank, or government, intervention. We just don't know when. Such times have never been experienced before. We have never really had a serious fiat currency deleveraging before. There has been the Japanese example, which doesn't exactly make things look rosy, but Japan also had the advantage that the rest of the world could still continue leveraging. In Capitalism one cannot impose decisions on the private sector (to or not to deleverage and so on). All that authorities can do would be changes in policies that would be encouraging, or discouraging, of an action. Encouraging indebtedness has worked for over three decades, but it will not work any longer since there is no room left for monetary policy to push for another round of exponential debt accumulation. Things can, theoretically, stay at their current level of total high indebtedness, but since we are talking, and dealing, with the private sector, it is not possible to force, or ask, them (perhaps in some parts of China's private sector) to do something. Interest payments and debt maturities will come due and once in a while short-term excesses, or simple mass failures of judgment (or even bad luck), will lead to problems. We are currently facing such an issue in the commodities (including crude oil and natural gas) sector, and a huge amount of their debts (probably in the hundreds of billions) are already worthless. Such periodic episodes have always happened, and will continue to happen. Will their natural disappearance in a relatively short time remove the current aggregate over-capacity? Nobody knows for sure, but I doubt it. The debt cycle started more than three decades ago, so there must be a lot more to go before we can really say that the whole debt (or rather credit) cycle has ended. As it can be seen in the seventh chart from above, private debt is still at record levels, and its household component (along with non-financial corporate) has actually been edging upwards again recently. Therefore US private debt hasn't really fallen much since the crash of 2008. Theoretically overall debt can stay at this level, as some businesses and households go bankrupt while new ones, perhaps with new technologies and ideas, come to life and replace them. But this will not create economic growth. Our economic growth has, to a significant degree, depended on exponential growth in debt. If total debt levels do not go any higher in the US, or abroad, in a meaningful way, there will be no economic growth left. Zero inflation will also wreak havoc on most of the indebted who have counted on rising inflation to be able to service their loans. As private loans (or corporate bonds), with various degrees of rates and yields, will mature, in the absence of an anticipated inflation and economic growth, larger and larger numbers of private sector debt will become non-performing. This - coupled with the natural tendency of technology and competition which tend to be deflationary all the time - will create a strong deflationary environment. The government will have to increase spending whenever there is an acute deflationary episode. Fed QE will do little by itself, but it will be essential in reducing longer-term interest rates for the remaining, solvent, private sector who are of course heavily in debt (corporate debt, mortgages, student loans and so on). Fed QE will also reduce (and probably eventually completely eliminate) the burden of interest expense on the government. The other option would be to do nothing and deflation would become deeper and deeper, causing bank-runs, mass unemployment and practically another depression. Although the government and the Fed will work together to prevent deflation from taking hold, it is unlikely they will have complete success. As explained earlier, US government is much smaller than the private sector and there are limits how much the government can spend (without causing serious political and social issues). The government cannot hire citizens, and pay them, for doing nothing. The government can indeed start building infrastructure, but they usually take time, and still can have a limited impact in a sophisticated and massive private economy like the one in the US. Nonetheless there are a lot the government can do. And there isn't anything other than potential political and social pressures preventing the government from increasing spending. At some point citizens, and politicians representing them, might feel they are not treated fairly by a government whose spending is helping a few at the expense of a tax-paying majority. Then of course the government can cut taxes, and accumulate even more debt, which would be even more inflationary. But those same tax-payers may not agree with this strategy either. Increasing spending, and cutting taxes, are pretty much all the government can do to spur growth and increase inflationary pressures. These measures will increase the public debt tremendously, and this in itself may cause many citizens (and their elected officials) uproar because they would feel they are being treated unfairly at the expense of those who have been irresponsible in taking on huge amounts of debt. These opposing camps are already making their marks in politics as extremists (or rather politicians with unconventional views) are advancing in mainstream politics all around the world. Even in the US two extremes are currently leading the polls, both to the right (Donald Trump) and to the left (Bernie Sanders).
There is one real, and practical, question facing government intervention in the economy, other than the social and political issues mentioned above. We do not know whether the government will be able to contain deflationary pressures from the private sector, and for how long. All we do know is that the government can try, and most likely will. Or at least, the government, no matter from the right, or the left, will have to abandon some fiscal discipline and spend a lot more, and probably even cut taxes. A Republican government will do both, increase spending and cut taxes, and a Democratic government will probably do a lot more spending and less tax cuts. Increased spending and tax-cuts will eventually trickle down to the economy and create inflationary pressures. But will they also kick-start private borrowing again? That's very unlikely, until inflation accumulates so much over time that the whole credit cycle could be declared over. We have just reached the peak of this credit cycle, so this is very unlikely to happen very soon. And the credit cycle has been roaring for about 35 years, if we take 1980 as our starting point. But the most important indicator of the end of the credit boom cycle is the inability of the central government to add to private credit through more rate cuts. Assuming that the government (no matter who actually takes over) will manage to keep deflation under control, through massive stimulative measures, massive QE and also fiscal policies mentioned above, it will most likely take a very long time to unwind excess capacity in the privet sector. The unwinding can be done in a relatively gradual and orderly manner in case the government and the Fed can be steadfast in their expansionary approach. But the unwinding will happen. There cannot be any way around it. You cannot maintain free market economy and at the same time avoid technological improvements and competition to evolve all the time, adding to deflationary pressures. This is also accompanied by private debt interest expense and loan maturations. Deflationary pressures of these two competing phenomena have been contained for decades, thanks to an ever increasing private sector debt around the world. Since there is no way to push private sector debt any higher, they will naturally face a painful and probably long unraveling. A shrinking private sector can create unemployment, which would, beyond a certain level, be unmanageably high. Therefore the government will have to fill some of the gap in the economy. The longer, and deeper, the private sector deleveraging will continue, the greater government share of the economy will become. As all parts of the US government represents less than 40% of the economy, it may end up at 60% or more toward the end of the credit cycle. It will all depend on 1) depth of the private sector excess, and 2) political will. Since we haven't lived such times before, we just don't know the answer to any of the two. In the future, when inflation caused by government 'stimulus' (or maybe meddling) will start to defeat deflationary pressures, we will be able to see how big the government will have become. And I believe we are just about to start the deleveraging cycle. Businesses, in general, are doing well around the world, especially in the US. Although private sector debt is near historically high levels, defaults are at historically low levels in the US. Consumer credit default (chart below) is almost at levels not seen even during the last trough in 2006. Second chart below (Deutsche Bank Research) also shows that default rates (actual rate) are still near record lows, even with all the turmoil in the energy and commodities markets.
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Click to enlarge
Some might say, or believe, that it is not possible for the government to spend indefinitely and add to its debt. All the evidence of our past experience with fiat money (printed by the few credible, stable, and democratic governments like US, UK, Japan, Switzerland etc) proves otherwise. It is possible though that only the Fed may be able (thanks to dollar's reserve currency status) to surpass certain levels without causing a capital flight. Can the government end up having 1,000% or more debt to GDP? I don't really see any reason it couldn't. The only problem would be, that in case it did happen, it would mean either that the government ends up owning a huge amount of hitherto private assets, or that the private sector would shrink so dramatically that a not-so-bloated government (assets-wise) would become comparatively much bigger. So, either the government would end up buying a huge amount of delinquent private assets in order to prevent the value of the collateral falling for the not-yet-delinquent private sector, or the private sector would shrink so dramatically (after deleveraging) compared to a relatively stable government (in assets) that the government would end up becoming a giant in comparison. Something similar to this (hopefully not very dramatic) seems to be the future. There is of course, as mentioned before, the social and political aspect, which can never be accurately predicted. There will be an ongoing battle between the indebted, and the not-so-indebted, the employed, and the unemployed, employees of the private sector, and those of the public sector. These social and political battles will eventually decide how big, and in which way, the government will end up being. But no matter which camp gains the upper hand and when, the government will end up much bigger than today. This will simply happen as the result of the government's inflationary actions against a deflationary deleveraging of an over-indebted private sector. But in the end risk asset (stocks, property etc) prices will fall and unemployment will rise, but at a much more manageable pace. It might end up, if we are lucky, being similar to the 1970s (in economic hardship), but instead of inflation there would be deflation, though hopefully in a much more moderate way than in the 1930s. Avoiding deflation all-together seems almost impossible unless the government takes measures (paying people for no reason, raising salaries, or maybe even giving large cash handouts to the indebted) which would render money worthless causing even greater problems for the economy.
How will the government succeed in borrowing such huge amount of money while the private sector will be in economic malaise? The government doesn't need to borrow money from the people. The government can also borrow the money directly from the Fed (Europe and Japan are already doing something similar, though there is still room) at zero interest. The Fed can roll on the debt indefinitely and the government can keep borrowing forever. Of course, as also mentioned before, there are two important issues when embarking on such an unprecedented adventure - social and political support, and government's practical capacity to add enough stimulus to the economy. But borrowing in itself is no problem at all. The government has one huge advantage no private debtor does - the Fed will never ask the government for its printed money back. The fed can simply print more! Nowadays there isn't even a need to print money on paper - it can all be done digitally. And after the credit cycle is over and we end up with a huge government and a much smaller private sector, government debt will be money owed by the government to the government, or a branch of it, the Fed. The Fed can then simply delete the debt and start from scratch, eventually after a bill passed in Congress which would allow it to do so. Of course it would be bizarre to maintain our current monetary model after such an embarrassment. The whole system would need an overhaul. The system must contain indebtedness to a certain level so that excess capacity does not build up in the private sector. And governments, and electorates alike, must become more tolerant of economic cycles and not expect continuous growth. We need the private sector. After-all our current prosperity has been achieved, fundamentally, through private ingenuity and entrepreneurship (beside a huge amount of debt). We cannot end up giving up on private enterprise and create a monster government. That would be similar to creating a democratic Communism out of a failed Capitalism.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am short Nasdaq 100 and the Hong Kong dollar.