Warning: Economies In Danger

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Summary

The three dangers.

Is there any dry powder left?

Who will bail out the Wizards?

In 1998, Long Term Capital Management (LTCM) rocked the financial markets losing $4.6 billion just a few short months after the 1997 Asian financial crisis and the 1998 Russian crisis. Ironically, two of LTCM's directors had shared the 1997 Nobel Prize in Economics. In September of 1998, the company's equity started at $2.3 billion and tumbled to $400 million just three weeks later. Given liabilities in excess of $100 billion, their leverage ratio was more than 250-to-1. It took 16 financial institutions (foreign and domestic) to bail out LTCM.

Just ten years later, the world was rocked by another financial crisis, orders of magnitude larger, that required a bailout from the Federal Reserve and the U.S. government (taxpayers). The Fed increased their balance sheet to over $4 trillion and the taxpayers provided the American Recovery and Reinvestment Act to the tune of $800 billion.

Notice the size of the second bailout compared to the first. Who will bail out the Fed and the U.S. government during the next crisis? This article examines three major risks that could place policymakers in the position of answering the previous question.

Debt

I won't delve into some of the root causes for the world's debt problems since I detail them in my book. An examination of the scope of the debt expansion is instructive. The following figures are courtesy of the Bank of International Settlements (NASDAQ:BIS). The table illustrates the magnitude of outstanding global debt (in $ trillions) from financial, government, corporate, and household sources.

Year

Outstanding Debt

Debt as a % of GDP

2000

87

246%

2007

142

269%

2014 (Q2)

199

286%

The first two years in the table are important. The year 2000 marked the end of the secular bull market that began in 1982. I discuss secular and cyclical markets in this article. The year 2007 marked an important top in the stock market and the end of a cyclical bull market within the secular bear. 2014 marked the ending period of the BIS study.

A household, a country, or the world can sustain debt increases provided there is growth. The chart not only shows how fast debt is accruing but how much larger a share it is consuming of the productive capacity of world economies. In Escaping Oz, I provided a rudimentary example of how one might assign a sub-prime credit score to the U.S. government (NYSE:USG). The USG's debt as a percentage of GDP is closer to 105% give or take. The percentage figures in the table are frightening in comparison.

Accumulating debt most rapidly are governments. In the opening paragraphs I noted that in the last crisis, government (taxpayers) provided a portion of the bailout. Debt is also growing in the other sources (financial, corporate, and household) though at a slower rate.

Household debt tapered initially after the 2008 financial crisis though it has returned with a vengeance. Specifically, student loans are now in the rarefied air of $1.3 trillion, a more than four-fold increase in the last dozen years. Default rates reached a peak and are rising.

Sub-prime auto loans have fueled booming car sales. These types of loans provide automobiles to weaker borrowers. A manifestation of this weakness is the percentage of vehicles being traded in that are upside down. According to Edmunds, almost a third of all vehicles offered for trade-in have negative equity. This will simply exacerbate an already weak borrower.

I've often heard that U.S. corporations are sitting on mountains of cash just waiting to be liberated. This is true for the top 1%. The bottom 99% are adding debt. Their cash-to-debt ratios hover around 15%, which is a low mark for the past decade. The low interest rate environment has caused many firms to accumulate debt, often for share buybacks and dividend payouts. This sort of debt accumulation is not conducive to income generation necessary to retire debt.

Gross Domestic Product/Productivity

As I mentioned in the section above, if debt grows, ideally, it should be matched by a commensurate growth in income/revenue. As noted in the table, debt-to-GDP ratios are increasing. In order to "fix" that ratio, debt must go down or GDP must go up. The world has an insatiable appetite for debt and the Wizards at the Fed and government have done everything in their power to encourage debt formation. That means the world needs to increase GDP. The formula for GDP, using the Expenditure method preferred by the U.S. Bureau of Economic Analysis, is as follows:

GDP = Consumption + Investment + Government Spending + (Exports - Imports)

Another way to look at GDP is to consider the number of people working and the productivity of each. If an economy has 10 workers and each produces $50 of value, the GDP is (10 x 50 = $500). In order to grow, an economy needs as many workers producing as much as possible. The ensuing two charts will show how labor productivity (first chart) and labor force participation (second chart) have fared since the year 2000.

With productivity in decline, save for the blip after the 2008 crisis, and labor force participation doing the same, GDP will be stressed to rise.

Consumption is also impacted by the number people actually consuming (i.e.) population growth. In Russia and Japan the population is actually contracting while in the Euro region, some countries are experiencing the same. In the U.S., the population is increasing mildly, mostly as a result of immigration. There are not flocks of immigrants headed to Russia or Japan so those countries will have to examine policy.

Gross Private Domestic Investment in the U.S. peaked in 2006 then fell dramatically into 2009 before resuming its upward course - helpful for GDP.

Government Spending increased during the Great Recession though its rate of increase has slowed. You can bet the Keynesians near the White House and Congress will make sure this component does not falter. This is why you hear discussion about infrastructure spending.

The U.S. economy has had a persistent deficit of net exports (exports - imports) since the year 2000. The stronger dollar will only exacerbate this. For other countries, say Germany, this figure will be positive.

The combination of slowing growth and increasing debt is lethal. Great Depression 2.0 will be hard to keep at bay. What can the Wizards do?

Wizards and their policies

The fallacy of the Wizards will be laid bare during the next financial crisis. In 2008, the Wizards in government and central banking took drastic action via massive spending, interest rate slashing and asset purchases with money created out of thin air. Do they have any dry powder left?

Global government expenditures have increased by over 9% annually since 2007. They tried to fill the void left by consumers who stood on the sidelines. Could they increase more? I fully expect governments worldwide to at least attempt it with central banks sopping up additional debt through government bond purchases, but there is a limit.

After the last crisis, the drastic measures taken by the central bank Wizards were not unwound. The Fed still has a $4 trillion plus balance sheet (they started well below $1 trillion before the crisis). Interest rates are still historically low. I can't suggest what the ultimate size of their balance sheet might be though the current nationalistic tones expressed in many countries may question this wizardry. If interest rates are near zero, how much lower can they go? If you believe in negative rates, I offer you an article from earlier this year on this topic.

In the next crisis, the public will no longer trust the Wizards. The ruling elite understand this and are looking for the next source of economic salvation.

Summary

Debt, Gross Domestic Product/Productivity, and the Wizards are the greatest threats to the economy. Debt is increasing at a rate faster than growth. Growth is lagging due to a variety of factors including lower productivity, slowing population growth, and lower labor force participation. The Wizards that so many have relied on for so long, are short on policy options to brew the inflation that will increase nominal growth and lessen debt burdens.

The next financial and economic crisis will leave policy wonks and government leaders looking for new and untried options, which can be covered in another article.

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.