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Ray Dalio, billionaire founder of one of the world's largest hedge funds, Bridgewater Associates, provides a thoroughly researched and agonizingly cogent explanation of credit cycles in his book titled Principles for Navigating Big Debt Crises.
Since our debt in America is denominated in our own currency, the next debt crisis is almost certain to be a deflationary one, says Dalio. And in such crises, central banks try to offset deflationary pressures with the inflationary act of lowering interest rates.
This may work for a while - many decades, even - but "when interest rates reach about 0 percent, that lever is no longer an effective way to stimulate the economy." Policy makers try to deal with the crisis through strategic debt restructuring and, because incomes and thus tax revenues are falling, austerity measures. "In this phase, debt burdens (debt and debt service as a percent of income) rise, because incomes fall faster than restructuring, debt paydowns reduce the debt stock, and many borrowers are required to rack up still more debts to cover those higher interest costs" (Big Debt Crises, Pt. 1, p. 15).
When interest rates have no more downside room, central banks inject liquidity into the financial system via digital money printing (given the equivocatory name of "quantitative easing") in an attempt to revive inflation. The idea is that the central banks' buying of debt assets - both treasuries (e.g., the iShares Core U.S. Treasury Bond ETF (BATS:GOVT)) and "toxic" assets like mortgage-backed securities (e.g., the iShares MBS ETF [MBB])) - will induce banks to lend, investors to invest, and savers to spend. But it turns out that inflation (in terms of the consumer price index) only results if QE is dispersed in large quantities. Those whose debt assets were purchased by the central bank go on to buy other financial assets, so "there must be very large market gains before any money trickles down into spending" (BDC, Pt. 1, p. 36).
And this "wealth effect" from QE is only experienced by a fraction of the population. NYU economist Edward Wolff demonstrates that, as of 2016, the richest 10% of American households own 84% of stocks. While only 27% of the middle class own "significant stock holdings" ($10,000 or more), 94% of the rich do. This may partly explain why luxury goods inflation is hitting 6% while consumer price inflation struggles to hit the Fed's 2% target.
Will the Real Depression Please Stand Up?
Dalio refers to the Great Recession of 2008-2009 as a depression and said in 2014 that the U.S. is in the midst of a "beautiful deleveraging," but would the Great Recession qualify as a "depression" according to his theory? Dalio says that depressions happen only after interest rates have been reduced to zero, extensive QE has been implemented, and substantial deleveraging occurs. Was that the case in the wake of the Great Recession?
Not really. Monetary policy makers had not yet exhausted their tools. They were able to drop interest rates by a little more than 5%, roughly the same amount as rates were dropped in 1990-1992 and 2001-2003. They also significantly ramped up the Fed's balance sheet from less than $1 trillion to $4.5 trillion-a $3.8 trillion increase.
But what about deleveraging? Surely with all the pain of the Great Recession, substantial and lasting deleveraging occurred at least somewhere. Right?
Well, it certainly didn't manifest in the public sector, either in total dollars or as a percent of GDP.
According to mainstream (predominantly Keynesian) economists, we should see government debt spike during recessions as automatic stabilizers kick in to maintain a base level of consumer spending, even as tax revenues fall. However, the acceleration of fiscal deficits (much less the lack of deleveraging) even ten years into an economic expansion defies any economic theory.
What about on the consumers' side? We did indeed see some deleveraging of mortgage, auto, and credit card debt during the recession ... that was promptly reversed around the time the second iteration of QE began in 2010.
Given the lack of sustained deleveraging in other areas related to the consumer, it should go without saying that student debt, almost entirely under the control of the federal government, has likewise seen no deleveraging.
You might object that total corporate debt matters less than debt-to-earnings or total debt as a percentage of GDP. And you would be right. Corporate debt as a percentage of GDP did indeed fall during the Great Recession ... but it resumed its climb around the beginning of QE2 and now sits as high or a little higher than in 2008.
Admittedly, current margin debt of 3% does not quite rival the excess seen in the stock market boom leading up to the Great Depression. (Given that the broker loan market reached $8.549 billion in 1929 and U.S. GDP stood around $105 billion in the same year, peak margin debt prior to the Great Depression reached 8.14% of GDP.) But it is now as high as it has been since then.
Objection: What About Total Debt to GDP?
One might object that while many forms of debt have increased since the Great Recession, total debt to GDP has actually declined. Dalio contends that the U.S. is in the midst of a "beautiful deleveraging" and shows this chart as proof:
First, as it pertains to debt service, it's necessary to remember that, since 2009, we've had eight years of near-zero interest rates. With rates being held low for that long, it's not surprising to see the interest burden fall even as total debt remains elevated.
And what explains the moderating total debt level? The main reason is that the housing bubble popped.
But there are specific reasons why a housing bubble was inflated in the United States, and those reasons have largely been dealt with. For instance, there is no longer a political push for "every American to own a home" like there was in the 2000s. Nor is it as easy now as it was then to originate loans to individuals who had no business taking on a mortgage. Nor, lastly, are Fannie and Freddie buying as many subprime or otherwise risky loans now as they were then.
If you adjust for the anomaly of excessive mortgage debt in the early to late 2000s, then the peak in debt-to-GDP which hit in 2009-2010 disappears.
Likewise, though credit card debt is higher today than in 2008, it has fallen somewhat as a percentage of GDP. Notice, however, that it leveled off in 2014 and began climbing slightly by 2016. If credit card debt continues to climb as GDP growth slows (as it is expected to in the coming years), then revolving credit to GDP could easily rise back to its previous highs in the early and late 2000s.
Will the Next Recession Be the "Real" Depression?
With the sort of debt situation we find ourselves in here in the U.S. (not to mention that much of the world is even more indebted than we are), it's difficult to see how the "big one" has already come and gone. Shouldn't a beautiful deleveraging involve more ... well, deleveraging?
The lack of substantial deleveraging, combined with the fact that the Federal Reserve hadn't quite run out of monetary policy tools in 2008, leads me to believe that the "big one"-the debt crisis which will leave no option but to painfully deleverage-has not yet hit us.
With another recession on the horizon, $4 trillion still on the books of the Fed, and the Fed Funds rate sitting at 2.5% (and widely expected to stay there in 2019), it sure looks like monetary policy makers have run out of fuel.
Source: Studebaker Studio
With this in mind, it's reasonable to conclude that the "big debt crisis"-the culmination of the long-term debt cycle-has not yet come. It's still lurking in the shadows of the near future. As bad as the Great Recession was, we will likely experience something worse the next time around.
And the "next time" is looking closer and closer.
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