Can a Fed Move Stop the Debt Supercycle?

by: Larry MacDonald

Friday's economic reports showing softness in U.S. employment and industrial production fanned recession fears and hit stocks hard, but an aggressive easing of monetary policy is expected to rally stocks -- especially emerging markets and U.S. large-caps -- once the usual fretting and handwringing subsides. That, in a nutshell, is the kind of scenario the Bank Credit Analyst advisory seems to be espousing.

It’s not that Federal Reserve Chairman Bernanke is such a nice guy but that the “Debt Supercycle” will force the Fed’s hand, starting with a likely 50-basis-point cut in its key lending rate at the institution’s rate-setting meeting on Jan. 30. The term, “Debt Supercycle” is attributed to the BCA advisory, which has chronicled the rise of U.S. debt in one of the scarier charts to be found on the long-term prospects for the U.S. economy.

You’ll find it on page 3 of the document, An Inflection Point in the Debt Supercycle (although this particular portrayal downplays the uptrend with a longish horizontal axis). It shows U.S. non-federal debt as a percentage of GDP from the 1970s to present. As can be seen, the percentage of debt to GDP has been cycling ever higher – from 100 to 180 (with the surge since 2000 quite startling).

What this means is that there is a real capacity for a major economic implosion if market forces are left to unwind on their own. A debt-deflation spiral like the Great Depression of the 1930s is a possibility even -- unless the Fed responds quickly and dramatically (as it likely will) to stop the economic multipliers from gathering downward momentum.

There will be the usual fears over “pushing on a string,” and deflationary vortexes but the history of the Debt Supercycle and Fed policy indicates the latter wins out. Besides, there is still plenty of scope for a policy response of sufficient magnitude thanks to low consumer price inflation, aided by fiscal re-stimulation (federal debt is still relatively low at less than 40% of GDP), and a falling dollar.

The side effect of staving off another financial Armageddon will be another upleg in the Debt Supercycle and bubble-like episode (BCA’s picks emerging stocks and U.S. large caps as the favored assets). But this leaves one wondering where it will all end. Debt can’t keep rising relative to income forever. Perhaps the doom-and-gloom prophets will be right eventually about a supernova-like trauma. I don’t look forward to that at all.

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