Crisis Progress Report (16): It’s Gone! by Robert Gore

Sixteen trillion dollars is a lot of money. That is approximately the size of the combined balance sheets of the world’s major central banks: the Federal Reserve, the European Central Bank, the Bank of England, the Bank of Japan, the Swiss National Bank, and the People’s Bank of China. It is 35 percent of their nations’ GDPs, up from only 14 percent in May 2006, when balance sheets summed to just shy of $6 trillion.

Here’s a larger number: $225 trillion. That’s the estimated global grand total of individuals’, businesses’, and governments’ nominal debt. It is over 14 times as large as major central bank balance sheets; the smaller figure is 6.23 percent of the larger figure. In the good old days when central bank balance sheets were larger relative to total debt, economics students were taught that when a central bank expanded its liabilities (currency and member bank deposits), the expansion had a multiplier effect as it worked its way through the banking system (those liabilities were sometimes called “high powered money”). In the good old days, a 166 percent increase in central bank liabilities in just ten years would have produced rip-roaring economic activity and galloping inflation. Pull out the end of the year polls of economists since 2006 and that has been the annual consensus, without the colorful adjectives: stronger growth and a pick up in inflation.

The economists have fixated on the smaller number and ignored the larger one. They rarely look at debt as an economic input that affects investment, production, and consumption. Like every other input, increasing debt leads to diminishing marginal returns. Debt’s return is automatically negative when it finances consumption, which yields no economic return versus debt’s interest and repayment burdens. Too much debt can lead to negative marginal returns for speculation, investment, and production as well, because as they increase, their expected returns decline below the costs of additional debt. It is safe to assume that with $225 trillion in global debt versus roughly $76 trillion in gross world product, the marginal return on debt, much of which has funded consumption, is negative. It is also safe to assume that most income streams are implicitly or explicitly servicing debt, and that most assets serve as either implicit or explicit security for one or more loans.

People are rational—sometimes—and when the real costs of debt outweigh the psychic` benefits of consumption, they usually seek to reduce debt. Enterprise does so as well when returns on speculation, investment, and production are below the hurdle rate implied by prevailing interest rates. Governments can temporarily exempt themselves, but even they eventually run into reality. As the marginal return on debt goes negative, debt is paid down or written off, liquidity is hoarded, and the velocity of money slows.

Central banks have been trying to foster credit expansion, but other than facilitating governments going deeper in debt and promoting speculation, their actions have had no discernible economic impact. Contrary to the textbooks, increases in their balance sheet liabilities, which are primarily reserves of the banking system, now has no multiplier effect at all. They either lie inert on banks’ balance sheets or, for the large money center banks, transmogrify into funding for their speculative activities.

Because what used to be high-powered money—fiat currencies plus banking system reserves with the central bank—is now no-powered money, in the inflation versus deflation battle, central bank units will be matched, unit for unit, against non-central bank debt. That’s $16 trillion against $225 trillion, which is why deflation has taken the lead and will win. If credit contracts a mere 6.23 percent, either through voluntary reduction, rescheduling, or repudiation, that offsets all central bank debt.

In response, central banks can theoretically issue an infinite amount of their own debt to exchange for an infinite amount of assets, but most central banks already have three digit debt-to-equity ratios (which would get them shut down if they were private banks). Every asset they purchase is subject to price risk, so it would require only a small price “correction” to wipe out their equity. Central banks don’t mark to market, and their governments make up losses and recapitalize them when necessary. That shifts the loss to those funding the government: taxpayers and creditors. However, from the standpoint of economic analysis, the most important point is the loss, not who bears it.

The more central banks have used their powers, the less powerful they have become. Negative interest rates, and proposals to ban cash and hand out fiat debt are last gasp confessions of complete impotence from a snow shovel brigade in front of an avalanche. The credit contraction underway will wipe out much more than 6.23 of the world’s debt, and it will wipe out the central banks, no matter how much government debt they monetize, savings and wealth they confiscate through negative rates and cash bans, and fiat debt units they paradrop. Most of what the world today reckons as wealth is simply someone’s debt (or worse, a residual after debt has been paid, i.e., equity), and as debt contracts, the world will come to a painful realization about its “wealth”: It’s Gone! At that point, pick your analogy: the avalanche buries the town, the dominoes fall, the skyscraper of cards collapses, the bubble bursts. The last analogy can be extended: no amount of central banks and government huffing and puffing will re-inflate the bubble.

Manias are a herd phenomenon; sanity restoration an individual project. Eventually, some, maybe enough, individuals will rediscover enduring truths. Deferred gratification, saving, investment, production, hard work, voluntary exchange, and honest capitalism are real. Fiat debt from central banks and governments, taxation, regulation, and crony capitalism are shell games designed to extract compliance and every last penny from the rubes. While waiting for sanity restoration to kick in, realize that if you can’t touch an asset or hold it your hand, it’s not an asset on which you can depend. Prepare accordingly.

AND IT’S GONE!

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