The greatest debt expansion in history draws to a close.
Conventionally measured economic growth is related to two aspects of debt: its growth rate and its marginal effectiveness. In terms of economic growth, debt should be thought of as a factor affecting production, like the supply and cost of labor, capital goods, and land. A business can increase the supply of whatever goods or services it produces by borrowing money. Whether it does so depends on the cost of debt service versus the expected return from the expansion. As long as the latter is greater than the former, the business should add debt and expand. This analysis applies to an economy as a whole: debt should increase as long as the return from debt is greater than its cost.
The more debt an entity incurs, the less productive each additional unit of debt becomes—diminishing marginal returns. For the global economy, the point has been reached where the benefit of an additional unit of debt is less than its cost. That point was probably reached years ago, but debt-funded consumption, and governments and central banks machinations, have obscured this reality. In GDP accounting, an increase in consumption is treated as an increase in GDP, regardless of where the money came from to pay for it. Increasing debt to fund consumption increases GDP. However, such debt, because it does not fund investment, does not increase production. There is no economic return to offset its costs; it’s economically counterproductive.
For at least the last seventy years, debt in the US has grown faster than GDP. The same is true for most of the developed world, including, since the turn of the century, China. The increasing absolute level of debt relative to GDP has only been partially offset by generally falling interest rates. The debt service burden has increased, debt is increasingly funding consumption, and that which is funding production has run into minimal or negative returns.
DEBT THAT PAYS FOR WAR IS THE STUPIDEST DEBT OF ALL
If this were happening in a strictly market economy, debt would be reduced, either paid off, rescheduled, or repudiated and written off. However, government and central bank fiat debt—debt that can be incurred in unlimited quantities by governments and central banks—stifles these adjustments. The central bank can use its fiat debt to purchase the government’s fiat debt (debt monetization) and in so doing set the price, or interest rate, for the government debt, influencing the configuration of interest rates throughout the economy.
Some who despair at these machinations conclude that there are no longer any adjustment mechanisms and that the machinations can continue in perpetuity, the tree of some asset prices (equities and real estate) growing to the sky. Perhaps they are right; the global expansion of central bank balance sheets since the last financial crisis is unprecedented; it’s at least a theoretical possibility that it will never end. However, this game of central banks conjuring fiat debt and monetizing governments’ debt (and other financial assets) doesn’t operate in a vacuum, rather it has promoted debt growth in the overall economy. There, signs that the marginal return on debt is now negative, that the burden of debt service outweighs the benefits of debt, are abundant, and debt contraction will happen regardless of the desires of central bankers and government officials. There are only so many private income streams that can pay debt service, only so many private assets that can be collateralized.
Global debt stands at a record 325 percent of global GDP. That number includes government and private debt, but not unfunded pension and medical liabilities. Their inclusion would significantly raise that percentage. As a greater proportion of income is devoted to debt service, a smaller proportion is left for saving and investment, which funds future growth, and consumption.
The long downtrend in global growth confirms the increasing toll of interest and principle repayment. In the most heavily indebted nations—Japan, Greece, Italy, Spain, Portugal, Puerto Rico, Brazil—GDP has been in multiyear contractions. In much of the rest of the developed world’s welfare states—the US and Western Europe—growth has been in long-term decline, and suspect price index calculations and seasonal adjustments cast doubt as to whether those economies are growing at all. In the US, annual growth never reached 3 percent during President Obama’s tenure, a first for a US president. Debt-fueled economic growth in China is slowing, probably more than suspect Chinese statistics are allowed to show.
US household debt has surpassed its 2008 peak and corporate and US government debt are at all time highs. Puerto Rico and Detroit have sought relief from creditors and Illinois and Chicago will soon join them. The municipal insolvency parade is just starting. Mounting unfunded pension liabilities are swallowing an ever-increasing share of municipal budgets.
Banco Popular in Spain was sold earlier this month for one euro after it exhausted its credit lines in a vain effort to contain depositor withdrawals. Equity and bond owners bore the brunt of the bank’s losses. Last Friday, two banks in Italy were shut down by the European Central Bank after repeated rescue attempts failed. More Italian banks will fall; their entire system is essentially insolvent and the economy hasn’t grown in years. Europe is holding its breath hoping that Italy’s depositors don’t panic, but they will
The last financial crisis started in the housing, mortgage, and mortgage-backed security sector, but was not, contrary to numerous official assurances, “contained” there. A debtor’s debt is a creditor’s asset. When the credit creation process reverses and a debtor’s debt is either rescheduled or repudiated, its creditor’s assets are impaired. That can impair the creditor’s ability to pay its own debt and curtail its extension of new debt. The 2008 crisis demonstrated how this chain reaction quickly spreads beyond the sector in which it began. Now there are multiple sectors that are as inflated as housing was back then and some are already unraveling.
According to Citibank, the growth in total global credit has just gone negative after eight years of the greatest expansion of government debt and central bank balance sheet expansion the world has ever seen. Their fiat debt can expand without limit, but not so the debt of individuals, businesses, and smaller governments bound by legal restrictions on debt issuance and without recourse to central bank monetization. Declining long-term growth trends and outright contraction, increasing outbreaks of fiscal stress around the globe, huge and growing unfunded pension and medical fund liabilities and aging populations that will draw on them are all indications that debt expansion by every class of entities but central banks and governments has hit a wall and is reversing.
There are proposals for central banks to simply hand out their fiat debt to everyone—helicopter money—and for partial or complete debt jubilees—legally mandated debt forgiveness. Helicopter money would be hyperinflation, which would devalue all debt and amount to a partial jubilee. One shouldn’t underestimate the political potency of such proposals. There are always more debtors than creditors and governments themselves are the biggest debtors. In the US there have been calls for student loan forgiveness, which are, not surprisingly, popular with millennials.
Whether or not governments enforce debt forgiveness, a de facto jubilee is coming. The world has far more debts and pension and medical liabilities than it can support and they will not be repaid, regardless of how much fiat debt governments and central banks crank out. There has never been a worse time to be a creditor: maximum risk, minimum yield. That serial defaulter Argentina was able to issue 100-year bonds at 8 percent interest is emblematic of the credit market’s thirst for yield and disregard of risk. The next ten years will a lender’s nightmare.
WHEN BUSINESS RAN ON INGENUITY, NOT DEBT
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If “helicopter money” was issued to simply offset existing debt, one could argue that it wouldn’t necessarily be inflationary (since the debt value already sort-of represents money in the mind of the debt-holder.) In practice, of course, I doubt it would be a neutral action, but I’m just saying.
While the number of self-identified creditors is smaller than self-identified debtors, I wonder if this too is a mirage. Most of the future cash flows promised to people (via debt ownership, direct or indirect) are in the form of pensions and such. I think many folks would be shocked to discover what they lost if a Jubilee was declared.
Lastly, what is the effect on bank deposits of a jubilee? Banks would be wiped out entirely, and bank balances are legally a loan to the bank from the depositor.
All roads lead to declining values for existing debt, which if they hit a Minsky Moment will initiate a stampede for the Bond Market exits, constituting the largest “bank run” in history even before the tsunami gets to bank accounts proper.
But then again, who knows? These are uncharted waters we navigate.