The debt dam is crumbling as central bankers and government officials frantically refill the escaping lake with eye droppers.
As background to this article, it would be helpful to read an article I wrote in 2015, “Real Money.”
The foundation of the world financial system is debt. Every currency in the world is debt whose value is not tethered to any real value. In a rare display of official truth-in-packaging, right there on the instrument itself a US dollar bill tells you it’s debt: Federal Reserve Note. A note is a debt. What do holders of Federal Reserve Notes, officially creditors of the Federal Reserve, get for repayment of the debt they hold?
Federal Reserve Notes have no maturity date, pay no interest, and can never be redeemed. If you go to a Federal Reserve branch and try to redeem one, they will either not accept it or they will exchange it for an identical Federal Reserve Note. Why would anyone accept this peculiar instrument? Because you cannot refuse it. Also right there on the dollar bill it says: THIS NOTE IS LEGAL TENDER FOR ALL DEBTS, PUBLIC AND PRIVATE. For American transactions, it’s reject the dollar, go to jail. The American government even levies punitive measures on foreign governments that just say no.
Because central banks and governments can repay their debt with more of their own debt, they have been unconstrained in the amounts they produce. You and I would do the same thing if we were so empowered. Governments, central banks, and debt are a ménage à trois from hell. The US ménage has debased the currency’s value against real goods and services at least 95 percent since the establishment of the central bank in 1913. The ménage’s ill-gotten gains are someone else’s loss—gullible savers and creditors who believe promises by politicians and central bankers that they will not engage in the debasement they have every incentive to promote.
Promoting debt in the public sector, the ménage also seeds it in the private sector. It should surprise no one that central banks tend to favor the politically popular and fiscally friendly (to the government) course of suppressing interest rates below where purely market-determined rates would be.
They are also a ready market for their governments’ debt, a process often mistakenly called monetizing debt. It’s really just an exchange of central bank debt for government debt. If you read “Real Money” you know that no money and consequently, no monetization, is involved. It should be called debtizing debt, but debtize and debtizing are not words. We’ll use them anyway. By having the central bank debtize its debt, the government avoids pushing up interest rates and crowding out private borrowers in the credit market, thus encouraging more private borrowing.
Paying back creditors with a devalued currency benefits all debtors, not just governments and central banks. Forget those hoary old homilies about pennies saved being pennies earned. For older folks, pennies aren’t even worth the lower back pain of picking them up off the floor. Everything governments and central banks do make debtors winners and savers suckers.
If I borrow at 5 percent to fund an investment that returns 10 percent, it’s a productive use of debt. If I borrow at 5 percent to fund a vacation, its economic return is zero percent and I have to repay the debt and interest. Most of the world’s debt is not just unproductive, it’s counterproductive. At positive interest rates debt-funded consumption is always an economic loser, yet most of the world’s debt funds consumption.
There is a school of thought called Modern Monetary Theory (MMT) that essentially says that central banks can debtize their governments’ debt and the governments can then use the central banks’ debt to buy guns, butter, and anything else the populace desires without consequences. It’s like those one simple tricks on the Internet that eliminate fat, wrinkles, baldness, or impotence. It isn’t as if this one simple trick hasn’t been tried and found wanting—repeatedly. See, for instance, Chapter 1, “The Mississippi Scheme,” of Charles Mackay’s classic Extraordinary Popular Delusions and the Madness of Crowds. Nevertheless, MMT is finding its rightful place in college curriculums along with Marxism, Keynesianism, and other economic and philosophical snake oil.
Central banks can swap their debt for governments’ debts until we’re all millionaires, billionaires, and then trillionaires, but there is a tether that eventually returns the whole daisy chain to earth: production. Here is a heretical idea that is nonetheless true: before something can be consumed, pledged as collateral for a loan, or its income stream used to repay debt, it must be produced. Debtors want to buy real goods and services with their debt, and creditors want to be repaid with either real goods or services, or with a debt they’re confident can be exchanged for real goods or services.
Ever-expanding debt can forestall consequences until debt saturation is reached: a unit of new debt buys less than a unit of production; debtors’ debt service burdens preclude incurring more debt, and creditors’ recognize that further extensions of credit are unlikely to be repaid. Once that point is reached, the process reverses and debt contracts. Debt contraction was gathering steam before the coranavirus outbreak and the official response has only accelerated it. Central bank novocaine masks it, but like real novocaine the central bank variety wears off and the patient must deal with the pain.
Central bank balance sheet expansion has been massive and unprecedented. The Federal Reserve’s has gone from just over $4 trillion at the beginning of March to just under $7 trillion, much of it debtizing the US government’s exploding debt. The Bank of England’s balance sheet has ballooned from £580 billion to about £780 billion, and the European Central Bank’s from €4.6 trillion to about €6.3 trillion. (The Chinese Central Bank’s has shrunk a bit.) Against what standard are these expansions to be measured? They’ve certainly put a spring in the step of financial assets and precious metals. However, they’re not going to stop a deflationary global debt contraction. This would be the case even if debt velocity—the rapidity with which debt turns over in the economy—were not pinned to the floor, which it is (see “Macro View: Fed Wants Inflation But Their Actions Are Deflationary,” by Lance Roberts.)
Compare magnitudes. Aggregated, the three central banks have expanded their assets—mostly with governments’ debt—about $5.25 trillion at current exchange rates. Nominal global debt is around $250 trillion, or over 47 times the expansion. Unfunded government pension and medical liabilities are multiples of governments’ stated debt (in the US they are $153 trillion versus stated federal debt of around $26.5 trillion, according to usdebtclock.org.), and the global derivatives market is so huge and opaque it can only be estimated—$1 to $2 quadrillion (one-thousand to two-thousand trillions). Derivatives are financial instruments whose prices are derived from other prices, generally those of another financial instrument, a commodity, or an index. They involve mutual promises of future payment or performance so they can be thought of as debt-like.
If you add all those debt and debt-like promises, let’s conservatively underestimate the global total at $2 quadrillion. That’s about 376 times the central bank balance sheet expansion. Say that only a wildly optimistic 10 percent of debt and debt-like promises go bad, that’s still 37.6 times the central bank balance sheet expansion.
You can argue that focusing on the debt side of the ledger ignores assets, which can be sold to pay off debts. That brings up a key point: at what prices can assets be sold? In our interconnected world, most financial assets are debt or equity claims whose prices have been lifted by the ongoing expansion of debt. If debt is contracting, what happens to prices? The nominal value of financial and other asset prices declines, but not the nominal value of debt. Which means more assets must be sold to meet an existing debt obligation, feeding into falling asset prices.
Credit extension and debt repayment are linked to production. As the debt daisy chain unwinds, both production and its income streams are subject to creditor claims. Bankruptcies reduce production and incomes, putting further stress on the system. In their wisdom the rulers of the world have addressed the threat of a germ by closing businesses and putting people out of work. These unquestionably (they’ve done their best to suppress questions) judicious and necessary policies have the unfortunate side effect of curtailing production, exacerbating the burgeoning debt crisis.
Central banks and accounting legerdemain (see “No Payment, No Problem: Bizarre New World of Consumer Debt,” Wolf Richter) allow limited extend and pretend, but it can’t last forever, or even much longer. Someone has to bear the loss of debts that won’t be repaid, those losses have to be recognized, and they will snowball throughout the financial system, intensifying the scramble for real production and income to cover them.
Debt contraction has initiated a global margin call. A speculator who is margined 10 to 1 borrows $10 for every $1 of his equity. A move of more than 10 percent against his speculation triggers a margin call that wipes him out unless he puts up more equity. If debt and debt-like promises are a conservatively underestimated $2 quadrillion, a global margin call will quickly overwhelm gross world product of around $100 trillion (5 percent of $2 quadrillion), debt supported asset prices (all of them), and the hyperactive swapping of central bank for government debt. Anything and everything will be for sale to meet the margin call and there will be few buyers. As more than one economist not currently taught in schools or universities has recognized, debt contractions are inherently and inevitably deflationary, regardless of what governments and central banks do to try and stop them (they usually create more debt).
The political impetus for debt jubilees—the mandated cancellation of debts—will be irresistible, and will find a sympathetic ear in governments, the world’s largest debtors. Already there is talk of debt forgiveness for certain classes of politically favored borrowers. That movement is still in its infancy, but in an age of increasing uncertainty and unpredictability, its explosive growth may be the easiest trend to predict over the next ten years, at least.
De jure jubilees will be accompanied by de facto ones. Unable to pay, people, businesses, other private entities, and governments will walk away from their debts en masse without penalty other than a destroyed credit rating. Those defaults will ratchet up the financial food chain, especially as assets are marked to market while liabilities must remain on the books at their nominal values. Virtually all of today’s nominal net creditors—banks, insurance companies, pension funds, etc.—will become net debtors and then bankrupts as their liabilities increasingly exceed the realizable value of their assets. No one will be immune from the global margin call.
Pandemic default will be both a cause and effect of chaos, which is the other easy prediction for the next ten years, at least. If you think the George Floyd riots are bad, wait until millions of people face foreclosure of their homes and repossession of their vehicles. Moulon labe and good luck with that. Anyone desperate enough to take a job in bill collection, repo, foreclosure, or tax collection will be taking his life in his own hands. The violence and insurrection will make the recent riots look like a low-grade bar fight.
A cottage industry of preparation writers and proprietors provide advice, provisions, and services for what’s to come. It would be wise to pay attention and stock up. It’s an article of faith in these circles that you should stay out of debt, which is certainly good advice. However, the latter part of Polonius’s admonition—“Neither a borrower nor a lender be”—will be just as vital, if not more so. At today’s artificially low interest rates, you’re not even being paid, not by a long shot, to take that risk.