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July 17, 2012

The Modern Debt Spiral

Any continued rise in prices is dangerous because, once we begin to rely on its stimulating effect, we shall be committed to a course that will leave us no choice but that between more inflation, on the one hand, and paying for our mistake by a recession or depression, on the other. -Friedrich A Hayek1…

The Modern Debt Spiral

Any continued rise in prices is dangerous because, once we begin to rely on its stimulating effect, we shall be committed to a course that will leave us no choice but that between more inflation, on the one hand, and paying for our mistake by a recession or depression, on the other.

-Friedrich A Hayek1

The US Economy has experienced an incredible period of virtually unbridled expansion over the past 50 years. Many would attribute this fairly consistent rate of growth to vast improvements in technology, corporate America becoming more efficient, and globalization allowing the US to expand its service sector where wages tended to be higher than manufacturing and other industrial professions. While these factors have played a role in our economic expansion, their impact pales in comparison to the role that debt has played in driving our society to new economic heights.

The US Economy has been built on the back of a 50-fold increase in total credit market debt over the past 50 years. For those of you not keeping score at home, that great expansion has left the US straddled with well over $52 trillion of debt (public & private) today… a figure whose growth doesn’t appear to be slowing anytime soon.

The Demise of the Gold Standard

The Federal Reserve Act of 1913 created the Federal Reserve System and gave it the power to issue Federal Reserve Notes (paper currency). However, that Act required the Fed to hold “reserves in gold of not less than forty per centum against its Federal Reserve notes in actual circulation.”2 This meant that the central bank was required to hold 40 cents worth of gold for each paper dollar it issued. In 1945, Congress reduced that ratio from 40 percent to 25 percent.

The instability of Europe during the 1930s and 1940s caused vast amounts of gold to flow into US banks, leaving them with very little trouble meeting the required reserve ratio until that tide reversed course throughout the 1950s and 1960s. In 1968, the ratio of the Fed’s gold reserves to currency in circulation declined to 25 percent, the base level required by law. It was at that time that Congress, at the urging of President Johnson, removed the requirement to back our currency with gold reserves. Had the Gold Reserve Requirement Elimination Act of 1968 not passed, the Fed would have either had to stop issuing new paper currency or struggle to find more gold to place into reserve.

Earlier that year President Johnson famously stated, “The gold reserve requirement against Federal Reserve notes is not needed to tell us what prudent monetary policy should be… It is not needed to give value to the dollar – that value derives from our productive economy.”3

Once dollars were no longer backed by gold, the nature of money changed. Rather than gaining its worth from a real asset with intrinsic value, it became fiat money – currency only because the government said that it was money. It was at this point that there was no longer a constraint on how much money of this kind that the government could create.

The Rise of Fiat Currency

Up until the US and the rest of the developed world shifted away from the gold standard and over to economies based on fiat currency, there had to be balance between debt expansion and contraction over secular periods. If debt expanded to a point where the borrower could no longer make good on their debts with a hard asset like gold, they had to go through a period of contraction where debts were paid back down to levels that could be sustained. This led to very normal cycles of expansion and contraction. Unfortunately, with debts no longer having to be supported by a hard asset, more and more fiat currency could be created to allow credit to continue to expand well beyond the limits it previously faced.

Without those impediments, credit was allowed to expand dramatically over the last five decades, which helped fuel the rise in what we all know as the “American Dream” – where one generation felt it was their right to surpass the quality of life of the generation that had preceded it.

As debt, both government and public, expanded over the years, normal barriers that would have caused the expansion to slow or even contract were eliminated.

Impediments to Debt Expansion

There are a variety of natural mechanisms that stand in the way of constant, long-term debt expansion.

  • Large scale credit expansion leads to short-term economic expansion where money begins to change hands at an accelerating pace, leading to inflation.
  • Inflation causes the nominal prices of goods and services to increase to levels that cannot be sustained over the long term given the growing cost to service the larger debt burdens.
  • As a borrower’s indebtedness increases, the interest rate charged and therefore the cost to service the debt generally rises.
  • As a borrower becomes overly indebted, they can no longer support the repayment of the interest let alone the principal. Debts are then written off and the economy slows down to reflect the loss of capital and purchasing power.

Economies generally begin to slow down under the weight of these problems, allowing them to hit the reset button from time to time in order to keep markets from soaring too high or crashing down too hard.

Globalization’s role in Debt Expansion

Over the decades, globalization has worked to erode those impediments, creating an open path for our domestic debts to grow without the typical negative effects setting in. Globalization’s role in credit expansion can be clearly seen today by looking at the balance sheets of various countries’ central banks. There is an ever-growing divide between the balance sheets of “consumer nations” and the “producer nations” in today’s global economy.

You have to look no further than the China for a clear example of globalization’s role in our unbridled credit expansion. China has the largest amount of foreign exchange reserves. How did that come to pass? Let’s look at a real time example:

In 2007, China’s trade surplus with the US was $259 billion. This means that China sold the US $259 billion more in goods and services than the US sold to China that year. When these Chinese companies sell their goods in the US, they are paid with US Dollars. These Chinese companies then need to convert their US dollars back into their local currency, the Chinese yuan. The problem comes when these companies look to buy $259 billion worth of yuan in the foreign exchange market. Without any governmental intervention, the value of the yuan would appreciate dramatically and the US dollar would weaken on a relative basis. This surge in the value of the yuan would then make Chinese exports less competitive which would then cause China’s exports and therefore economic growth to slow.

Given that a slowdown in growth is not part of the Chinese government’s plans, the Chinese central bank must then step in to ensure that the yuan’s value doesn’t soar relative to the dollar. The People’s Bank of China (PBOC) has been instructed to buy all of the dollars coming into China at a fixed exchange rate to ensure that the yuan would not appreciate. The PBOC created $259 billion worth of fiat yuan and then used it to buy the $259 billion (US) held by Chinese businesses to remove these dollars from local circulation. The local businesses could then do whatever they pleased with the newly minted yuans while the PBOC was left with an additional $259 billion from the US.

It is important to understand that the US dollars were acquired with Chinese fiat currency that was created from thin air specifically for that purpose. The Chinese government then must use all of the US dollars they have accumulated to acquire US dollar denominated assets – most commonly US Treasury notes.  With the Chinese recycling their dollar holdings back in the US to keep their yuan from appreciating, the by-product is that the US government now has a willing “lender” to keep up with their wild spending habits at a cost (or interest rate) that is considerably lower than it would be without this manipulation.

Debt Expansion’s Wealth Effect

The other main by-product of China and other US trading partners’ willingness to continue lending capital to the US while also investing in domestic, dollar denominated assets is that these assets being bought by foreigners saw their prices increase, helping to fuel some of the asset bubbles that have plagued the US in recent years. As these foreign entities look for greater returns than the paltry ones offered by treasuries, they began to buy up domestic real estate, equities and fixed income, and were unwittingly creating “paper-wealth” for the American citizens that already own these assets here in the US. The best examples were the huge run-up for domestic equities during the latter part of the 1990s followed by the massive run-up in residential and commercial real estate throughout the 2000s.

Obviously foreign trading partners weren’t the only ones to blame for the bubble that formed and subsequently burst in the stock or housing markets. They were but a single player that utilized debt in the form of fiat currency creation to push forth their individual economic agendas. The politicians and the banks in the US also played a massive role in expanding credit facilities through the dramatic growth of Fannie Mae and Freddie Mac and the explosion of the mortgage backed securities markets.

Setting aside the problems that we now know occurred as a direct result of these policies, there was a period there where most Americans simply felt wealthier. They had more equity in their homes, larger nest-eggs in their retirement accounts, the economy as indicated by gross domestic product (GDP) growth was booming; all creating a sense of the “American Dream” that I referred to earlier.

Where does this leave us?

We have arrived at a pivotal cross-roads for our economy here in the US at the same time as many nations across Europe and elsewhere deal with similar problems stemming from decades of unfettered debt expansion. Many politicians in the US and abroad have called for austerity measures to ensure that debt levels are brought back into reasonable levels in order to keep up faith in currencies like the US Dollar and the Euro. If investors lose confidence in the future value of these currencies, their ability to preserve purchasing power will be seriously diminished and inflation will rule the day.

The other side of the political landscape continues to push for the government to play a larger role in supporting their respective economies. With the private sector facing their own “forced austerity” though bankruptcies, foreclosures, and the reduction of their “paper wealth” – based on falling asset values – the “bigger government is better” politicians feel that more government spending is the only thing that will keep us out of the next Great Depression.

Which side is right?

I wish I could say that one side or the other has the right idea about how to cure our economic woes but in truth, they both miss the mark. Cutting government spending during a period where the private sector is so weak would almost assuredly push our economy into recession if not ultimately into depression. The resulting contraction in GDP would bring about deflation – a period marred by falling asset prices, stagnant economic output and vast unemployment.

On the other hand, raising taxes during a period of great economic weakness so that the government can continue to placate the masses with its spend first, ask questions later attitude will simply work to undermine the strength of our currency, driving inflationary pressures higher, reducing our wealth in real terms, and possibly undermining our currency’s place as key component for trade and global reserves. Raising taxes during a period of economic weakness is like kicking a man when he’s already down.

The US will have an election in November that will likely determine which of these two bickering sides will control our monetary, fiscal and economic policy going forward. The reality of the situation is that whichever party is left wielding control after November will have to embrace policies that both wisely reduce government spending while also increasing the revenue base through comprehensive tax reform.

My two cents…

I believe that the government should reevaluate their “spending” habits and look to build “investing” habits. There’s an old saying that goes something like “Give a man a fish, and you’ll feed him for a day. Teach a man to fish, and you’ve fed him for a lifetime.” If the government treated itself like a business rather than a big warm blanket, they might realize that there are means of continuing to support the economy through various channels of governmental spending that can also bring about positive change in society and provide the government a sustainable return on their “investment” helping to actually reduce our massive deficits over the long term.

The idealist inside of me would love for whichever party assumes control after the elections to make decisions that were based on our long term solvency and prosperity however the realist in me requires that I not simply sit back and hope that Washington sorts out this mess, but rather prepare for a variety of policy decisions and the resulting impact to the economy and investments. The first step in the process to protect yourself in this era of uncertainty is to accept that you won’t know for sure what will come to pass. Once you can accept that anything can happen, you can then position your portfolio into a variety of vehicles that will act in a non-correlating fashion so that you are prepared to ride out the inevitable economic peaks and valleys in a relatively stable, consistent and likely much happier fashion.

-Posted by Kelly

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