debt


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The federal debt has gone from astounding to unbelievable to incomprehensible, a new problem has emerged: The US government is actually running out of places to borrow.

How Many Zeros Are in a Trillion?

The $20 trillion debt is already twice the annual revenues collected by all the world’s governments combined. Counting unfunded liabilities, which include promised Social Security, Medicare, and government pension payments that Washington will not have the money to pay, the federal government actually owes somewhere between $100 trillion and $200 trillion. The numbers are so ridiculously large that even the uncertainty in the figures exceeds the annual economic output of the entire planet.

Since 2000, the federal debt has grown at an average annual rate of 8.2%, doubling from $10 trillion to $20 trillion in the past eight years alone. Who loaned the government this money? Four groups: foreigners, Americans, the Federal Reserve, and government trust funds. But over the past decade, three of these groups have cut back significantly on their lending.

Foreign investors have slowed the growth in their lending from over 20% per year in the early 2000s to less than 3% per year today. Excluding the Great Recession years, American investors have been cutting back on how much they lend the federal government by an average of 2% each year.

The Fed is the only game left in town.

Social Security, though, presents an even bigger problem. The federal government borrowed all the Social Security surpluses of the past 80 years. But starting this year, and continuing either forever or until Congress overhauls the program (which may be the same thing), Social Security will only generate deficits. Not only is the government no longer able to borrow from Social Security, it will have to start paying back what it owes – assuming the government plans on making good on its obligations.

With federal borrowing growing at more than 6% per year, with foreign and American investors becoming more reluctant to lend, and with the Social Security trust fund drying up, the Fed is the only game left in town. Since 2001, the Fed has increased its lending to the federal government by over 11% each year, on average. Expect that trend to continue.

Inflation to Make You Cry

For decades, often in word but always in deed, politicians have told voters that government debt didn’t matter. We, and many economists, disagree. Yet even if the politicians were right, the absence of available creditors would be an insurmountable problem—were it not for the Federal Reserve. But when the Federal Reserve acts as the lender of last resort, unpleasant realities follow. Because, as everyone should be keenly aware, the Fed simply prints the money it loans.

A century of arguing about how much to increase spending has left us with a debt that dwarfs the annual economic output of the planet.

A Fed loan devalues every dollar already in circulation, from those in people’s savings accounts to those in their pockets. The result is inflation, which is, in essence, a tax on frugal savers to fund a spendthrift government.

Since the end of World War II, inflation in the US has averaged less than 4% per year. When the Fed starts printing money in earnest because the government can’t obtain loans elsewhere, inflation will rise dramatically. How far is difficult to say, but we have some recent examples of countries that tried to finance runaway government spending by printing money.

From 1975 to 1990, the Greek people suffered 15% annual inflation as their government printed money to finance stimulus spending. Following the breakup of the Soviet Union in the 1990s, Russia printed money to keep its government running. The result was five years over which inflation averaged 750%. Today, Venezuela’s government prints money to pay its bills, causing 200% inflation which the International Monetary Fund expects to skyrocket to 1,600% this year.

For nearly a century, politicians have treated deficit spending as a magic wand. In a recession? We need jobs, so government must spend more money! In an expansion? There’s more tax revenue, so government can spend more money! Always and everywhere, politicians argued only about how much to increase spending, never whether to increase spending. A century of this has left us with a debt so large that it dwarfs the annual economic output of the planet. And now we are coming to the point at which there will be no one left from whom to borrow. When creditors finally disappear completely, all that will remain is a reckoning.

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Chinese “depreciation” and all its ensuing hysteria occurred just about a year ago. It has also been a about a year since I co-wrote a book on China with Worth Wray titled A Great Leap Forward?

The title was meant to be ironic. The original Great Leap Forward was imposed by Mao in the 1960s. It was one of the most economically disastrous times in Chinese history. Food production increased, yet 30 million people starved. China underwent a true financial and economic crisis due to the insanity of central control of markets.

China now attempts something that is as powerful in scope as Mao’s Great Leap Forward. It has amassed a huge amount of debt in its drive to enter the modern world. China has succeeded in becoming a major force. But those who are paying attention see the country’s debt growing at a phenomenal rate.

It is much higher than the economy’s rate of growth, which is shrinking. That means the ability to service the debt is shrinking, too. And we are talking about massive amounts of debt in relation to GDP.

There is a lot to like and appreciate about China. But it isn’t clear what they are going to do about their current circumstances. This includes the inevitable shift from being a manufacturing powerhouse to being a consumer powerhouse. It’s not an easy transition.

My friend Michael Pettis is a professor at the Guanghua School of Management at Peking University in Beijing. I think it’s safe to label him a long-term China insider. He’s possibly the most knowledgeable person I know on China’s inner workings.

Here is his latest article on the nature of Chinese debt and the problems that the resolution of that debt is going to create.

Does It Matter If China Cleans Up Its Banks?

By Michael Pettis
I’ve always thought that Shirley Yam of the South China Morning Post has a great nose for financial risk, and this shows in an article she published last week on mainland real estate. For anyone knowledgeable about the history of financial bubbles and crises, much of the following story will seem extremely familiar. The point to remember is that what is normally recorded as business operations in activities described in the article, results in fixed payments that are inversely correlated with underlying conditions, and so is really no different than debt in the way it will begin to generate financial distress costs when the economy turns—goosing economic activity on the way up while exacerbating the contraction when it comes.

Yam discusses how building contractors must pay developers to build real estate projects and write about one such contractor, whom she calls “George”:

This is how the system works. Say an apartment building costs 1 billion yuan to build. George will provide the developer 300 million yuan as “facilitation money” at an interest rate of about 4 percent to win the job. The latter will then give George 80 million yuan for the services rendered.

George, however, does not have any shareholding in the project, whatsoever, to cover his back. Neither is he assured that the facilitation money would not end up in the stock market. All George can do is pray and hope that the apartments sell well and he gets his money back with interest plus the construction costs. Despite the risk, there has been no dearth of interested players. As George puts it, it has been getting worse. His state-owned rivals are now offering “facilitation money” of up to 50 or even 60 percent of the construction cost. Some are even pitching in with zero interest, while others are promising to help in eventual sales.

She goes on to talk about the desperate competition among developers to get new projects, and what is driving the record-beating real estate prices:

The obvious question that comes to mind is why are developers willing to pay record amounts to own a piece of land—or as some suggest, pay more for the flour (land) than the bread (flat). But then the land parcels are not really meant to be the flour for the bread. A good case is China Cinda Asset Mangement, which has invested more than 61 billion yuan in property during the past 12 months.

Among its acquisitions was a piece of land in suburban Beijing that was so expensive that it will break-even only if the property prices are four times higher. But Cinda has piles of liquidity to splash about. Its debt to equity ratio rose by a third to 368 per cent in 2015 and it paid just a quarter of the loan rate of its private rivals. For Cinda, property seemed the best bet. After all, the real economy was not going anywhere and the stock market was twisting and turning. On the other hand, property investment promised huge returns and was more self-fulfilling in nature. The record-breaking land prices support the property market and therefore the repayment of the multi-billion yuan of loans via shadow banking that Cinda and other state firms are loaded with. So overpayment seemed perfectly okay.

Keep all of this in mind when thinking about stepped-up efforts to clean up China’s banking system. There has been a flurry of reports recently about steps taken to clean up the banking system, but from an economy-wide point of view, it is not clear that any reduction in debt burden’s for the banking system actually reflect a reduction in the debt burden for the economy as a whole. And anyway, new kinds of debt are growing quickly enough that even if it did, the country’s debt burden is almost certainly rising.

Here is Bloomberg on a UBS report two weeks ago on the topic of bank clean-ups:

The good news is that the capital raises have begun. The bad news is that they need to continue. An analysis of 765 banks in China by UBS Group AG shows that efforts to clean up the country’s debt-ridden financial system are well underway, with as much as 1.8 trillion yuan ($271 billion) of impaired loans shed between 2013 and 2015, and 620 billion yuan of capital raised in the same period. But the work is far from over, as to reach a more sustainable debt ratio, the Chinese banking sector will still require up to 2 trillion yuan of additional capital as well as the disposal of 4.5 trillion yuan worth of bad loans, according to the Swiss bank’s estimates.

I think a lot of this misses the point, and not just because there is a lot more debt out there than we think. I think the optimism with which this news has been received reflects a failure to think systemically about the Chinese economy. The fact that bad loans overwhelm the capital of the banking system should not blind us to the fact that China’s problem is excessive debt in the economy, and not a banking system that risks collapse because of insolvency. The only “solution” to excessive debt within the economy is to allocate the costs of that debt, and not to transfer it from one entity to another.

The recapitalization of the banks is nice, in other words, but it is hardly necessary if we believe—and most of us do—that the banks are effectively guaranteed by the local governments and ultimately the central government, and that depositors have a limited ability to withdraw their deposits from the banking system. “Cleaning up the banks” is what you need to do when lending incentives are driven primarily by market considerations, because significant amounts of bad loans substantially change the way banks operate, and almost always to the detriment of the real economy.

Debt matters, not merely its location

Cleaning up the banks is much less important, however, when lending incentives are driven mainly by policy and there is widespread moral hazard. What matters is the impact of overall debt on Beijing’s ability to implement policies that work as expected, and its impact in generating economy-wide financial distress costs.

The key in China, in other words, is not whether the banks have been cleaned up. It is how the losses are going to be allocated, and that remains no clearer today than it ever has been. Until the losses are allocated, they will simply show up in one form or the other of government debt. Because debt itself is constraining growth—I expect it to force economic activity to drop to less than half current levels well before the end of this decade—the debt must be written down or paid down and its costs must be allocated, the sooner the better for China.

But that is of course, easier said than done. I have already discussed many times why the losses should not be allocated to the household sector or the SME sector. Allocating it to the former worsens the imbalances and makes economic activity more dependent than ever on increases in investment, to which China will soon reach limits. Allocating it to the latter would undermine the only really efficient part of the economy and so disrupt any chance China has of long-term growth. The losses also cannot be allocated to the external sector because it isn’t large enough, and it will not be allocated to the central government as long as the leadership believes it necessary to continue centralizing power. In the end, the losses can only be allocated to local governments, but that has proven politically impossible.

I warn my clients that while all the excited chatter about reformist froth in the formal and informal banking sectors may seem like progress is being made or not made—and of course will have some impact on the stock selection process—in the end, they should not take their eye off the ball. China’s problem is that to keep unemployment low, the government must rely on a rising debt burden powered by surging non-productive investment. The only way to constrain the growth in the debt burden and keep unemployment from soaring is to allocate the debt-servicing and adjustments costs to whichever sector of the economy is able to bear it with the least damage to China’s longer-term economic prospects.

This process is not being helped by a slowdown in the growth in household income. A July article in Bloomberg explains and presents a graph that shows cumulative disposable income per capita dropping quarter by quarter over a two-year period from 8.5% to 6.5% as GDP drops over that period from 7.5% to 6.7%:

Chinese consumers, whose spending helped underpin the first-half expansion this year, may not be able to deliver a repeat performance in the second as income growth slows. Household income growth slumped to 6.5 percent in the first six months from 7.6 percent a year earlier, data released Friday showed. Headwinds on consumer spending may increase as officials signal they will step in to curb pay gains to keep manufacturing competitive with rival nations that have cheaper production costs.

As shoppers become an increasingly crucial growth driver, any erosion of their strength would weaken the ability for the consumer-led expansion to offset weakness in exports and investment. That threatens the government goal of raising gross domestic product by 6.5 percent a year through 2020 and slow the rebalancing away from factory-led growth.

The conclusion is inexorable. Beijing must find a way of generating domestic demand without causing China’s debt burden to surge, which basically means it must rebalance the economy with much faster household income growth than it has managed in the recent past, and it must begin aggressively writing down overvalued assets and bad debt to the tune of as much as 25-50% of GDP without causing financial distress costs to soar. Everything else is just froth.

Can China “grow out” of its debt burden?

After many years of assuring the leadership that the debt burden was easy to manage and that reforms would resolve the problem of growth, economic policy advisors have still not been able to prevent the balance sheet from deterioration. They continue to promise that with the right combination of efficiency-enhancing reforms—and there seems to be a dispute among one group arguing for “demand-side” reforms and another for “supply-side” reforms—Chinese productivity will rise by enough to outpace the growth in debt.

But this will almost certainly not happen. Simple arithmetic indicates that the amount by which productivity must rise to resolve debt servicing is implausibly large and requires an unprecedented amount of efficiency enhancement. In the newsletter I sent out to clients on June 28, I calculated that if we believe debt is equal to 240% of GDP, and is growing at 15–16% annually, and that debt-servicing capacity is growing at the same speed as GDP (6.5–7.0%), for China to reach the point at which debt-servicing costs rise in line with debt-servicing capacity, Beijing’s reforms must deliver an improvement in productivity that either:

  1. Causes each unit of new debt to generate more than 5–7 times as much GDP growth as it does now, or
  2. Causes all of the assets backed by the total stock of debt (which we assume to be equal to 240% of GDP) to generate 25–35% more GDP growth than they do now.

If we change our very conservative assumptions so that debt is equal to 280% of GDP, and is growing at 20% annually, and that debt-servicing capacity is growing at half the rate of GDP (3.0–3.5%, which I think is probably still too high), for China to reach the point at which debt-servicing costs rise in line with debt-servicing capacity, Beijing’s reforms must deliver an improvement in productivity that either:

  1. Causes each unit of new debt to generate 18 times as much GDP growth as it is doing now, or
  2. Causes all assets backed by the total stock of debt (280% of GDP) to generate 50% more GDP growth than they do now.

These levels of productivity enhancement do not seem very plausible to me, and I do not think it is possible for reforms to improve efficiency by nearly enough to solve the country’s debt problem. What is worse, the historical precedents indicate that while many debt-burdened countries have attempted the same efficacy-enhancing reform strategy, there does not seem to be any case in which this strategy has actually worked. No highly-indebted country, in other words, has been able to grow its way out of its debt burden until after it has explicitly or implicitly paid down or written down the debt. There are different ways in which this history has been exemplified:

  • In some cases, as in Mexico in 1989, after many years of struggling unsuccessfully to implement productivity-enhancing reforms and suffering from low growth and economic stagnation, governments finally obtained explicit write-downs of the debt when the debt was restructured with partial debt forgiveness (35% of the nominal amount, in the case of Mexico). In this case, the cost of the write-down was allocated to foreign creditors, although during the many years of stagnation workers paid for financial distress costs through unemployment and suppressed wage growth.
  • In some cases, governments never restructured their debt, and so never explicitly obtained debt forgiveness, but they did monetize the debt and so obtained implicit debt forgiveness through high levels of inflation (as was the case of Germany after 1919) or through financial repression (as was the case of China’s banking crisis at the end of the 1990s), or both (as was the case of the UK after 1945), in which the cost of writing down the debt was mostly absorbed by household savers. This last point is important because it creates a great deal of confusion among analysts who think that China can resolve its debt problem the same way it did fifteen years ago. China effectively forced the debt-servicing cost onto household savers mostly during the first decade of this century. With nominal GDP growth ranging between 16% and 20% and a GDP deflator between 8% and 10%, lending rates should have probably been at least 13-15%, but instead they were set much lower, between 6% and 7%, and deposit rates even lower, between 2.5% and 3.5%. Negative real lending rates effectively granted insolvent borrowers debt forgiveness every year equal to at least 6–9 percentage points for a decade or longer. Depositors effectively paid for the full amount of the debt write-down as well as to recapitalize the banks. Forcing the cost of the write-down onto household savers worsened China’s imbalances significantly, however. The household consumption share of GDP fell from a very low 46% in 2000 to an astonishing 35% in 2010. This was not a coincidence.
  • In other cases in which governments never defaulted or restructured their debt—and so never explicitly obtained debt forgiveness—they implicitly wrote down the debt not by monetizing it but by means that involved allocating the costs to the wealthy in the form of expropriation or to workers in the former of wage suppression.
  • Finally, in other cases—the most obvious example being Japan after 1990 and now parts of Europe after the 2009 financial crisis—governments never explicitly or implicitly wrote down the debt, and have instead spent many unsuccessful years attempting to implement reforms that will allow them to grow their ways out of their debt burdens. They have failed so far to do so, and after so many years, it is hard to see how they will succeed.

Resolving the debt burden

Debt must be paid down or written down explicitly, or it will be implicitly amortized over time in an unplanned way and at great cost to the economy. A fundamental part of Beijing’s reform strategy, in other words, must be to reduce the debt burden as quickly as it is politically able in order to minimize the economic costs of economic adjustment and to allow for the most rapid economic recuperation. Reducing the debt burden means selecting the sectors of economy that are best able politically or economically to absorb the cost, and forcing them to absorb the cost of the debt write-down, however reluctant they are to do so.

We typically think of the economy as consisting of four sectors: the external sector, households, businesses, and the government. In China, however, it is more practical to subdivide these further into the following:

  • Creditors. Creditors are forced to absorb the losses associated with writing down the debt when the borrower defaults on its debt and restructures it with a principle or interest reduction. Much of China’s debt burden has been extended through the banking sector, however, and because the debt that must be written down exceeds the banking industry’s capital base, ultimately the cost will be passed on to some other economic sector—for example, Chinese households ultimately absorbed the cost of the banking sector losses generated in the late 1990s.
  • The external sector. To pass on costs to foreigners requires that they have significantly larger exposure to China than they actually do, and would also probably require defaulting on debt—a path Beijing is unlikely to choose to follow.
  • Ordinary households. Most banking crises, like the recent US and European crises and the Chinese banking crisis at the end of the 1990s, are resolved by hidden transfer mechanisms that pass the cost of writing down debt to households. China today, however, must increase household wealth, not reduce it, if consumption is to rise fast enough to allow investment to decelerate. This process will be explained in more detail further on, but it means ordinary households cannot be allowed to absorb the cost.
  • Wealthy households. Given high levels of income inequality and the low propensity to consume of the wealthy, forcing them to absorb the costs of writing down debt—in the form of highly progressive income taxes, for example—is likely to be among the less costly ways economically for Beijing to pass on the costs of paying down debt. As their income or wealth is reduced, the wealthy are likely to convert most of that reduction into lower savings and very little of it into lower consumption, thus minimizing its adverse impact on domestic demand.
  • Small and medium enterprises. Chinese SMEs are among the most efficient economic entities in China and are likely to be the main source of innovation and value creation in the future. Their long-term success is vital to China’s long-term growth. Like ordinary households they should be protected from absorbing the costs of Beijing’s debt-management policies.
  • Local and provincial governments. These have amassed a considerable amount of assets whose liquidation would most efficiently absorb debt write-down costs and would entail the lowest medium and long-term costs. As their assets are liquidated, total Chinese savings will decline and Chinese consumption will remain largely unchanged, thus minimizing the adverse impact on domestic demand.
  • The central government. Beijing too could pay for the cost of writing down debt by liquidating central government assets, although this may conflict with other economic policy objectives, including overcoming vested-interest opposition to the reforms.

These are the major sectors of the Chinese economy within which the cost of debt-management policies can be absorbed, and although there is likely to be a great deal of reluctance on their parts, the most efficient way economically is for the costs to be underwritten by the liquidation of local and provincial government assets and, perhaps to a lesser extent, by taxes on very wealthy households.

It is important to recognize that if debt-servicing costs are not covered by the higher productivity generated by the relevant investment, the process by which the debt will be implicitly or explicitly written down and allocated will necessarily happen anyway, and according to only a limited number of ways. The only question is the extent to which it is directed by Beijing:

  1. Chinese borrowers can default or otherwise restructure debt such that the cost of the write-down is allocated to creditors in the form of a haircut on the debt. Because the creditors for the most part are the banks, which are insufficiently capitalized to bear the full brunt of the losses, these losses will still have to be allocated to some sector of the economy.
  2. If the regulators avoid defaults, there are three further potential outcomes. First, the authorities can implement efficiency-enhancing reforms that cause economic productivity to surge to the point at which excess debt-servicing costs can be covered by the additional productivity.
  3. Second, the authorities can implement reforms that specifically assign excess debt-servicing costs to targeted economic sectors in order to minimize the economic or political costs. For example, it can force local governments to liquidate assets, or it can use taxes to appropriate the wealth of the economic elite—the proceeds of which are then used to absorb excess debt-servicing costs.
  4. Finally, if the authorities do not move quickly enough, excess debt-servicing costs, along with financial distress costs, will be allocated to those least able to protect their interests once debt-capacity limits are reached. There are many ways these costs can be allocated in an unplanned way. One way, and among the most likely, is if the debt is effectively monetized by continuous rolling-over of principle and accommodative monetary policy. While part of the cost may be paid out of an increase in productivity, this is likely to be a small part and can only happen to the extent that unemployment is already very high and the costs of increased production are low. Otherwise, eventually either financial repression or unexpected inflation (with the former more likely than the latter because of the structure of debt in China) will force most of the costs onto household savers and others who are long nominal monetary assets, while unemployment and real wage suppression will force additional financial distress costs onto workers.[1]

Put simply, to the extent that Beijing refuses to follow the first path—and cannot follow the second—it must choose the third path or eventually the fourth will be imposed.

[1] Contrary to what many believe, the PBoC cannot simply monetize the debt. There seems, however, to be a huge amount of confusion about why it cannot. The standard objection is that “China’s ability to monetize this debt will only severely hurt households if it results in a hyperinflation.” This is simply not true, and reflects a misunderstanding of economies whose financial systems are structured in a very different way than that of most Western countries, especially the US.

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The U.S. stock market’s rally from its dismal start to the year appears to be a classic investor trap.

Many investors have the tendency to jump in a bit too early on first signs of improvement in economic indicators or positive news. But the markets are primed to trap the solvent investors and fool the most rational among us.

Nowadays, in a world of high-frequency trading and speculative derivatives, it is hard for even the most experienced investors to stay rational, let alone be clear on whether to buy or hold or sell. This is why so many experts on Wall Street are giving so much conflicting advice. Current forecasting science and predictive models are not yet developed enough to time the market for the next month or quarter.
What is clear is that even though stock markets have not been hit as expected, it is not safe to jump all-in. At the International Institute of Management, our stock-market predictive model flashed a red alert in the second-quarter of 2015, indicating a double-digit decline. If current central bank policies and financial market trends continue, we could see a severe market correction either in 2016 or 2017.

Currency risk

This year investors have worried about China, oil prices, terrorism, Brexit, and the outcome of the U.S. presidential election, but few are paying enough attention to currency and derivative risks.

The Federal Reserve’s interest rate decision-model places more weight on inflation than financial market risks. Fed Chairwoman Janet Yellen was wrong not to raise rates in 2013 to brake high-risk consumer and corporate debt and the stock market bubble. On the other hand she was right not to raise interest rates this March, as this reduced the risk of an international currency crisis, even if that was not the main goal.

Yet if the Fed raises rates while other central banks keep lower or negative interest rates, this will increase the risk of capital outflow from those countries to the U.S., causing a major decline in those countries’ stock markets. Currency traders in turn will short those currencies, and hedge funds will short those stock markets.

This scenario could happen quickly, with lasting impact. The global foreign-exchange market dwarfs the stock and bond markets. Forex trades more than $5 trillion a day. More than 80% of this volume is generated by currency speculators who can swoop in and rapidly capitalize on misdirected policies.

This is what happened in 1997 with the Asian financial crisis and could happen again. High-risk countries are the ones burdened with excessive debt, high net-external debt, and lower interest rates compared to other countries.

U.S. is not immune

But what if the Fed decides to cut interest rates instead? Then the risk of intensifying currency wars increases in order to compete for international exports. In price wars, be it oil or currency, the parties involved lose the most.

Central banks now are caught between a bad choice and a worse one. If the timing and the size of their actions are not properly calibrated and synchronized, you can expect havoc in the global financial markets.

To be sure, the U.S. dollar DXY, -0.02% is strong and the U.S. economy is growing. But in a global economy, no country — even the U.S. — is immune from its trading partners. In a trade war, it will not take long before the U.S. financial markets are negatively impacted. The majority of the S&P 500 SPX, -0.10% companies generate substantial export revenues; accordingly, U.S. stocks and the economy cannot escape a hit for long.

The International Institute of Management’s forecasting model showed that fewer than 20% of publicly listed companies on major U.S. stock exchanges grew sales and profits in 2015 over 2014, while the rest stagnated — i.e. sales or profits were flat or declining. Large-cap companies fared better than mid- and small-caps. But if large companies cannot find a way to grow, some market sectors could decline by 20% or more this year or in 2017 from their highs. Yet in this recent market rally, many investors see good economic data, more supportive central banks, and believe they are buying a dip.

Read: Phil van Doorn on 12 U.S. companies have increased sales for at least 60 straight quarters

Moreover, U.S. consumer and corporate debt, debt derivatives, currency, and the European Union pose real threats to investors. About $10 trillion of corporate debt in the U.S. alone is due over the next five years, and about 30% of this total is high-risk. Risky debt of $3 trillion can impact the U.S. financial markets, whether the Fed or the banks want to admit it or not.

Add to that the derivative markets and you get a completely different picture. To put the risk in perspective, the size of the global stock markets is estimated at $30 trillion to $40 trillion, of which about $20 trillion reflects the U.S. stock market.

However, the derivatives market — future bets on the price of bonds, commodities, or the stock market indices and ETFs — is estimated at $800 trillion globally. The U.S. derivative market is estimated at $300 to 400 trillion. That is 10- to 20 times the size of the U.S. stock market.

Unlike standard loans and stock investments that actually help grow an economy, derivatives are a zero-sum game. It is exactly like playing in a casino, one must lose for someone else to win. Derivatives are a wealth-transfer tool from the uninformed, unsuspecting investor, saver, or retiree to informed market insiders. So, even if banks can avoid losses on derivative bets, investors still get hit.

Derivatives explain why so many Americans lost value in their homes, retirement accounts, and life savings after the 2008-09 crash. The news media reported that more than $5 trillion disappeared from the market in that downturn. But the money did not just disappear — that would be against the law of physics. It only got transferred from the masses to the few. If this happens again, extreme civic unrest could damage global financial markets for a long time. When the potential damage can be so large, some regulation is needed to protect Main Street from the massive gambling instruments of Wall Street.

Yet central banks and mainstream economists tell investors and businesses not to worry and go ahead with investing and spending, while central banks do what they can to support economies and markets.

Except that central banks have reached a limit. If conditions remain the same, annualized stock returns for most investors will be in single-digits at best, and more likely in negative double-digits. Investors would be wise to take measures now to preserve capital rather than invest aggressively at every market dip.

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An essay on debt that I disagree with.

Through history public debts have gone up and down, often expanding in periods of war or large changes in basic infrastructure and technologies, and then going down in periods when things have settled down.

The pros and cons of public debt have been put forward for as long as the phenomenon itself has existed, but it has, notwithstanding that, not been possible to reach anything close to consensus on the issue — at least not in a long time-horizon perspective. One has as a rule not even been able to agree on whether public debt is a problem, and if — when it is or how to best tackle it. Some of the more prominent reasons for this non-consensus are the complexity of the issue, the mingling of vested interests, ideology, psychological fears, the uncertainty of calculating ad estimating inter-generational effects, etc., etc.

In classical economics — following in the footsteps of David Hume – especially Adam Smith, David Ricardo, and Jean-Baptiste Say put forward views on public debt that was as a rule negative. The good budget was a balanced budget. If government borrowed money to finance its activities, it would only give birth to “crowding out” private enterprise and investments. The state was generally considered incapable if paying its debts, and the real burden would therefor essentially fall on the taxpayers that ultimately had to pay for the irresponsibility of government. The moral character of the argumentation was a salient feature — according to Hume, “either the nation must destroy public credit, or the public credit will destroy the nation.”

Later on in the 20th century economists like John Maynard Keynes, Abba Lerner and Alvin Hansen would hold a more positive view on public debt. Public debt was normally nothing to fear, especially if it was financed within the country itself (but even foreign loans could be beneficient for the economy if invested in the right way). Some members of society would hold bonds and earn interest on them, while others would have to pay the taxes that ultimately paid the interest on the debt. But the debt was not considered a net burden for society as a whole, since the debt cancelled itself out between the two groups. If the state could issue bonds at a low interest rate, unemployment could be reduced without necessarily resulting in strong inflationary pressure. And the inter-generational burden was no real burden according to this group of economists, since — if used in a suitable way — the debt would, through its effects on investments and employment, actually be net winners. There could, of course, be unwanted negative distributional side effects, for the future generation, but that was mostly considered a minor problem since, as  Lerner put it,“if our children or grandchildren repay some of the national debt these payments will be made to our children and grandchildren and to nobody else.”

Central to the Keynesian influenced view is the fundamental difference between private and public debt. Conflating the one with the other is an example of the atomistic fallacy, which is basically a variation on Keynes’ savings paradox. If an individual tries to save and cut down on debts, that may be fine and rational, but if everyone tries to do it, the result would be lower aggregate demand and increasing unemployment for the economy as a whole.

An individual always have to pay his debts. But a government can always pay back old debts with new, through the issue of new bonds. The state is not like an individual. Public debt is not like private debt. Government debt is essentially a debt to itself, its citizens. Interest paid on the debt is paid by the taxpayers on the one hand, but on the other hand, interest on the bonds that finance the debts goes to those who lend out the money.

To both Keynes and Lerner it was evident that the state had the ability to promote full employment and a stable price level – and that it should use its powers to do so. If that meant that it had to take on a debt and (more or less temporarily) underbalance its budget – so let it be! Public debt is neither good nor bad. It is a means to achieving two over-arching macroeconomic goals – full employment and price stability. What is sacred is not to have a balanced budget or running down public debt per se, regardless of the effects on the macroeconomic goals. If “sound finance”, austerity and a balanced budgets means increased unemployment and destabilizing prices, they have to be abandoned.

Now against this reasoning, exponents of the thesis of Ricardian equivalence, have maintained that whether the public sector finances its expenditures through taxes or by issuing bonds is inconsequential, since bonds must sooner or later be repaid by raising taxes in the future.

In the 1970s Robert Barro attempted to give the proposition a firm theoretical foundation, arguing that the substitution of a budget deficit for current taxes has no impact on aggregate demand and so budget deficits and taxation have equivalent effects on the economy.

The Ricardo-Barro hypothesis, with its view of public debt incurring a burden for future generations, is the dominant view among mainstream economists and politicians today. The rational people making up the actors in the model are assumed to know that today’s debts are tomorrow’s taxes. But — one of the main problems with this standard neoclassical theory is, however, that it doesn’t fit the facts.

From a more theoretical point of view, one may also strongly criticize the Ricardo-Barro model and its concomitant crowding out assumption, since perfect capital markets do not exist and repayments of public debt can take place far into the future and it’s dubious if we really care for generations 300 years from now.

Today there seems to be a rather widespread consensus of public debt being acceptable as long as it doesn’t increase too much and too fast. If the public debt-GDP ratio becomes higher than X % the likelihood of debt crisis and/or lower growth increases.

But in discussing within which margins public debt is feasible, the focus, however, is solely on the upper limit of indebtedness, and very few asks the question if maybe there is also a problem if public debt becomes too low.

The government’s ability to conduct an “optimal” public debt policy may be negatively affected if public debt becomes too small. To guarantee a well-functioning secondary market in bonds it is essential that the government has access to a functioning market. If turnover and liquidity in the secondary market becomes too small, increased volatility and uncertainty will in the long run lead to an increase in borrowing costs. Ultimately there’s even a risk that market makers would disappear, leaving bond market trading to be operated solely through brokered deals. As a kind of precautionary measure against this eventuality it may be argued – especially in times of financial turmoil and crises — that it is necessary to increase government borrowing and debt to ensure – in a longer run – good borrowing preparedness and a sustained (government) bond market.

The question if public debt is good and that we may actually have to little of it is one of our time’s biggest questions. Giving the wrong answer to it — as Krugman notices — will be costly:

I haven’t been over to Armo’s blog for a while. Jerry as usual is way off.

Republican Vice-presidential candidate Paul Ryan is set to debate Vice-President Joe Biden on Thursday night. While I am not sure if he will exactly talk about, I am sure he will mention the national debt. In his “Path to Prosperity” budget, Ryan has an amazing chart that shows what our debt would be if we continued in our current path compared to what the debt would be if we adopted his plan. Here’s the famous chart. It shows debt skyrocketing to nearly 900% of GDP in 2080!

Armo is not overly impressed.

Wow, Paul Ryan was able to project debt all the way to 2080, which is nearly 70 years away! He must be an amazing debt projectionist/forecaster.

Don’t disagree here. Projections are notoriously difficult and almost invariably are wrong.

OK, enough of the sarcasm. I’m sorry to break this Paul Ryan, but this chart is ridiculous in many ways.

Here come the reasons.

First off, it ignores what national debt is. If the US Federal Government owes debt, someone must OWN it. Guess which 2 sectors own the national debt? The foreign and private sector.

Well yes the foreign and private sectors do own government debt. So does the government however.

The Federal Reserve has also been buying government debt.

Why is this a concern?

Looking at the foreign sector:

The foreign sector owns US debt mainly because of trade balances. When a country like China holds nearly half of the foreign holdings, there is a reason behind it. They run a trade surplus with the US, and because of that, they have all these US dollars lying around. They can either go out and use it to buy resources, or they can put it in the safest asset out there, US bonds. This post clearly explains this process.

Armo has a view. He seems unable to move past that view. True China and the US have run trade imbalances. That is to say the US has imported in excess of what they have exported to China.

Where did all the dollars come from with which to purchase these Chinese imports? They were not earned through selling exports to China. They were either created [printed] or borrowed. In this case they were borrowed from the Chinese. So China didn’t have all these US dollars lying around, the US borrowed the dollars.

This leaves the private sector. Basic accounting identity tells us that the national debt is (net) private savings. And as I’ve blogged about in the past, to reduce the national debt is to reduce net private savings. Insufficient net private savings usually lead to a recession (see how a drop is usually followed by a recession?).

This is Cullen’s Chartalist nonsense. The private savings is in part constituted of the government debt held by private holders…true. To reduce the national debt however is not to reduce savings when part of the national debt is held by owners other than private individuals. Incorrect.

Anyway, the point here isn’t to debunk Paul Ryan’s chart and why it makes no economic sense. My point is to show how absurd it is to project debt 70 years into the future.

Just as well, as you have signally failed to do so. Well I agree that projections into the future are fraught with difficulty. Seventy years into the future, and you can just about guarantee that they will be wrong.

First off, to project future liabilities is to put it frankly, dumb.

No not really. The important point is not the final value of the liabilities, rather the direction of the trend with a given set of policies. These policies are entrenched in law. They are not that easy to shake off. Social Security, Medicare, Medicaid, these are liabilities enshrined in law, that are growing as the demographics move against the US.

Then consider interest rates. Currently interest rates are at all-time historic lows. This has been accomplished via the Federal Reserve, not the free market. If the Federal Reserve were to remove this support and allow the free market to set rates, the rates would be higher and the liabilities on that debt, due to the rise in interest rates, would increase dramatically.

Whether the liabilities reach that, exceed that, or fall below, is not critically important at this point. What is important is the direction of the trend. This takes on additional significance when real growth is extrapolated.

Secondly, it is insanely HARD to project debt in the near future, let alone 70 years into it! Think its easy? Here’s a Debt/GDP chart since ~1940 (about 70 years back). Try drawing the path for the last 70 years. Given that you might even slightly know the estimated path of the chart, it’ll still be hard to draw it to close proximation – and you’re even using historical facts to help you! Now imagine not even knowing that, it is nearly impossible.

Obviously for you it is an issue. This is a simple matter for someone versed in math. Now whether the accuracy is there, I already agree that it will almost certainly be off, but the direction of the trend is not at issue.

To conclude, projecting debt is dumb, impossible, fear-mongering and a useless political game. Stick to figuring out a way to get us growing again.

Far from it. Highlighting the unsustainable trajectory of debt growth, given current policies, is actually very valuable, unfortunately, probably due to your Chartalistic ideology, you are simply blind to economic reality.

An article from Krugman

Perhaps most obviously, the economic “experts” on whom much of Congress relies have been repeatedly, utterly wrong about the short-run effects of budget deficits. People who get their economic analysis from the likes of the Heritage Foundation have been waiting ever since President Obama took office for budget deficits to send interest rates soaring. Any day now!

Well of course with the Federal Reserve monetizing the debt across the curve, there is currently no ‘market rate’ of interest. If there were, and it were higher, the % of tax revenues required to service the astronomical levels of government debt would soon start to impact the services that are currently provided by government.

And while they’ve been waiting, those rates have dropped to historical lows. You might think that this would make politicians question their choice of experts — that is, you might think that if you didn’t know anything about our postmodern, fact-free politics.

Again, simply predicated upon the ever increasing monetization by the Federal Reserve of US government debt.

But Washington isn’t just confused about the short run; it’s also confused about the long run. For while debt can be a problem, the way our politicians and pundits think about debt is all wrong, and exaggerates the problem’s size.

Krugman will put us right.

Deficit-worriers portray a future in which we’re impoverished by the need to pay back money we’ve been borrowing. They see America as being like a family that took out too large a mortgage, and will have a hard time making the monthly payments.

This is, however, a really bad analogy in at least two ways.

First, families have to pay back their debt. Governments don’t — all they need to do is ensure that debt grows more slowly than their tax base. The debt from World War II was never repaid; it just became increasingly irrelevant as the U.S. economy grew, and with it the income subject to taxation.

Krugman adopts the MMT brigade mantra: that a currency issuer can never go bankrupt. The problem is that fiat money is not wealth, production is wealth. Produce all the paper fiat money you wish, ironically, you will actually decrease your wealth via falling production as malinvestments increase under the confusion of the increasing money supply.

Second — and this is the point almost nobody seems to get — an over-borrowed family owes money to someone else; U.S. debt is, to a large extent, money we owe to ourselves.

Unbelievable. The decades old fallacy reasserted by Krugman. The fallacy is predicated through thinking about debt as ‘money’. Money is always substituted as money forms the basis of economic calculation, which allows us to choose and assign marginal values.

Saving is always in reality, saving of capital goods, which are then allocated to longer term production methods, which produce more goods, ultimately resulting in a higher production of consumer goods. Through increasing debt for consumption, which is government spending, larger quantities of capital goods are consumed in the present, thus reducing the ability to allocate them to more roundabout processes that would increase consumer goods in the future.

This was clearly true of the debt incurred to win World War II. Taxpayers were on the hook for a debt that was significantly bigger, as a percentage of G.D.P., than debt today; but that debt was also owned by taxpayers, such as all the people who bought savings bonds. So the debt didn’t make postwar America poorer. In particular, the debt didn’t prevent the postwar generation from experiencing the biggest rise in incomes and living standards in our nation’s history.

Helped in no small measure by American industrial capital being largely untouched by the war, whereas Europe suffered wholesale destruction of capital. America thus by default became the world’s producer.

The debt of WWII was never paid. It was simply defaulted upon. The increase in, and perpetual inflation since [and prior to WWII] is a de facto debt default.

But isn’t this time different? Not as much as you think.

It’s never different. Perpetual inflation, perpetual default.

It’s true that foreigners now hold large claims on the United States, including a fair amount of government debt. But every dollar’s worth of foreign claims on America is matched by 89 cents’ worth of U.S. claims on foreigners.

Held by who? US government, or Corporations?

And because foreigners tend to put their U.S. investments into safe, low-yield assets, America actually earns more from its assets abroad than it pays to foreign investors. If your image is of a nation that’s already deep in hock to the Chinese, you’ve been misinformed. Nor are we heading rapidly in that direction.

China et al are practicing mercantilism, and inflating even faster than the US largely due to pegging to the US dollar, and their requirement to export through currency debasement. Hardly a ringing endorsement.

Now, the fact that federal debt isn’t at all like a mortgage on America’s future doesn’t mean that the debt is harmless. Taxes must be levied to pay the interest, and you don’t have to be a right-wing ideologue to concede that taxes impose some cost on the economy, if nothing else by causing a diversion of resources away from productive activities into tax avoidance and evasion. But these costs are a lot less dramatic than the analogy with an overindebted family might suggest.

Hardly. As monopoly holders of the money supply, the government has availed itself of the ‘legal’ right to expropriate their populace. Theft through inflation is yet another ‘tax’. Tax lowers production, lower production lowers the wealth producing potential of an economy. Thus the perpetual inflation, as a perpetually increasing tax, has, seriously eroded the wealth producing capability of the private free market sector.

And that’s why nations with stable, responsible governments — that is, governments that are willing to impose modestly higher taxes when the situation warrants it — have historically been able to live with much higher levels of debt than today’s conventional wisdom would lead you to believe.

‘Responsible’. You jest surely.

When you increase taxes, or have any taxes at all, government raises the time preference of all those whom it taxes. This reduces production, in that the longer, more roundabout production methods must be abandoned, with shorter, less productive methods employed. Not only is production lowered, but also the employment that results from the longer processes.

Therefore ‘taxes’ of any description are bad. They destroy the wealth of all, some directly bear the brunt, but ultimately all, indirectly suffer the consequences of taxation. Taxes are of course incompatible with the principals of ‘natural law’. Taxes are always created through legislation, which is then enforced via coercion.

Britain, in particular, has had debt exceeding 100 percent of G.D.P. for 81 of the last 170 years. When Keynes was writing about the need to spend your way out of a depression, Britain was deeper in debt than any advanced nation today, with the exception of Japan.

Of course, while we had an imperialistic empire that we could exploit, we could carry more debt. With the loss of empire, the ability to service that debt seriously eroded, with it Britains pre-eminent position in the world disappeared right along with it.

Of course, America, with its rabidly antitax conservative movement, may not have a government that is responsible in this sense. But in that case the fault lies not in our debt, but in ourselves.

Increasing consumption by government is a monster feeding itself, increasingly threatening the very life of the economy. America while still the most powerful economy, is consuming itself, and contributing to its eventual fall.

So yes, debt matters. But right now, other things matter more. We need more, not less, government spending to get us out of our unemployment trap. And the wrongheaded, ill-informed obsession with debt is standing in the way.

Krugman has presented, as usual, absolutely nothing of any substance. He relies on his status as a Nobel Prize winning economist. Essentially he is clueless.

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