Garrett Fisher
March 31, 2020
“Economic fundamentalism” can fall victim to the same traps as religious or political fundamentalism: the refusal to accept change when it is afoot. While core principles of economics have merit, an evolving society causes some element of change such that looking to the past as a perfect prologue to the future has its weaknesses. So far, we have managed to alter our paradigm by having central banks creatively intervene in ways like never before.
The Fundamentalist Meltdown
A fundamentalist view of our current problem would go something like the following. Eventually, after excesses of record ongoing deficits, emergency measures during coronavirus, and other steps which balloon US Treasuries to stratospheric heights, investors would grow skeptical of ultralow interest rates afforded to the US government, out of fear that the amounts could not be paid back. By simply choosing not to buy newly issued debt, market forces would adjust the effective interest rate at Treasury bond, bill, and note issuance to a higher number. While forces that give rise to not buying Treasuries would likely be incremental, a crisis moment happens when yields rise quickly to stimulate demand.
I have to note that such a situation would require that investors a) not have the cash to park in Treasuries, b) something better would come along, or c) public sentiment would turn against Treasuries. As European sovereign debt spreads from earlier in the past decade have shown, this process can take some time to develop, working iteratively over some years to progressively increase effective interest rates. At first, it looks attractive to scoop up Treasuries at such a valuation, though a problem begins to materialize: the debt spiral. How is the government going to afford the annual interest burden on this debt? With total balances increasing, and now interest rates increasing, the situation has a potential unsustainability point looming in the future. As happened in the European sovereign debt crisis, a reverse bubble occurs, where Treasury valuations crash and effective interest rates spike. It happened with Spain and other countries until the European Central Bank said it would “do whatever it takes” to keep the euro together.
What happens when the United States reaches a point where debt burdens are so insurmountable that investors determine that they cannot pay them and interest rates spike? Spain and other European countries are member nations of an international currency bloc, with a supranational central bank that could buttress their runaway interest rates. The United States has the largest economy in the world, with a larger central bank. No one but the United States will buttress its own finances.
Let’s assume that the matter was somewhat temporary. Perhaps the market got spooked by some congressional stupidity and rates started climbing. If the situation was not past the point of no return, a tax hike adequate enough to put an end to excess borrowing would likely calm the nerves of the market, stabilizing interest rates for Treasuries. Equity markets and corporations wouldn’t like it, though that is why we often call it “taking our medicine” as, while it may be unpleasant, it’s what must be done.
While that is all well and good, lets now imagine a situation where our drunken debt spree goes on without a solution. For real and psychological reasons, the buck stops with the United States government. As dysfunctional and moody as it can be, it is generally accepted that the best place for one’s money is something derived of a US government obligation. So, lets imagine that the party goes on so long that there isn’t a slow and progressive warning.
Sound familiar? Well, it could be like the present, with stratospheric debt balances and deficits, yet Treasuries recently were at record low interest rates (translation: highest market valuations), out of financial panic due to coronavirus. So far, numbers outside of our wildest imaginations in 2007 are proving to be perfectly safe.
The Modified Fundamentalist Meltdown
So, lets imagine this party continues past coronavirus, past whatever recovery takes place, into the loving arms of the next financial implosion some years ahead. Instead of $23T of debt (as before coronavirus), lets imagine something like $40T is due (economists estimate indebtedness could be at $29T by the end of 2021), with Social Security and Medicare now having exhausted their Trust fund balances, adding more to the debt pile to keep the system funded. To get through the next downturn, Congress proposes a stimulus package, pushing debt issuance to over $4T in one year.
After some of the bonds get bought, nobody steps up to buy more. Interest rates come up, and investors swoop in. Then the next month, the cash again runs dry, valuations drop, rates creep up more, and investors think they are getting a deal. This goes on for a bit….until investors don’t want to purchase any more.
Now, why would they do that? Perhaps Congressional dysfunction discourages the world from investing in US Treasuries. Perhaps the economy is so bad that no one has spare cash to invest. Or consider another option: maybe the yuan or euro is more attractive, and people wish to park their cash elsewhere. Markets are markets, and where opportunity lies, there goes the cash to follow it.
Just when the economy is on its knees and “needs” stimulus, there is no way to fund it by issuing debt. What can Congress do to fix the problem? Raise taxes to boost confidence? That wouldn’t work as it would negate the stimulus package. This is previously where “economic fundamentalism” said that the shit would hit the fan, the party was over, the jig is up, and the Great Depression begins again, first with deflation….national bankruptcy. Well, not exactly…..
Enter in the Federal Reserve.
Spooked by rising bond yields, central bankers realize the shit is about to hit the fan, so they buy some new print cartridges and turn the money printer into overdrive, buying up Treasuries to prevent an interest rate apocalypse. The problem is, the reality does not escape anyone’s notice, as Fed balance sheet information is published. Excess money supply starts creating price bubbles, which feed into consumer products and services, and now we have inflation.
Inflation is a beautiful thing….if you’re a fixed rate debtor. It really is no good for those who hold cash, and if history is an indication, its hard on an economy overall. That is why central bankers work so hard to prevent it in the first place, while attempting to maximize employment in the process. Remember the quaint old days of just tinkering with the federal funds rate? At any rate (pun intended), inflation destroys liquid net worth and undermines an economy, which is why we try to avoid it. On the other hand, it does one sneaky little thing which is to devalue fixed rate debt.
Instead of the apocalyptic economic meltdown that we fundamentalists presume would occur, inflation is plan B for not paying national debt. Each year that inflation exceeds by a viable percentage the fixed interest rate of underlying Treasury debt, that debt grows smaller in real terms. Sure, in nominal terms (i.e., as measured in numerical dollars), no funny business is taking place; interest and principal are paid per the terms of the debt, in US dollars….albeit worth a hell of a lot less. Eventually, over time and when compounding works its “magic,” debt as measured by percentage of GDP normalizes to a level we can live with. Oh sure, our cash is worthless, our economy would be stagnant, real growth would be nonexistent….but seriously, who the hell thought we were going to actually pay down the national debt? Ha!
The problem with existential inflation is that it tires people living in tepid economic mire, languishing in non-growth for years paying the sins of the past. Eventually, it will be good for the economy to get out of the [self-created] mess. How can that be done? The Federal Reserve figured it out in the late 70s, by jacking the federal funds rate through the roof enough to squeeze money supply, discourage lending, break the momentum of the economy, thrust the country into a recession, and use sponsored economic contraction as a tool to stop price increases. The late 70s and early 80s were such splendid years, with repeat recessions.
So, let’s think about it. Over decades an economy goes on a drunken debt spiral, slams into a wall, prints money, evaporates much of its wealth through inflation, checks itself into recession rehab, and now, after its all said and done, is standing on the other side with normalized national debt, normalized inflation rates….and no cash. What the hell is the point?
Well, I digress. There isn’t much of a point to such a cycle of despair and recall that this is a proposed template of what could occur under a modified economic fundamentalist model. However, there is some logic to believe that things may not materialize exactly as written.
Fundamental Differences
There is a core rule of accounting: for every debit, there is a credit somewhere. A similar core rule of economics exists: every sale is also a purchase. Where economic fundamentalism goes off the rails is to fail to consider the true scale of purchases and sales, vested interests, motivators, and changes. An overly traditional view of a 21st century economy may miss core changes that drive economic shifts that are in compliance with economic fundamentals. Perhaps we simply are not aware of changes in economic behavior and erroneously ascribe the change as some form of malfeasance.
Automation, technology, and productivity are consistent, cumulative, iterative, and ongoing changes to the way work is done. Coincident to continued increases in real GDP per capita in the United States, interest rates have fallen. Could it be that the time value of money has changed? In the 19th century, when most labor was manual, stored capital had tremendous value, as it was in literal short supply. How much manual labor could we store up in an antiquated society with a fraction of the population we have today? It is possible that the advent of robotics and other forms of automation and information interconnectivity is a valid market-based reason to not demand traditional interest rates.
The United States dollar has been the world’s reserve currency since the end of World War II. As such, it enjoys a position that Zimbabwe and Argentina do not. If the dollar is mismanaged, the vast majority of international settlements still occur in the currency, eliminating certain consequences that exist for non-reserve currencies. The moment a developing nation makes adjustments to money supply, the market is incentivized to immediately price in those changes, imposing consequences for running the monetary printing press, as the currency otherwise has less intrinsic value merely by not being used for settlements.
It is also noteworthy that forex investing and international finance is a game of relativism. If the United States prints money and every other major economy in the world does not, then the United States will likely have to pay the price. QE, money printing, interest rates, and debt-to-GDP ratios are similar in the entire developed world. Most countries got nailed with the 2008 crisis and similarly with coronavirus in the same way, and most responded eventually in a similar fashion. Because of international finance relativism, the economy that screws up the least wins and enjoys a dominant position. So far, the US holds that throne.
Another theory as to why inflation has not materialized may have something to do with inherent poor core economic performance. Recall that QE prints dollars, pushes them into Treasuries and Mortgage Backed Securities, and lowers the cost of borrowing. If demand in that situation is excessive, then prices begin to rise in an inflationary way. Well, for the most part, prices have not. What would have happened if QE did not occur? Lending rates would have remained higher for real estate and business, and the economy would be performing quite terribly. That implies that core economic demand is not adequate to produce the inflation that we expected post 2008. While that is not a “get out of jail free card” for unlimited, eternal money printing, it could explain a delay in inflationary consequences.
I have long suspected that there is a seemingly symbiotic cycle between corporate profits, stock market performance, international trade, destinations for bank deposits, and excess Treasuries. Could imbalances in other sectors be demanding Treasuries as a destination for their profits, offsetting each other, at least for the time being? This is a highly intuitive and speculative concept, where I have not had the chance to precisely map the flow of funds. At the very least, for the moment, the existing flow of funds has been working long enough to avoid a consequence. Supposing there is no systemically viable equilibrium that can remain for eternity, it could be obfuscating underlying rot.
Nobody imagined the Federal Reserve operating as a trading desk. 2008 was a large expansion in its creativity, market intervention, and dynamism. Still, a few years ago, former Treasury Secretaries and Federal Reserve Chairmen were pointing out how ill-equipped the Fed was for the next downturn. And, as I write this, the Fed has invented FIMA, a new facility to innovatively expand dollar-for-Treasury swaps to international entities, on top of an incredible resurrection and expansion of 2008 crisis facilities, along with unlimited QE, muni bond, ETF, corporate bond, Treasury market, money market intervention and the like. The question becomes, is the Fed’s elaborate dance a mechanism to smooth market overreaction and keep the system going, buying time to normalize, or is it a grand dance to kick the can down the road where money printing finally causes the shit to hit the fan? We honestly do not know at this time. These are new and interesting developments, and the question remains if they are true to economic fundamentals or are delaying the consequences of the problem while it grows.
Conclusion
The basis for morbid fear of an economic apocalypse is rooted in a perception of fiscal irresponsibility, looming consequences, and the day when we cannot get around those consequences resulting in something like the Great Depression. Since the time of the original “Anatomy of a Meltdown” article, changes in our society indicate that we may avoid a certain fiscal doom, in the form we expect, as parties and structures involved continue to confound expectation. It is likely that, when it does hit the fan, the result will be shades of grey versus a binary response. Instead of a cliff with languishing poverty for untold years, we will likely see currency devaluation, inflation, and “Japanification,” where the days of continued growth disappear for an entire generation. As our news cycles indicate, we have a psychological indication as humans to tend our attention toward highly improbable yet highly impactful events, skipping over moderate yet very real detriments to our personal and business economic picture that are right in front of our face. The economic fundamentalist in me steps aside to recognize changes in our society and a likely ambiguity as to our possible economic demise.