Bubbles

The unprecedented expansion of the Fed’s balance sheet over the last few years looks like it may be setting us up for a bond bubble and future currency crisis of historic proportions. Looking over the $17 trillion in national debt, and the Fed’s creation of over $3.5 trillion on its own, should give even a high school dropout with basic math skills pause.[1] 

Now I know I may be preaching to the choir, but there is a large percentage of the population that is comfortable with or oblivious to the spiraling debt. “The deficits don’t matter” nonsense, spouted off by elected officials like Dick Cheney, is akin to a two pack-a-day smoker justifying continuing to smoke because he hasn’t gotten cancer yet. These deficits do in fact matter when they get too large. And guess what? Our debts are too large!

Unfortunately, you usually can’t win politically by informing the public that we have collectively spent more than we should have and that we will need to face up to the reality that the current rate of spending cannot continue. At some point, our creditors are going to say, “enough is enough,” and we’ll likely witness this massive mess completely unravel. Decades of “cheap” money has its limits that, if not addressed, will reach an irreversible tipping point where it becomes mathematically impossible to pay the debt back with sound currency. Unfortunately, I believe we are experiencing this tipping point right now, with its repercussions to be felt sometime after 2015, right on time for the next presidential election cycle to begin.

Historically, very few countries have been able to recover from tremendous debts of our size without significant inflation and currency devaluation. Back in 1981, the national debt hovered around 33% of GDP during Ronald Reagan’s first year in office, with the national population at 226 million persons. Since this time, the population has grown to its current 317 million, a 40% increase, but our debt has exploded over 200%. You read that correctly. The debt is now more than 100% of our GDP, and we are in effect borrowing money to pay the interest.[2] 

On top of these large numbers is the Fed’s current Quantitative Easing fix of $85 billion a month, which works out to about $265 dollars per person per month (a car payment) just to suppress interest rates to keep the debt loads manageable. It is this manipulation of the monetary system that is the basis for the bond and currency bubbles forming all over the world. This gigantic mountain of debt is so large that a return to rates of where they were just a decade ago could implode entire economies. 

The best example of this is Japan, where if current interest rates were to rise to just 4%, it could consume the entire country’s tax receipts–engulfing the budget and leaving very little for anything else. The U.S., on the other hand, has at least some flexibility if rates were to rise, but it would probably entail massive cuts in defense spending and entitlements (which are the vast majority of our budget). The caveat is we need to act now rather than later.

Our financial system is being held together in a massive coordinated effort by central banks across the world to keep rates low that at some point will have to be scaled back. From my perspective, what the markets fear right now more than anything else is the slowing down of cheap money being injected into the economy on an almost daily rate through the Feds Permanent Open Market Operations (via POMO). It is my assertion that it is in fact this same cheap money that appears to be the largest factor in keeping the world economy from officially stagnating, moving stock market valuations ever higher, and postponing the impending danger of currency and bond bubbles, all due to this misallocation of capital. The longer we wait, the worse this problem becomes.

Surely you’ve seen all the charts and heard all the analogies, but let’s put this in simple terms: debt is helpful to a point, but once it gets too large it becomes an anchor on growth due to the costs of rising rate payments. Despite all of our fantastic innovations and efficiency, it has been our country’s increasing debt that has fueled much of the misleadingly false prosperity we have witnessed over the last three decades, as well as the rise in wealth inequality. Of course, I could go back to the creation of the Fed and the subsequent abandonment of the gold standard back on August 15, 1971 as the key turning points in U.S. monetary policy that set us on this path, but for now let’s just focus on the recent history–that which most of us can remember.

For most Americans’ lives, we have lived in a world of falling interest rates. Thirty year fixed mortgage rates that topped out at 18.45% back in October of 1981 have, for the most part, been on a steady decline since, allowing for the illusion of prosperity to take hold in the American psyche. When “what does it cost?” was replaced with “what is the monthly payment?” not only on car showrooms floors, but within the halls of government at every level, the financial cancer of debt began to thrive. 

This lack of fiscal discipline, from a pay-as-you-go lifestyle, was perverted by the rolling of debts into lower rates and shorter maturities year after year. The extra savings, which should have been used to pay debts down and build surpluses for a rainy day (as Keynes advocated) instead became the exploding consumer spending juggernaut constantly touted about on the CNBC’s of the world. Regrettably, it also enabled the unchecked expansion of the governments military and entitlement spending.

But what would happen if rates were to rise? Rising rates could consume every bit of extra cash the consumer has left. State and local government lacking the ability to print money from nothing (like only the Federal government can) could see themselves falling into Greece-type scenarios. Housing across the country could find itself falling once again, and corporate balance sheets would start to deteriorate as increasing interest payments eat into profits. It is the inability to roll large debts over into lower rates that will be the turning point for most entities. Higher interest payments will leave little extra cash for that American consumer who previously could always be counted on to spend greater amounts of money every year, financed through cash-out refis and expanded credit lines. These spending patterns of the past will diminish as a national retrenching begins.

By now you might be asking yourself, what is the Fed to do in the face of all these risks? I believe that they will do what most countries do when faced with the pain of paying down debt and raising taxes, they will resort to full blown monetization. This would most likely lead to a currency debasement and subsequent rise in rates beyond the Fed’s control, resulting in spiraling bond losses. History is littered with examples of this, and, unfortunately, we as a nation are not prepared to face the real hard work and pain of repaying what we owe. 

But don’t take my word for it; read what Paul Krugman had to say back in 2003 when it was a Republican at the helm: “But my prediction is that politicians will eventually be tempted to resolve the crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt.”[3]

Interesting how Krugman changed his tune once there was a Democrat in office, but I’ll save that for another day. In the end, we are left with the same misguided manipulations of monetary policy that lead to the Dot-com bubble and real estate bubble. The Fed never seems to learn from its past mistakes, continuing to blow bigger and bigger bubbles that endanger us all.