Have we ever experienced the “Big One” of our lives?
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Ray Dalio, billionaire founder of one of the world’s largest hedge funds, Bridgewater Associates, provides an in-depth and terrifyingly compelling explanation of credit cycles in his book, Principles for Navigating Major Debt Crises.
Since our US debt is denominated in our own currency, the next debt crisis will almost certainly be a deflationary one, said Dalio. And in such crises, central banks attempt to offset deflationary pressures with the inflationary act of lowering interest rates.
This may work for a while – several decades or even – but “when interest rates reach around 0%, this leverage is no longer an effective way to stimulate the economy”. Policymakers are trying to deal with the crisis through strategic debt restructuring and, because incomes and therefore tax receipts are falling, austerity measures. “In this phase, the debt burden (debt and debt service as a percentage of income) increases, as revenues fall faster than restructuring, debt repayments reduce outstanding debt, and many borrowers are required to accumulate even more debt to cover these higher interest rates. (Big debt crisis, Pt. 1, p. 15).
When interest rates no longer have room to fall, central banks inject liquidity into the financial system via digital money printing (equivocally named “quantitative easing”) in an attempt to revive inflation. . The idea is that the purchase of bond assets by central banks – the two treasuries (for example, the iShares Core US Treasury Bond ETF (BATS: GOVERNMENT)) and “toxic” assets like mortgage-backed securities (e.g. iShares MBS ETF [MBB])) – will encourage banks to lend, investors to invest and savers to spend. But it turns out that inflation (in terms of the consumer price index) only happens if QE is dispersed in large quantities. Those whose debt assets have been bought by the central bank then buy other financial assets, so “there must be very large market gains before the money trickles down to spending” (BDC, p.t. 1, p. 36).
And this “wealth effect” of QE is only felt by a fraction of the population. NYU economist Edward Wolff shows that in 2016, the richest 10% of US households owned 84% of the stock. While only 27% of the middle class own “significant stock holdings” ($10,000 or more), 94% of the wealthy do. This may partly explain why luxury goods inflation is running at 6% while consumer price inflation is struggling to meet the Fed’s 2% target.
Will the real depression lift?
Dalio calls the Great Recession of 2008-2009 a depression and said in 2014 that the United States was in the midst of a “beautiful deleveraging,” but would the Great Recession qualify as a “depression” according to his theory? Dalio says that depressions only occur after interest rates have been reduced to zero, extensive QE has been implemented and substantial deleveraging occurs. Was this the case following the Great Recession?
Not really. Monetary policy makers had not yet exhausted their tools. They succeeded in lowering interest rates by just over 5%, roughly the same amount as the rate cuts in 1990-92 and 2001-03. They also dramatically increased the Fed’s balance sheet from less than $1 trillion to $4.5 trillion, an increase of $3.8 trillion.
But what about deleveraging? Certainly, with all the pain of the Great Recession, substantial and lasting deleveraging has occurred at least somewhere. Law?
Well, that certainly hasn’t manifested itself in the public sector, either in total dollars or as a percentage of GDP.
According to mainstream (mainly Keynesian) economists, we should see public debt skyrocket during recessions as automatic stabilizers kick in to maintain a base level of consumer spending, even when tax revenues decline. However, the acceleration of budget deficits (let alone the absence of deleveraging) even after ten years of economic expansion defies all economic theory.
What about the consumer side? We have indeed seen some deleveraging of mortgage, auto and credit card debt during the recession…which quickly reversed as the second iteration of QE began in 2010.
Total mortgage, car and credit card debt is higher than at the start of the Great Recession of 2008. And delinquency rates are also rising for all three.
Given the lack of sustained deleveraging in other consumer-related areas, it stands to reason that student debt, almost entirely under the control of the federal government, has also not experienced deleveraging.
What about the business side? Contrary to what one might think, the United States has seen no net deleveraging of corporate debt during or after the Great Recession.
You might object that total corporate debt matters less than debt-to-earnings ratio or total debt as a percentage of GDP. And you would be right. Corporate debt as a percentage of GDP did indeed decline during the Great Recession… but it resumed its rise around the start of QE2 and is now as high or slightly higher than it was in 2008.
As a final example of the absence of sustained deleveraging, consider margin debt, which is higher than in 2000 or 2008 on a total basis as well as as a percentage of GDP.
Admittedly, the current 3% margin debt does not quite rival the excess seen during the stock market boom that preceded the Great Depression. (Given that the broker loan market was $8.549 billion in 1929 and the US GDP was about $105 billion in the same year, the maximum margin debt before the Great Depression reached 8.14% of the GDP.) But it is now as high as it has been since then.
Objection: what about total debt in relation to GDP?
It could be objected that while many forms of debt have increased since the Great Recession, total debt to GDP has actually decreases. Dalio argues that the US is in the midst of a “beautiful deleveraging” and shows this graph as proof:
How could this be possible when both public debt and corporate debt as a percentage of GDP have increased since 2008?
First, with regard to debt service, we must remember that since 2009, we have had eight years of interest rates close to zero. With rates kept low for so long, it’s no surprise to see the interest burden diminish even though total debt remains high.
And what explains the moderation in the level of total indebtedness? The main reason is that the housing bubble has burst.
But there are specific reasons why a housing bubble has been inflated in the United States, and those reasons have been widely covered. For example, there is no longer political pressure for “every American to own a home” as there was in the 2000s. Nor is it as easy today as it once was. was then to grant loans to people who had no reason to take out a mortgage. Finally, Fannie and Freddie are also not buying as many sub-prime or sub-prime loans as they were then.
If you correct for the anomaly of excessive mortgage debt in the early to late 2000s, the debt-to-GDP peak that peaked in 2009-10 disappears.
Similarly, although credit card debt is higher today than in 2008, it has fallen somewhat as a percentage of GDP. Note, however, that it stabilized in 2014 and started to climb slightly in 2016. If credit card debt continues to climb while GDP growth slows (as expected in years to come), then revolving credit to GDP could easily rebound to its previous highs in the early and late 2000s.
If the “great debt crisis” – the worst depression of our lives – is already past us, shouldn’t there have been a little more deleveraging than that?
Will the next recession be the “real” depression?
With the kind of debt situation we find ourselves in here in the United States (not to mention that much of the world is even more indebted than we are), it’s hard to see how the “big” has already come and left. Shouldn’t good deleveraging involve more…well, deleveraging?
The lack of substantial deleveraging, combined with the fact that the Federal Reserve was not entirely out of monetary policy tools in 2008, leads me to believe that the “big one” – the debt crisis that will not leave no choice but to painfully deleverage – hasn’t hit us yet.
With another recession on the horizon, $4 trillion still on the Fed’s books, and the Fed Funds rate at 2.5% (and widely expected to stay there in 2019), it seems policy makers currency run out of fuel.
Source: Studio Studebaker
With this in mind, it is reasonable to conclude that the “great debt crisis” – the culmination of the long-term debt cycle – has not yet arrived. He still lurks in the shadows of the near future. As bad as the Great Recession was, we’ll probably see something worse next time.
And the “next time” is getting closer and closer.