The fixed-income side of finance used to be where "serious" business was conducted. Lending to governments and blue-chip corporations, bond issuance, mortgages, project finance... Oh, there were instances of excess from time to time when parvenus briefly rocketed to the bond limelight (Drexel and junk bonds, for example), but the market quickly corrected and went back to its staid ways. With good reason: borrowing large sums of money to finance governments and productive investments was at the very heart of the economy. But it has all gone to pot now...
"Debt" is a growth business just like "technology", "genetic engineering", "communications" or "dotcom". The amount of total debt versus economic activity (debt/GDP ) is at record levels (~360% for the US), with credit somehow extended even to the least credit-worthy. Sub-prime and liar loans, usurious pay-day lending and home mortgages in yen and swiss francs, mega-LBO loans and margin debt... a proper list is too long.
Naturally, dozens of spin-offs have been created to take advantage of the trillions in new debt: loan securitization, debt derivatives, structured bonds, debt and debt derivative indexes, hybrid products, correlation trades. They, in turn, are greasing the rails to make the issuance of even more debt easier - a huge upward spiral of debt and debt derivatives the likes of which the world has never seen before. We call it "liquidity", but this is dangerously misleading: the word implies a condition of being flush with cash and free of liabilities, liens and encumbrances - but the reality is exactly the opposite.
According to ISDA, the total notional amount of global debt-related derivatives outstanding (credit default plus interest rate swaps) has grown 460% from $70 trillion to an astonishing $320 trillion in just 5 years. These are truly hubristic rates of increase, particularly since published inflation is a puny 2-2.5%. The title of this blog, both literal and as an allusion to "sudden death", is inspired by just such numbers.
Prior instances of deflated exuberant silliness in internet grocery stores and miracle drugs were benign by comparison. The sums involved were much smaller and the damage was concentrated in just a few sectors of the economy. But debt is universal and at the core of our free-market, capitalist economy. If it gets too large it ends up seriously distorting and obscuring the value of all assets, as borrowing substitutes equity in the capital structure of households and corporations. A private-equity fund chief recently said that he can raise $10 billion (or more) in debt at the snap of his fingers; I strongly believe this to be self-evidently dangerous.
It's really simple: as debt balloons versus income it gets progressively more difficult to service and ultimately repay debt. Default ensues, debt gets wiped out and everyone gets poorer as asset prices decline to adjust to the new level of "liquidity". To get a measure of this I have calculated and charted historical levels of total debt vs. annual gross personal income (instead of GDP).
After decades of holding steady around 2 times gross income, total debt started growing quickly after 1980 and accelerated even more rapidly after 2000 to reach 4.1x at the end of 2006. If it keeps growing the same way, it will reach 4.7x by 2010. Pick a reasonable debt service rate (interest plus principal repayment) and you quickly see that things are getting dangerous: the debt-carrying capacity of the US is reaching a breaking point.
Therein lie expectations that we may soon suffer deflation, characterized by debt destruction and near zero interest rates. There is no way to inflate out of this monster and, in a peculiarly perverse way, it is easier (and more socially acceptable) for this to happen today than 20 years ago. Loans have been securitized and purchase by the top 5% of the US population to generate rentier income: they hold over 60% of national wealth. Banks are not as exposed to loans as they once were, having become loan packagers/merchandisers instead of lenders.
Apart from all "radical" notions of social justice, what would political leaders choose in a bind? To look after the 5% of their coupon-clipping voters, or the 95% of debtors and small-time bank depositors? Within a one person - one vote system the answer is obvious. The "sock it to the rich guy" bear may have been hibernating for years (decades, even) but she will wake up fast, furious and hungry when her stored fat runs out. In fact, the current negative saving rate and spending debt in lieu of income means the bear has run out of fat and she's surviving on muscle tissue. And not for long, because she's getting really disturbed in her sleep by news that the top 10 hedge fund managers made a combined $9.6 billion last year alone (we're talking about 10 physical persons here, not the funds).
So, debt having gone from a sublime business to a ridiculous bubble, it won't be too long before its popping. The physical world simply cannot forever sustain a trend that has gone parabolic.
"Debt" is a growth business just like "technology", "genetic engineering", "communications" or "dotcom". The amount of total debt versus economic activity (debt/GDP ) is at record levels (~360% for the US), with credit somehow extended even to the least credit-worthy. Sub-prime and liar loans, usurious pay-day lending and home mortgages in yen and swiss francs, mega-LBO loans and margin debt... a proper list is too long.
Naturally, dozens of spin-offs have been created to take advantage of the trillions in new debt: loan securitization, debt derivatives, structured bonds, debt and debt derivative indexes, hybrid products, correlation trades. They, in turn, are greasing the rails to make the issuance of even more debt easier - a huge upward spiral of debt and debt derivatives the likes of which the world has never seen before. We call it "liquidity", but this is dangerously misleading: the word implies a condition of being flush with cash and free of liabilities, liens and encumbrances - but the reality is exactly the opposite.
According to ISDA, the total notional amount of global debt-related derivatives outstanding (credit default plus interest rate swaps) has grown 460% from $70 trillion to an astonishing $320 trillion in just 5 years. These are truly hubristic rates of increase, particularly since published inflation is a puny 2-2.5%. The title of this blog, both literal and as an allusion to "sudden death", is inspired by just such numbers.
Prior instances of deflated exuberant silliness in internet grocery stores and miracle drugs were benign by comparison. The sums involved were much smaller and the damage was concentrated in just a few sectors of the economy. But debt is universal and at the core of our free-market, capitalist economy. If it gets too large it ends up seriously distorting and obscuring the value of all assets, as borrowing substitutes equity in the capital structure of households and corporations. A private-equity fund chief recently said that he can raise $10 billion (or more) in debt at the snap of his fingers; I strongly believe this to be self-evidently dangerous.It's really simple: as debt balloons versus income it gets progressively more difficult to service and ultimately repay debt. Default ensues, debt gets wiped out and everyone gets poorer as asset prices decline to adjust to the new level of "liquidity". To get a measure of this I have calculated and charted historical levels of total debt vs. annual gross personal income (instead of GDP).
After decades of holding steady around 2 times gross income, total debt started growing quickly after 1980 and accelerated even more rapidly after 2000 to reach 4.1x at the end of 2006. If it keeps growing the same way, it will reach 4.7x by 2010. Pick a reasonable debt service rate (interest plus principal repayment) and you quickly see that things are getting dangerous: the debt-carrying capacity of the US is reaching a breaking point.Therein lie expectations that we may soon suffer deflation, characterized by debt destruction and near zero interest rates. There is no way to inflate out of this monster and, in a peculiarly perverse way, it is easier (and more socially acceptable) for this to happen today than 20 years ago. Loans have been securitized and purchase by the top 5% of the US population to generate rentier income: they hold over 60% of national wealth. Banks are not as exposed to loans as they once were, having become loan packagers/merchandisers instead of lenders.
Apart from all "radical" notions of social justice, what would political leaders choose in a bind? To look after the 5% of their coupon-clipping voters, or the 95% of debtors and small-time bank depositors? Within a one person - one vote system the answer is obvious. The "sock it to the rich guy" bear may have been hibernating for years (decades, even) but she will wake up fast, furious and hungry when her stored fat runs out. In fact, the current negative saving rate and spending debt in lieu of income means the bear has run out of fat and she's surviving on muscle tissue. And not for long, because she's getting really disturbed in her sleep by news that the top 10 hedge fund managers made a combined $9.6 billion last year alone (we're talking about 10 physical persons here, not the funds).
So, debt having gone from a sublime business to a ridiculous bubble, it won't be too long before its popping. The physical world simply cannot forever sustain a trend that has gone parabolic.
well, we agree, and while not necessarily causal, there's a perhaps informative, though loose, correlation between the two moments of debt growth acceleration - 1980 and 2000 - and nonfininancial sector declines in rate of economic profit.
ReplyDeleteboth the 1980-83 double slump and the 'weak' 2001-02 recession saw a this measure at post-WWII lows.
It should, though, be noted that the downwards tendency had begun earlier, just as had use of debt as a substitute.
looking back to the minneapolis fed's 1974 annual report, for example, we find notice that:
"we have substituted credit expansion for savings as the means to finance the growth of consumer and business spending. Another dose of the old medicine would only worsen the disease, in the longer run if not immediately."
thank's for the excellent blog.
regards
Thanks for your comments.
ReplyDeleteMy view is that finance is an ancillary economic activity, not a primary one. While smaller nations can survive and even thrive by concentrating on finance, the US cannot - at least not as a global power.
I can't imagine what the authors of the 1974 Minn. Fed's report would think of today's debt/GDP ratios and our dependence on consuming assets through MEW's...
Hi Hellasious,
ReplyDeleteGood post as always. You're possibly blogging for history in a sense. The current situation looks cyclonic.
Expecting deflationist signs, here. Still not seeing any serious ones however. But the tough scenario definitely is worth considering.
Well for the moment, the current pumped-up stocks markets are not deflationist. Not really!
Most local european housing markets are not doing well. Transactions down but nominal market prices are still doing reasonably well here.
What will break first then? Housing prices, stock markets or currency or all of them at once?
Is the deflation coming at first or a VERY severe monetary crisis (my bet). We'll see.
François
A few questions:
ReplyDeleteIs it correct to say that as U.S. manufacturing productivity went into irreversible decline decades ago that the debt monster truly came into its own? Put another way, is the debt monster nothing more or less than an attempt to make up for the loss of the ability to create real wealth the old fashioned way?
And if you had to make a best guess estimate on when the debtberg runs its course and deflation takes over once and for all, when would that be?
As for the poster who is not seeing signs of deflation, I would argue that the massive asset inflation(s) we have seen and are seeing are signs of deflation from the standpoint that they are the result of the PTB fighting inflation. They are the result of credit dislocations. The credit does not go into the real economy but into asset spec or so I assert.
Dear ross & Francois,
ReplyDeleteThe US manufacturing industry started weakening back in the late '70s - '80s, when Japan became a major exporter of high value goods. But the real down-shift occurred as recently as 2000-01. That's when China truly kicked in. We can see this from the sudden drop in manufacturing jobs in the US, from which we have not come back at all.
When will the debt finally run aground? The process has started already: the weakest go first (sub-prime mtg.), followed by near prime residential and commercial mortgages. I believe the next step will be in the junk bond category, now mostly used to finance LBO's and takeovers.
What will this result in... deflation or hyper-inflation? Again, I cannot see the US choosing to inflate the value of the dollar to nothing, on its own. It will be the end of Pax Americana, or Pax Dollariana to be precise. Better to accept some bitter medicine (debt destruction, economic doslocation) than destroy the dollar's position as a store of valus in the world. It would be criminal to do so.
Regards
hellasious,
ReplyDeletejust read your response - '...finance is an ancillary activity..' - and can only agree, i.e. no society can reproduce itself for any duration on the basis of unproductive activity...
value must be created and that takes place soley within the process of production, not circulation/distribution. that is, the generation of claims, of claims to claims, claims to claims to other claims, is perfectly unproductive and in last instance must rest on the results of real productive activity, which was my point in bringing up changes in rate of profit in the real economy and the attempts to mitigate this via credit expansion.
as you imply, today's credit bubble is global and, for practical purpose, has escaped control of central banks...something that began some years ago and, later, in 2001 i believe, was even mentioned by larrey lindsey with his use of the term 'nuclear credit fission' as a descriptive for the combined action of banks, non-bank banks, government sponsered enterprises.
in short, today's financial ballooning represents a systemic struggle but one which, as ever more claims are created, undermines its own but now often forgotten basis in the real, while at the same time demands the impossibility of permanent credit inflation.