I hope readers don't mind, but I'm diverging a bit from my usual today, because a) I spent way too much time on this article and b) I'm actually running out of ways to say the same thing over and over regarding the intermediate outlook. The market outlook remains essentially unchanged on an intermediate basis -- it's still watch and wait at the pivotal 1600 +/- zone. So today, I'm going to embark on a more overarching economic commentary.
The U.S. Government made big headlines recently by announcing it will pay down a portion ($35 billion) of the national debt this quarter, the first such pay-down in six years. $35 billion sounds like a lot, until you consider that the national debt has been increasing by an average of $3.83 billion
every single day since September 2007. I guess we're making progress by reversing about 9 days of the past 2,000+ days of debt, but that means we're still left with... let's see, carry the zero... 2,000+ days of debt to go! If Uncle Sam can maintain this strict level of discipline, we'll be completely paid off by the 23rd century.
I maintain that our policymakers are creating a massive debt-driven bubble, and in this article I'm going to outline why I feel this is a mistake by analogizing some of the unintended consequences in depth (in "debt-th"?).
Briefly, the historical chart below is from the always-interesting Sentimentrader.com, and shows the current ratio of mutual funds and ETF assets to money market assets. The chart suggests equities are approaching the upper range of the Bubble Zone. We can see the current ratio of 3.31 has only been reached once before, in 2006-2007; and we can also see in that instance, equities continued to rise for a while afterwards -- so these types of signals can take time to work. But they're hard to ignore. As Edmund Burke said, "Those who don't know history are destined to repeat it."
The x-factor impacting all of our lives and driving the equities bubble has been the Fed's printing press and Quantitative Easing. The majority of Americans don't even know what QE is, much less care -- but I believe there are genuine consequences awaiting the Fed's current policy, which will ultimately impact the lives of virtually all Americans. (The fact that you're even reading this suggests you're probably more informed than the average American, and already know what QE is -- but in case you don't, here's the
Wiki explanation.)
The Fed's stated goal with QE-Infinity is to improve the labor market -- and yesterday, new jobless claims came in at a five-year low, which undoubtedly has the Fed Governors secretly high-fiving each other in the restroom. As I see it, though, there's a problem here (beyond hygiene): they are attempting to grow our economy through debt-driven consumption.
My contention is that there can be no lasting growth though this type of debt expansion. It will seem to work for a while, because the Fed's printing press is creating a liquidity boom, and that excess liquidity is driving an increase in certain asset prices. This is not unlike the way they created the housing bubble. Excess central bank liquidity sends false signals to the market -- essentially, the market sees all the extra cash floating around and incorrectly concludes that the economy is better than it actually is.
To illustrate the impact of these false signals on the future economy, I'm going to draw an analogical story about a poor man who's suddenly (and erroneously) granted a big line of credit, which he begins using immediately and irresponsibly. Purely for sake of illustration in this story, let's give our hypothetical big spender a name: We'll call him "Benny B" ("B" stands for "Big spender"! I have no idea who
you're thinking of here.) Benny B has no job and no assets, but he's mistakenly granted a humongous line of credit by our hypothetical credit card bank, which we'll call simply, "The U.S. Government."
For a while, Benny B can use his line of credit to run around town spending like crazy. People see him cruising in his limo, dressed in his new Armani suit, and eating at the finest restaurants every night. The community naturally assumes he's rich, and in short order, Benny B gains a good reputation. Eventually, Benny B's favorite fancy restaurant even decides to extend a very large monthly tab to him.
Never one to miss an opportunity, Benny B starts treating all his family and friends to dinner at this restaurant every single night. He runs up his tab higher and higher. Of course, the restaurant owner sincerely believes Benny will eventually pay his debt -- so each night after the restaurant closes, he includes Benny B's latest tab in the restaurant's asset column as "uncollected profit and revenue." And since Benny B has an abundance of "friends" nowadays, the owner notes there's an awful lot of new business coming in, night after night. He decides he needs to hire more chefs and waiters, and also begin an extensive remodel.
Benny's heightened consumption is sending the restaurant false signals about the overall state of the local economy -- and with the owner now
taking action based on those false signals, they have officially been sucked into the
Benny B Bubble.
This all seems to be working out great for everyone, for a while anyway. Benny is living high on the hog and local businesses seem to be benefitting. Even when it's time for Benny B to start paying down a portion of his debt to the restaurant, there's no crisis right away, because initially Benny can pay some of that debt with his US Government Credit Card (USGCC). By doing so, he effectively "kicks the can" on a portion of his restaurant debt straight into someone else's "uncollected profit and revenue" column. Now the restaurant
and the credit card company are
both inside the
Benny B Bubble -- but still, neither of them know it yet.
For most people, the real trouble would begin when it's time to pay off the debt they kicked over to the credit card -- but not for Benny B! He's a financial
genius, so by the time the first credit card payment comes due, he's managed to finagle a loan from the -- again, purely hypothetical! -- Credit Bubble Bank of China (CBBC), which he uses to pay the interest (but not the principal) on the debt he owes to the credit card company. He's kicked the can again, and now involved yet another company in his debt scheme. The bubble grows larger.
The root problem here is that Benny B isn't
producing anything at all; he is only consuming, which temporarily increases demand and thus seems to be stimulating the local economy. But because his consumption is debt-driven, it is unsustainable, which means the signals it sends to businesses are false. And, as one example of a direct unintended result, the restaurant owner is now unwittingly doing two things which will actually
hurt his business down the road:
1) He's counting Benny B's debts in his asset column.
2) He is relying on Benny's large nightly "revenue" to justify certain forward-looking expenses.
Other businesses are in a similar conundrum -- for example, Benny purchased a new Ferrari on credit, and he's having a new McMansion custom-built by a small local homebuilder (via minimum down payment, of course). Due to Benny's debt-driven consumption, these other business also mistakenly think things are going
better at the moment -- but they too will be hurt down the road.
Without even consciously thinking in these terms, these businesses naturally assume that, somewhere up the line, Benny B is
producing something, which he's exchanging for the money he will then give to them. After all, money is simply a convenient tool which stores value from one form of production to another, and thus allows us to bypass direct barter. If we remove its use as an indirect exchange of
my goods/services for
your goods/services, then money has no intrinsic value of its own. Benny B's money isn't coming from production (current or future) in any form at all -- in fact,
Benny B lacks the ability to produce anything himself -- thus his money is, in effect, completely worthless.
Still: no one in our story realizes that just yet.
We could go on and on with the can-kicking (if Benny B obtained yet
another loan), but for sake of time, let's bring this to conclusion here and assume the CBBC is Benny's lender of last resort. It's finally time for him to pay
that loan -- except he can't, because he has no income. Thus the CBBC is the first to have Benny's bubble pop in their face. And since Benny also has no real assets, they have no choice but to write off Benny's debt completely.
Soon after, the USGCC learns that Benny B had been maintaining the interest on his debt to
them with that now-defunct CBBC line credit. All the money they lent to Benny is gone forever, and they too have to write off his debt. At this point, Benny B's banks are suffering, but their suffering is not immediately driven home to the local economy. That's about to change.
Sadly, as Benny B's massive credit scheme falls apart, he will bring real people down with him. The restaurant owner is one of the last to learn what's been going on, and he suddenly realizes that the $250,000 line of credit he extended to Benny B will never be repaid. He sits down that night with the books, recalculating his balance sheet without that $250,000 "asset" (which just vanished back into the thin air from whence it came). He realizes he can no longer afford the restaurant's new staff, they must all be fired. Worse, he realizes he's now overcommitted on
his debts, because he thought he had additional assets, and -- with the restaurant packed with Benny's friends every night -- he thought his business had reached a new permanently-high plateau.
The false signals Benny B sent caused him to conclude the business was doing much better than it actually was, and much better than is actually sustainable.
He checks the numbers several times, but there is no way around it. Without Benny B's nightly business, the owner realizes he is overextended to the point where he can no longer stay afloat at all. He must close the restaurant, firing everyone. Benny B's temporary "stimulation of the work force" has backfired in the end.
The small local home builder, who just completed Benny's McMansion, won't go bankrupt immediately, but his future hangs on whether or not he can sell the house quickly and recoup his capital. The Ferrari dealership is able to repo the car, but it's completely thrashed and littered with empty beer cans and old beard clippings. They take a write-off. Not all of the businesses who acted on Benny B's false signals will go bankrupt -- but all will suffer to one degree or another.
Every one of the businesses Benny purchased things from was producing real goods and services, so his demand for those things briefly
seemed to stimulate the economy -- yet because Benny's money came from debt and not production, there was no way his spending spree could have any lasting positive impact. In fact, in the end, it hurt more than it helped.
The
problem is debt does not help when used as an end in
itself; debt can only stimulate the economy when it is used as the
means to invest in future production. If Benny had taken his loan
and built a successful business, instead of simply consuming, this
story would have a much different ending. The same is true of our
story out here in the actual world: In the first decade of the 2000's,
each dollar of new credit has produced a mere 18 cents of new GDP, which
is ridiculously low from a historical standpoint (contrast that with more than
59 cents per dollar of GDP growth in the '60's), which suggests
that most new debt is being used for consumption and
speculation. Debt-driven consumption always backfires in the end,
for the same reason it would backfire personally if you simply ran
up your own debts endlessly without increasing your income.
To drive
this all home to our current situation: the Fed and
our government are "creating" money through debt and
from thin air, and this will seem to work for a time. But real
money simply can’t be
created from thin air, any more
than we can create the tangible things money represents, like cars and houses,
from thin air.
The market
presently believes there's more demand than there actually is, and
is thus expanding accordingly (or, in some cases, shrinking
slower than it normally would), which makes this a bubble. They can’t continue this debt expansion
indefinitely; it must end eventually.
At some
point they will be forced to stop consuming, because of fiscal problems or due
to rabid inflation, or due to something presently completely unforeseen
-- and this whole grand economic experiment will fall apart.
Exactly when the endgame arrives is anyone's guess. But
when we finally reach the end of the Fed's rainbow, we'll find there's no
mythical pot of gold -- only a pot full of worthless
IOU's, which are redeemable for nothing. Trade safe.
