The Global Debt Bubble

I reprint this Bloomberg article in full because it lays out all the ways global policymakers have increased the risks of a global debt-driven correction, sometimes called a depression.

These policymakers have decided that since there is no shortage of global labor, there is little chance of cost-push inflation. But this ignores the very real effect of excess credit, which is the relative price changes reflected in real assets, such as land, real estate, and the control of Big Data. These assets are being more and more concentrated in fewer hands – it’s like a return to feudalism where a few lords owned all the productive assets and the laboring peasants were forced to work for subsistence living.

So, the real question is which comes first: a global financial collapse or a political revolution? Neither are smart risks for public policy and democratic governance.

My comments in bold red.

The Way Out for a World Economy Hooked On Debt? More Debt

By Enda Curran

December 1, 2019, 4:00 AM PST Updated on December 2, 2019, 12:12 AM PST

    • Cheap borrowing costs have sent global debt to another record
    • Options to revive economic growth require even more borrowing
    • Zombie companies in China. Crippling student bills in America. Sky-high mortgages in Australia. Another default scare in Argentina.

A decade of easy money has left the world with a record $250 trillion of government, corporate and household debt. That’s almost three times global economic output and equates to about $32,500 for every man, woman, and child on earth.

Global Debt

Much of that legacy stems from policymakers’ deliberate efforts to use borrowing to keep the global economy afloat in the wake of the financial crisis. Rock bottom interest rates in the years since has kept the burden manageable for most, allowing the debt mountain to keep growing.

Now, as policymakers grapple with the slowest growth since that era, a suite of options on how to revive their economies share a common denominator: yet more debt. From Green New Deals to Modern Monetary Theory, proponents of deficit spending argue central banks are exhausted and that massive fiscal spending is needed to yank companies and households out of their funk. [But we can’t ignore the fact that central banks are largely funding this deficit spending by buying bonds. If they can no longer expand their balance sheets, the private sector would have to buy this excess debt at much higher yields.]

Fiscal hawks argue such proposals will merely sow the seeds for more trouble. But the needle seems to be shifting on how much debt an economy can safely carry.

More than a decade after the financial crisis, the amount of combined global government, corporate and household debt has reached $250 trillion.

One solution proposed by policymakers? More debt pic.twitter.com/KVrv3CdlW1

[Debt growth is an exponential function – thus as we increase debt, we have to increase it at an ever greater rate just to keep the game going.]

Central bankers and policymakers from European Central Bank President Christine Lagarde to the International Monetary Fund have been urging governments to do more, arguing it’s a good time to borrow for projects that will reap economic dividends.

“Previous conventional wisdom about advanced economy speed limits regarding debt to GDP ratios may be changing,” said Mark Sobel, a former U.S. Treasury and International Monetary Fund official. “Given lower interest bills and markets’ pent-up demand for safe assets, major advanced economies may well be able to sustain higher debt loads.”

Rising expectations of fiscal stimulus measures across the globe have contributed to a pick-up in bond yields, spurred by signs of a bottoming in the world’s economic slowdown. Ten-year Treasury yields climbed back above 1.80% Monday, while their Japanese counterparts edged up closer to zero.

A constraint for policymakers, though, is the legacy of past spending as pockets of credit stress litter the globe.

At the sovereign level, Argentina’s newly elected government has promised to renegotiate a record $56 billion credit line with the IMF, stoking memories of the nation’s economic collapse and debt default in 2001. Turkey, South Africa, and others have also had scares.

Debt:GDP

[The trend of total debt/GDP tells us whether are deficit spending is paying off. When it gets too high, most of our GDP will need to service existing debt loads. The more likely scenario is widespread defaults that ricochet through the global economy.]

As for corporate debt, American companies alone account for around 70% of this year’s total corporate defaults even amid a record economic expansion. And in China, companies defaulting in the onshore market are likely to hit a record next year, according to S&P Global Ratings.

So-called zombie companies — firms that are unable to cover debt servicing costs from operating profits over an extended period and have muted growth prospects — have risen to around 6% of non-financial listed shares in advanced economies, a multi-decade high, according to the Bank for International Settlements. That hurts both healthier competitors and productivity.

As for households, Australia and South Korea rank among the most indebted.

The debt drag is hanging over the next generation of workers too. In the U.S., students now owe $1.5 trillion and are struggling to pay it off.

Even if debt is cheap, it can be tough to escape once the load gets too heavy. While solid economic growth is the easiest way out, that isn’t always forthcoming. Instead, policymakers have to navigate balances and tradeoffs between austerity, financial repression where savers subsidize borrowers, or default and debt forgiveness.

“The best is to grow out of it gradually and consistently, and it is the solution to many but not all episodes of current indebtedness,” said Mohamed El-Erian, chief economic adviser to Allianz SE.

Gunning for Growth

Policymakers are plowing on in the hope of such an outcome. [Hope for the best? In the meantime, elites’ ability to manage a crisis of their own making is more secure.]

To shore up the U.S. recovery, the Federal Reserve lowered interest rates three times this year even as a tax cut funded fiscal stimulus sends the nation’s deficit toward 5% of GDP. Japan is mulling fresh spending while monetary policy remains ultra easy. And in what’s described as Britain’s most consequential election in decades, both major parties have promised a return to public spending levels last seen in the 1970s.

China is holding the line for now as it tries to keep a lid on debt, with a drip-feed of liquidity injections rather than all-out monetary easing. On the fiscal front, it has cut taxes and brought forward bond sale quotas, rather than resort to the spending binges seen in past cycles.

What Bloomberg’s Economists Say…

“When a slump does come, as surely it will, monetary policy won’t have all the answers — fiscal policy will contribute, but with limitations.”

— Bloomberg Economics Chief Economist Tom Orlik

As global investors get accustomed to a world deep in the red, they have repriced risk — which some argue is only inflating a bubble. Around $12 trillion of bonds have negative yields.

Anne Richards, CEO of Fidelity International, says negative bond yields are now of systemic concern.

“With central bank rates at their lowest levels and U.S. Treasuries at their richest valuations in 100 years, we appear to be close to bubble territory, but we don’t know how or when this bubble will burst.”

The IMF in October said lower yields are spurring investors such as insurance companies and pension funds “to invest in riskier and less liquid securities,” as they seek higher returns.

“Debt is not a problem as long as it is sustainable,” said Alicia Garcia Herrero, chief Asia-Pacific economist at Natixis SA in Hong Kong, who previously worked for the European Central Bank and Bank of Spain. “The issue is whether the massive generation of debt since the global financial crisis is going to turn out to be profitable.”


 

Okay, so we know that public debt never gets paid back, just rolled over with new debt. The question, as Ms. Herrero says, is whether this debt leverage is productive or not; does it make our lives better in material and non-material terms; will it help us tackle non-monetary challenges like climate change?

Credit constraints are those that penalize unproductive investments in favor of productive ones before we know which is which. The elimination of credit constraints means we are just throwing money at the wall to see what sticks, and whoever gets those credits is largely arbitrary. The whole strategy is driving global inequality, so the question again is which comes first: financial collapse or political revolution?

Oh yeah, Merry Christmas!

The Punch and Judy Show

Punch

The recent default show-down was pure political theater. We take sides and condone this at our own peril, while serious issues loom over the long-term health of our society. This excerpt is from Thomas Donlan in this week’s Barrons:

If journalists can be the fourth estate of representative government by chattering about the official executive, legislative, and judicial estates, investors must be members of the fifth estate. Their opinions, expressed in bids to buy and offers to sell rather than in narrative, also send important information to the whole system about value and financial stability.

So what did the fifth estate say about the government’s financial crisis last week, and the week before, and the week before that? Not much.

They were right. The whole thing was a Punch-and-Judy show, making farce out of genuine political conflict. It was default theater, as meaningless as the security theater that’s on continuous display in our airports.

….

The important result of the two-week government shutdown has been to take away another bit of Americans’ confidence in government and respect for their leaders. Most Main Streeters were like Wall Streeters, going about their other business with barely a glance at the televised theatrics in Washington. To a large extent, this is healthy.

The people have come to believe, on evidence that is all too good and repeated all too often, that Punch and Judy are both operated by the same hidden puppeteer, who goes by the title professional politician. The politicians’ fights are not real; they are staged to shock and horrify a childish audience.

The October show was just an insignificant preliminary exhibition, anyway. The championship event will come when the entitlements go bust, maybe decades from now. When the people learn that the government has been kidding them about their rights to Social Security, health care, and other public benefits, they also will find that those programs are overstretching the resources of half the country to support the other half.

China and the dangers of unbalanced growth

image

The article below reiterates one of the basic economic truths explained in Political Economy Simplified, which is that growth requires a cyclical balance between consumption and savings; borrowing and investment. China is producing more exports than the world can consume, especially by the de-leveraging developed economies. China’s growth path is essentially too steep to keep up and so will correct to a more sustainable path. This is what happened with the credit bubble in the US as well. China is attempting to turbo-charge both consumption and investment at the same time by excessive borrowing, just like the US did in the 2000s.

Fundamentally, the economy runs on four wheels: consumption, saving, investment and production. If either of these gets out of sync with the others, the vehicle will sputter and crash. Interest rates are normally what keeps it all together, but we’ve been distorting those worldwide for the past two decades. Such mismanagement will demand a reckoning, and more of the same merely delays the inevitable.

From the WSJ:

China Has Its Own Debt Bomb

Not unlike the U.S. in 2008, China is at the end of a credit binge that won’t end well.

 By RUCHIR SHARMA

Six years ago, Chinese Premier Wen Jiabao cautioned that China’s economy is “unstable, unbalanced, uncoordinated and unsustainable.” China has since doubled down on the economic model that prompted his concern.

Mr. Wen spoke out in an attempt to change the course of an economy dangerously dependent on one lever to generate growth: heavy investment in the roads, factories and other infrastructure that have helped make China a manufacturing superpower. Then along came the 2008 global financial crisis. To keep China’s economy growing, panicked officials launched a half-trillion-dollar stimulus and ordered banks to fund a new wave of investment. Investment has risen as a share of gross domestic product to 48%—a record for any large country—from 43%.

Even more staggering is the amount of credit that China unleashed to finance this investment boom. Since 2007, the amount of new credit generated annually has more than quadrupled to $2.75 trillion in the 12 months through January this year. Last year, roughly half of the new loans came from the “shadow banking system,” private lenders and credit suppliers outside formal lending channels. These outfits lend to borrowers—often local governments pushing increasingly low-quality infrastructure projects—who have run into trouble paying their bank loans.

Since 2008, China’s total public and private debt has exploded to more than 200% of GDP—an unprecedented level for any developing country. Yet the overwhelming consensus still sees little risk to the financial system or to economic growth in China.

That view ignores the strong evidence of studies launched since 2008 in a belated attempt by the major global financial institutions to understand the origin of financial crises. The key, more than the level of debt, is the rate of increase in debt—particularly private debt. (Private debt in China includes all kinds of quasi-state borrowers, such as local governments and state-owned corporations.)

On the most important measures of this rate, China is now in the flashing-red zone. The first measure comes from the Bank of International Settlements, which found that if private debt as a share of GDP accelerates to a level 6% higher than its trend over the previous decade, the acceleration is an early warning of serious financial distress. In China, private debt as a share of GDP is now 12% above its previous trend, and above the peak levels seen before credit crises hit Japan in 1989, Korea in 1997, the U.S. in 2007 and Spain in 2008.

The second measure comes from the International Monetary Fund, which found that if private credit grows faster than the economy for three to five years, the increasing ratio of private credit to GDP usually signals financial distress. In China, private credit has been growing much faster than the economy since 2008, and the ratio of private credit to GDP has risen by 50 percentage points to 180%, an increase similar to what the U.S. and Japan witnessed before their most recent financial woes.

The bullish consensus seems to think these laws of financial gravity don’t apply to China. The bulls say that bank crises typically begin when foreign creditors start to demand their money, and China owes very little to foreigners. Yet in an August 2012 National Bureau of Economic Research paper titled “The Great Leveraging,” University of Virginia economist Alan Taylor examined the 79 major financial crises in advanced economies over the past 140 years and found that they are just as likely in countries that rely on domestic savings and owe little to foreign creditors.

The bulls also argue that China can afford to write off bad debts because it sits on more than $3 trillion in foreign-exchange reserves as well as huge domestic savings. However, while some other Asian nations with high savings and few foreign liabilities did avoid bank crises following credit booms, they nonetheless saw economic growth slow sharply.

Following credit booms in the early 1970s and the late 1980s, Japan used its vast financial resources to put troubled lenders on life support. Debt clogged the system and productivity declined. Once the increase in credit peaked, growth fell sharply over the next five years: to 3% from 8% in the 1970s and to 1% from 4% in the 1980s. In Taiwan, following a similar cycle in the early 1990s, the average annual growth rate fell to 6%.

Even if China dodges a financial crisis, then, it is not likely to dodge a slowdown in its increasingly debt-clogged economy. Through 2007, creating a dollar of economic growth in China required just over a dollar of debt. Since then it has taken three dollars of debt to generate a dollar of growth. This is what you normally see in the late stages of a credit binge, as more debt goes to increasingly less productive investments. In China, exports and manufacturing are slowing as more money flows into real-estate speculation. About a third of the bank loans in China are now for real estate, or are backed by real estate, roughly similar to U.S. levels in 2007.

For China to find a more stable growth model, most experts agree that the country needs to balance its investments by promoting greater consumption. The catch is that consumption has been growing at 8% a year for the past decade—faster than in previous miracle economies like Japan’s and as fast as it can grow without triggering inflation. Yet consumption is still falling as a share of GDP because investment has been growing even faster.

So rebalancing requires China to cut back on investment and on the rate of increase in debt, which would mean accepting a rate of growth as low as 5% to 6%, well below the current official rate of 8%. In other investment-led, high-growth nations, from Brazil in the 1970s to Malaysia in the 1990s, economic growth typically fell by half in the decade after investment peaked. The alternative is that China tries to sustain an unrealistic growth target, by piling more debt on an already powerful debt bomb.