Guest post by The Zman
One of the unintended consequences of a world of floating exchange rates has been the geometric growth of debt. The total amount of debt in the world currently sits at around $300 trillion, which is about three times the global GDP. That seems like an impossibility, but the value of all assets on earth is estimated to be around $300 trillion, which means every bit of potential collateral is pledged to someone, somewhere in some fashion. The world is literally drowning in debt, you could say.
Of course, those are just guesses. Some debt is actually listed as both an asset and a liability. Your mortgage is most likely in some sort of synthetic financial instrument as an asset against which there is some form of debt. Government bonds are used for collateral, as they are often considered the most reliable and trustworthy asset on earth. Banks soak up US debt, for example, because it is worth more to the bank than their cash deposits, as they can quickly package bonds into other financial transactions like repo agreements.
It’s also why the US government has no trouble finding willing lenders, despite having record debt and deficits. Those lenders are holding cash, which is not as valuable to them as the bonds. It’s not just the US government. The Germans also enjoy high demand for their debt. In Europe, the German Bund is the preferred collateral in finance transactions. In fact, it is so valuable, there is a shortage of it. The result is there is always pressure on the European Central Bank to not hold Germans bonds.
It is an important thing to understand about the world of modern finance. It is entirely driven by debt. When company X wants to do a deal, it does not reach into its cash reserves to finance the transaction. Instead, it will pledge an asset in a repurchase agreement. This is where it agrees to sell the asset to another party, but simultaneously agrees to buy it back at some point in the future at a fixed price. This is a modern form of pawning the wife’s wedding ring. The company gets the cash and the lender gets interest.
Of course, no tree grows to the sky, but the modern financial system is counting on debt being the exception.
Down in the depths of Europe’s financial system, a nasty blockage is building. The plumbers at the European Central Bank meet next week to try and fix it.
They may be four days too late. Italy’s referendum could just stretch the system to breaking point before then.
At stake is the health of the 5 trillion-euro ($5.3 trillion) securities lending market, which greases the wheels of all manner of derivative, short-selling and structured transactions. A crunch point has arrived in Europe. The last few days have seen an extreme spike in demand in particular for short-dated German government bonds.
These are among the few securities of high enough quality to be accepted as collateral in repurchase agreements. Cash is no good (well, not for the Bundesbank anyway). These agreements operate like high-quality loans whose proceeds are normally used for activities like financing the purchase of other securities. Without them, a lot of other everyday activities — such as bidding at bond auctions and hedging underwriting risk — could seize up.
The demand spike is from the usual year-end surge in demand for collateral getting pulled forward, and has exacerbated a shortage of securities that count as collateral.
In normal times, firms borrow the securities they need and quickly return them — there’s usually a flood of lending and borrowing going on, and the repo market operates silently in the background of Europe’s financial system.
But the ECB’s drive to jump start the economy has led it to buy up about 20 percent of the market for German bunds and other top-quality securities. Schatz — German government bonds of a two-year maturity — had become notably harder to come by. Firms can borrow them from the ECB, but only on the strictest of conditions. The Bundesbank has been even more resistant: it’s long been reluctant to accept any kind of collateral of lesser quality than German government bonds.
What all that means is the modern financial system has come to rely so heavily on government debt that governments cannot issue enough of it. The trouble is, government debt can take cash from the economy. This is fine when the economy is overheated or there is inflation. Central banks can step in and sell their bond holdings to soak up the excess cash. That’s not the case today anywhere in the world. Instead, governments are looking to boost the retail economy by getting more cash into the system.
The result is an unsolvable conflict. On the one had we have a financial system demanding ever more high quality debt, in order to drive growth in asset values. On the other hand, we have a retail economy demanding more cash moving around in the system in order to stimulate economic growth. It’s why smart guys like James Rickards see a financial crisis in the near future. The methods to paper over this inherent conflict are just a delaying action. At some point, the pressure exceeds the restraints and you get a crisis.
An organized unwinding of trillions in debt is never going to happen, so that means we will have a disorganized unwinding of trillions in debt. That’s the definition of a crisis. It is the unexpected, disorganized unraveling of something that probably should never have been allowed to happen. The mortgage crisis is the most recent example. Lending billions to people, who have no way to repay the loans, turned out to be a bad idea. In the fullness of time, the mortgage crisis will be seen as a warning, one everyone ignored.
“One of the unintended consequences of a world of floating exchange rates has been the geometric growth of debt.”
Debt is the consequence of politicians and their spending policies, always thinking the citizen can be gouged for more and more again.
So far they’ve been right.
Wonder how much longer it will last and how it will be reconciled when it can no longer be sustained?
I think we’ll find out the answer to this sooner rather than later.
Very Proud.
Yes and no. In some ways the citizen is the least of it.
The big movers seek fees/profits by moving things around.
The citizen is expected to pay the interest on the debt.
Z explains the chess pieces fell off the table.
It’s more about sustaining the illusion that the country is more prosperous than it really is until the next election, and it doesn’t have to be (unfunded) government expenditure that does this. Any form of large scale debt escalation will have the same effect, which is why it is necessary to watch for buildups of any form of debt all the time.
Some estimates of total debt place it at north of $700T, including derivative exposure.
There is an old maxim: Gold is the money of monarchs; silver is the money of gentlemen; barter is the money of peasants; debt is the money of slaves.
So what am I, if I have gold, silver, and debt as well as occasionally barter?
Lunatic Fringe.
Well diversified!
Out here in the backwaters of the Left Coast a lonely voice cries out:
“Just face facts. The US government works the way it was intended to work, for the people it was intended to work for. You are not among those people. You are just another amber shaft of grain in their vast plantation. Your life, measured in rent checks, mortgage payments, health insurance premiums, student loan remittances and credit card payments, is their harvest. You are just livestock to them, and the planet is your overgrazed pasture. Your job is to devour the world and turn it into their money. That’s why we have a government, and that’s why we have the government we have.”
The harvest is just about complete with just a little more room in the storage bins…..
I prefer the metaphor of a Mt. Vesuvius of debt being piled up, and we all live in Pompeii.
The period following WW2 was phenomenal for US citizens. When the party started to wane in the mid-1960’s, people wanted to keep things going so they elected rulers who promised to keep spiking the punchbowl. The dollar was divorced from any consistent ruler (silver in 1964, gold in 1971) and a series of “We Can Do ANYTHING” follies were undertaken, from eliminating poverty to making real the Blank Slate beliefs of anti-racism.
Then in 1981 the secular bear market in bonds ended and for 35 years holding the debt of someone was tantamount to planting a money tree in the back yard.
The real effects of piling up Mt. Vesuvi-Debt are these:
1. Nominal prices for assets sailed higher because optimistic people who were sitting on a mountain of future cash flows (IOU’s, AKA bonds) engaged in a feedback loop of spiraling prices. IBM is worth $159.30/share at this moment because traders agree on that value. They can agree on a different value at any time.
2. Those who issued debt took that spending power into the marketplace and warped the entire economy in favor of their demand.
The former of these promises a crash of historic proportion.
The latter of these, however, is far worse. For decades and decades economic demand encouraged people to structure their entire lives around conditions that only exist because of the ability to issue endless debt.
EVERY JOB in EVERY INDUSTRY supported by government spending exists only until (in the USA’s case) Uncle Sam’s credit card gets declined at the cash register.
Do we really “need” (as in economic demand for) the millions and millions of doctors, nurses, med & imaging techs, etc., etc., being paid for by Medicare/Medicaid? What about the vast labyrinth of “non-government” social service agencies whose only “business” is administering billions of dollars of welfare services?
These are but a few of the jobs for which there will be a tiny fraction of existing demand, once interest rates rise enough to choke off borrowing.
Last JULY (!) the 10 Year US Treasury Note yielded 1.32%. Today it yields over 1% higher, a stunningly massive increase on a percentage scale. Similarly, the 3 month T-bill had a NEGATIVE YIELD 14 months ago; today’s yield is 0.5025%, which incidentally all but guarantees the Fed will raise its benchmark rates at its upcoming FOMC meeting.
These rate increases are like small tremors or smoke rising from Mt. Vesuvi-Debt. Perhaps they mean nothing, but they also may mean a new trend toward higher rates has begun its inexorable march. If that’s so, sooner or later the S will finally HTF, and the dollar-wealth-value of those IOU’s will begin to evaporate.
What will happen to pension promises, endless guns-and-butter government spending, essentially all promised future cash flows and (last but not least) asset prices when rising rates erode trillions of dollars of “wealth” from people’s (and corporations’) balance sheets?
Just for the sake of argument:
If there’s $300 trillion in debt outstanding
If its average maturity is 5 years
If we assume its coupon at = to the 10 year T-note last July (1.3%)
and rates rose to today’s ~ 2.3% ……………..
The loss in wealth value of that $300t is almost $50 trillion.
Bond value is leveraged across all outstanding debt; any interest rate change affects ALL outstanding obligations, whether they’re explicitly bonds or any other form of IOU, including the NPV of entitlement spending like Medicare or Social Security.
It is a paradox of the ages, that only when interest rates are in constant decline toward zero will people pile up debts to the stratosphere, yet when rates have nowhere to go up higher, the resulting mountain of debt turns into the most destructive force known to Man in economics, finance and monetary systems.
Remember, that “nearly $50 trillion dollar loss in value” occurred (using those assumptions) with only less than five months’ rise in rates.
If interest rates truly have begun a secular trend higher, long before the time rates across the yield curve approach even “normal” for the last 75 years pretty much all the world’s tax revenues and all the world’s profits will be consumed by interest expense.
Game Over.
My point is that common sense never could have imagined this would get to this point. I thought this trend would have stopped a full 21 years ago. Instead, we launched into the greatest Mass Mania in recorded history. It’s all we know now.
The denouement is going to exceed any rational forecast, too. I wish I could afford to buy a decommissioned missile silo with some adjacent farm land, and have Amish neighbors.
At long last after many years of waiting for the opportune moment and overcoming bureaucratic hurdles, the digital capital is going into a top-of-the-line water well drilling rig to complete the water systems business launched by my son, who lives next door on our farmlette in the Southern Cone. Everything owned outright, no debt (and those rigs are expensive!), shop on premises, and a solid Texas A & M engineering education combined with six years on an offshore oil drilling platform makes for good possibilities in an under-represented business in our area and beyond.
This idea began forming about 15 years ago, five years after I believed it would all go blooey and decided to leave the US. I was wrong, of course, and honestly hope I continue to be, but even so, no regrets about putting the eggs into the productive tangibles basket; if anything, I’m relieved.
The Fed is starting to slowly tighten the notch–
http://wolfstreet.com/2016/12/06/fed-has-been-sneak-tightening-dollar-rates-balance-sheet/