The Death Spiral of Debt Approaches
An extraordinary age of excess is coming to an end. Did you miss it? It's time to take The Sniff Test.
The bonanza of a lifetime is ending. Have you made the most of it?
Here’s a chart for those unsure we live in extraordinary times. It shows the US government debt as published by the Treasury. The rate of increase is getting steeper.
Debt is essential to market economies, the lifeblood of entrepreneurs and the way to deliver productive investment and growth. This becomes more important as populations slow. But debt borrows from the future because what the future spends on interest it cannot spend on anything else. Interest on government debt costs $660 billion this year, which is three-quarters of healthcare spending and 50% more than corporation tax receipts. Interest is the fastest rising element of the budget deficit.
Debt becomes an issue when it doesn’t fund productive growth and cannot be paid back. What do we have to show for the explosion in borrowing of the past 40 years?
A straw poll highlights more disposable income leading to frequent travel and eating out, but the biggest change is in technology. The first PCs appeared in UK secondary schools four decades ago, since when the internet made information free and a phone costing a few hundred dollars has the power of tens of thousands worth of technology from the eighties.
But the last 40 years haven’t been boom times. For sure, house prices and stock markets are much higher, especially in America. This has exacerbated the wealth gap and created a new middle class that is disaffected, opiate addicted and suicidal. Especially in America.
Those who made the most of the debt bonanza borrowed aggressively and typically that means the wealthy with assets to pledge as collateral. If you didn’t re-mortgage your house, your company and your country, frankly you’re a loser. Welcome to the club.
The surge in government debt is the dollar system working at its maximum in America’s favour, while the rest of the world struggles to keep up. It’s an economic cold war that America wins by outspending every other nation on earth.
How did we get here and how might it end?
Why Entrepreneurs are Essential for Growth
The United States is as polarised as at any time since the 1930s. This was the Depression era when the clarion calls of communism and fascism were heard and there was growing malaise with the economic collapse. People feared another civil war which was only averted by a second world war.
Why did the economy stop working? Market economies evolve from the production of surplus, but this alone is not enough for capitalism. A feudal economy produces surplus for landowners who turn it into debt by making loans, most frequently to the monarch to raise an army or fellow aristocrats to buy land.
A market economy requires that the debt comes first. People borrow to buy or rent the means of production and set about making things for surplus. This is how inventions become products. In a feudal society a technological innovation is a curio presented to the monarch and treated as a sign of how great his kingdom is. But in a market economy the same innovation is exploited for profit and that requires debt to get the venture started.
The Chinese claim to have invented many things that later became commercially available in the West. This may be true but the value of the invention is not in the research but the development. An entrepreneur need not be an inventor but they must convert ideas into products.
Entrepreneurs stands alone in taking risk. The landowner knows what they will be paid in rent, the labourer gets their wages and the banker is paid interest, but the entrepreneur takes what remains, if anything. This uncertainty of return is why 90% of small businesses cease trading within a decade but also why vast fortunes accrue to the entrepreneurs who make it.
Pruning the Grapes of Wrath
The great novel of the depression era is Steinbeck’s The Grapes of Wrath. The wrath is the anger of the people at the failure of the system to feed them and it grows like grapes on the vine. The injustice is epitomised when the people see the destruction of potatoes and oranges when many are starving.
In a market economy it is the role of the money lender to recycle surplus. This necessity is performed by outsiders because religious authorities outlaw usury, the lending of money for interest, to protect the status quo. The surplus of a feudal society sustains the aristocracy and organised religion and social climbers prevail by judicious observance of societal norms.
This means a competition to be pious and feudal societies get increasingly dogmatic through time, which is why more women wear the burka in the Middle East than 40 years ago. The Catholic church still outlaws usuary but defines it as charging excessive interest, whereas Islam retains control by requiring holy men to interpret what qualifies as Sharia finance. This differing attitude to debt is fundamental to the contrast between societies.
Entrepreneurs are outsiders, which is typified by the Silicon Valley trope of move fast and break things. They do things differently in California compared to the establishment back East. Observing the huge cash generating machines of today’s technology giants it may be hard to see the role of debt. But scratch the surface and you find thousands of wannabee companies sustained by venture capital that is little more than borrowed finance spread across multiple bets.
The Great Depression occurred because the banks stopped recycling surplus production. Fast forward to present day and the authorities swept in to save Silicon Valley Bank because, while it was relatively small, the surplus cash of California’s venture capital industry was concentrated there. The authorities have learned to prune the grapes of wrath.
In the Dollar We Trust
While you may think that banks collect deposits and lend them out, the opposite is true. A debt is created on one side of the balance sheet and a deposit appears by magic on the other, thereby allowing borrowers to spend. There is little constraint on how much money banks create.
It wasn’t always this way. The United States was on the gold standard until 1971, which meant that new dollars issued had to be backed by a fixed amount of gold. The backing of gold is the hallmark of the currencies of empire and the treasures of the New World enriched first Spain and then England through the piracy of the latter’s legendary naval heroes. Eventually though, the demand for new currency exceeds the availability of gold and the empire experiments with fiat currency, meaning money is backed only by faith in the soundness of the system.
The dollar system of the last 50 years is a fiat system supported by the financial, military, social and political reach of the United States. Unconstrained by gold, the currency has exploded into a pile of debt. The increase in dollars and the international recycling of them increasingly favours the US and is reflected in the performance of stock markets.
Why Banks Cause Cycles
The great returns from debt go to the risk takers not the lenders. Banks put a lot of money on the line for little return, measured by the interest rate. These rates have been unusually low since the financial crisis a decade and a half ago, meaning banks have been extra careful to lend to people who can pay the money back. By and large this means wealthy people and hence the debt explosion has exacerbated the wealth divide.
To stay in business banks must spread their risks. They make a lot of loans and when faced with very large ones they syndicate the debt to other lenders. The increasingly complicated ways to do this create a legal minefield over who owns what and was one cause of the financial crisis.
There is little incentive for banks to deviate from their role recycling surplus. Citibank’s Chuck Prince described this as dancing while the music plays, which while correct was unfortunate timing coming just before it stopped in 2007. What he meant was that banks rise and fall as one and senior managers are rewarded for conformity not diversity.
In this way banks eventually lend too much and too great a surplus of production occurs. Prices collapse. Banks stop lending more and the system shudders to a halt, triggering runs on banks as people fear for their savings. Banks recall good loans as well as bad in a dash for cash to pay depositors and the problems spread from one section of the economy to another. This is how a surge in manufacturing unemployment in one part of the country can cause house prices to fall in another.
Why Banks Must be Rescued
During the Great Depression the authorities doubled down on economic orthodoxy and forced the economy to take its medicine. Whatever the merits of the economic theory, this was bad politics and fed the grapes of wrath. Only the ratcheting up of government spending, mostly on the war machine, restarted the flow of cash that is the lifeblood of an economy.
Having learned a lesson the authorities now intervene to protect banks. Initially the central bank replaces lost deposits with its own, and as they carry the aura of state guarantee this is enough to stop minor panics.
When problems run deeper the state rescues banks. This is a political decision about who to save and has a lot to do with how big the bank is and, as with Silicon Valley Bank, how concentrated is its customer base. The frequency with which bank regulators resign to take jobs with the largest financial institutions is merely another thread in the financial web. Banks are essential to modern economies which means they are political as much as financial institutions.
The third intervention of the state is to guarantee deposits, which aims to avoid panic withdrawals by savers. Legally there are limits on the amounts covered but the most recent rescues in the US ignored these in the name of stability.
The End of the New Cold War
What do you do when driving and you see a speed camera flash? You slowdown and drive cautiously for a while even though it’s too late to avoid a fine. Pretty soon you shrug it off and you’re back speeding, after all you’re only keeping up with the flow of traffic. Your driving is as cyclical as banking.
Successful economies need debt to fund new technologies. This means supporting greater food production, cleaner manufacturing and better healthcare, as well as iPhone applications. Occasionally lending grows too fast and banks navigate more cautiously for a while. Government intervention is designed to accelerate the return to normality.
History teaches this is the way to regulate surplus. Governments have tried and failed to design and control banking systems but in doing so they stifle creativity elsewhere in the economy. The weakest part of a dictatorship is its banking system because it’s primary purpose is political patronage rather than funding innovation.
This is the challenge of our polarised world. As competition mounts between East and West in clean tech and artificial intelligence, the massive subsidies required to emerge victorious resemble patronage and pile up government debt. This crowds out less politically significant innovations, which might design better ways to grow sustainably. China only overtakes the US if the US becomes more like China (the reverse won’t happen).
The ending of the gold standard, the post-war global dollar system and the massive increase in government debt, delivered victory for the West in the Cold War. The Soviet Union lacked any semblance of the banking system required to match America and Europe rode the US coattails.
But the spending continues and debt piles up. For all the success tackling cancer and heart disease in the last 40 years, there is always more healthcare spending. Social security bills mount as the population ages and it is the young who resist changes because they want the same entitlements as their parents. Military spending is on the increase.
The one to watch though is the cost of interest. There long ago ceased to be enough surplus to pay back debt in our lifetimes, but once there is not enough to service the debts then it’s game over.