Today, I want to talk about something I believe will be critical to our mission of building long-term family wealth: the saturation of debt in the global economy. We no longer live on Planet Earth. We now live on Planet Debt.
A recent report from the ‘central bank of central banks,’ the Swiss-based Bank for International Settlements (BIS) throws this into sharp relief. It told us that world debt levels have soared since 2007.
Contrary to the popular belief that the global economy started to deleverage following the 2008 debt crisis, the BIS reports that between 2007 and 2013 the world took on about $30 trillion more in debt – a 40% increase.
To put it another way, it took Planet Earth about 4,540,000,000 years to reach $70 trillion in debt. The next $30 trillion came in a flash – just six years. At the present rate, in about 2028 the world will have twice as much debt as annual economic output (GDP) – the level more or less of debt-soaked Japan.
But if the rate of increase continues on its asymptotic launch path, we could reach this level sooner: like the day after tomorrow. The incontestable fact on the table: This debt bubble will implode. Families who understand this will be able to protect their legacies. Those that don’t will see their savings flushed away in the following debt deleveraging.
Just seven years ago, the developed world entered into a major debt crisis. At the time, world debt was only $70 trillion. According to Neil Barofsky, inspector general of the Troubled Assets Relief Program, the most aggressive EZ money program the world has ever seen followed.
The Fed alone put at risk about $23 trillion of guarantees and assurances to keep the debt bubble expanding. Other estimators put the total cost of US recovery efforts at over $10 trillion. This does not include the collateral damage caused by the US Federal Reserve’s zero-interest-rate policy: the compressor that has done the most to inflate this bubble further.
As Genesis led to Exodus, the feds’ rescue brought forth debt. Since the Fed’s relief efforts began, total world debt has gone up by $30 trillion, while world income went up only by $20 trillion. Debt rose 1.5 times faster than income, in other words. Total debt now exceeds 115% of total world GDP.
At a nominal (not adjusted for inflation) 5% interest rate, it would take $5 trillion to pay the annual interest on all this debt – or nearly half the world’s output which, according to the IMF, is about $85 trillion.
When this bubble bursts, can all the king’s horses and all of his men put it back together again? We doubt it. Short-term interest rates are already near zero in the major developed economies. Central banks have no other tricks up their sleeves. And world debt levels are approaching what must be another calamity point. What will happen this time? Who will bail out the Debt Planet? Mars? Or Venus?
But wait… If the world owes $100 trillion, whom does it owe it to? It owes it to itself, economists will tell you. But the comfort you get from that realization should last you roughly half a second – just as long as it takes to realize that there’s no one on the other side of the trade.
Normally, or I should say theoretically, the two sides of a ledger always equal out. If there’s a debtor, there is also a creditor. Like day and night, horns and clarinets, whiskey and branch water – they must always balance out. One man’s liability is another man’s asset. Between the two of them, net debt is always zero.
So, nothing to worry about, right? Every penny of debt owed by Thais, Argentines and Lithuanians must be owed to Germans, Indonesians and Japanese, right? When they settle up – as eventually they must – the result is perfectly acceptable and entirely predictable? The borrowers give their money up; the lenders get their money back. You think so? I just hope I’m there to see it. I want to see the looks on the lenders’ faces.
Governments have issued the bulk of this new debt. This leads many to believe “we owe it to ourselves.” Nothing to worry about. Here’s Cullen Roche of Pragmatic Capitalism off base, but on the subject:
‘Okay… a lot of government debt. But that also means the private sector has a lot of savings (by accounting identity, the government’s debt is the non-government’s saving). I know people seem to have an aversion to government debt, but debt alone is not an ingredient for disaster. After all, our entire monetary system is credit based. One person’s liabilities are someone else’s assets. That’s just double-entry bookkeeping.’
Unfortunately, double-entry bookkeeping doesn’t tell you whether the debt is good or bad. The fact that one person owes a lot of money does not mean he’s ever going to pay. The books always balance out to zero: debits on the left, credits on the right. But the credits may be worthless, while the debt will still be owed. It will go away too, eventually, but how? I don’t know, but I can’t wait to find out.
There’s a difference between small scale, dispersed transactions and large scale, aggregated ones. This is part of the problem of central planning. A man may eat his porridge at home and find it rather agreeable. Put it out in public kitchens for the masses, as part of a government program, and it will make him sick.
You can see this phenomenon in corporate earnings. Although a single company’s earnings may be relatively independent of the rest; all of them can’t be independent of each other.
You can say company “X” is likely to increase earnings by 10% next year. That could happen in a couple of ways. The company could increase sales. Or it could cut costs. Higher earnings would likely follow.
But if you say, all US companies will increase earnings 10% next year, you are talking about a different kind of phenomenon. For all of them to increase earnings at once, something must happen to the entire system.
A single company can increase sales by taking sales away from other companies. But all companies cannot increase sales in the same manner. They would just be taking sales from each other. Likewise, they cannot reduce costs collectively. Because one’s costs is another’s income. The miller may cut his fuel costs, for example. But then the fuel company loses revenue.
That is called the ‘fallacy of composition.’ And it applies to debt – big time. A single debtor can pay down his debt with little adverse consequences for others. But if all debtors do so, the entire system goes into a tailspin. An episode of collective debt reduction is called a “debt deleveraging” – the very thing the Fed is trying to stop.
When all debtors try to cut back on their debt at the same time, balls start ricocheting all over the table. To pay off its debt, the seven ball stops spending so much… which bounces off the left rail and reduces income to the 11 ball… which forces the two ball to lay off employees… and knocks into household, and puts the whole consumer economy directly behind the eight ball.
Trying to reduce leverage by paying it off would almost certainly lead to a debt-deflation. This would reduce incomes and make it more difficult to pay off debt! That’s how you get into a real depression. But when you have so much debt, there is no avoiding it.
One hundred trillion dollars is a lot of money. What is amazing is not that lenders lent so much… nor that borrowers borrowed so much… but that savers were able to save so much.
The US savings rate is 10% max. On national income of $17 trillion, that gives you $1.7 trillion – max – to lend out. Total world savings are maybe about $10 trillion. Of course, people have other uses for their savings than lending it. Most of it is used for weddings, funerals, real estate, stocks, art, vacations and spending in retirement. Only a small part is available to borrowers. The bond market is huge, but it doesn’t absorb 100% of national savings – not even close. Anyway you figure it, there is no way savers socked away $100 trillion, which they then lent out to borrowers.
So, the mystery of the world ledger deepens. Where did the money come from? From outer space? Okay… I’m just teasing you. You know as well as I do that this money never existed. Instead, it was called into being by the magic of the banking system, with the not insignificant help of central bank prestidigitation.
This introduces a new wrinkle. We had hoped to see the looks on lenders faces when they realized they had been had. They lent out trillions of dollars. Like sending children to boarding school, they hoped to see the kids come home better behaved than before they left. Imagine how they’ll feel when the children never come home at all!
But what if the kids didn’t exist? No father. No mother. These poor orphans were created in central bank test-tubes. The Fed has expanded its balance sheet – and the monetary base – by more than $3.2 trillion since the debt crisis first erupted. The Bank of England has added another $500 billion. And the Bank of Japan promises another $2 trillion by the end of next year.
Who would mourn for them if these children never came home? Who would look at a school photo, shed a tear, and give an interview to the local paper? Surely, this is a case of owing nothing to nobody.
I am not the only one to ask the question. Serious economists have suggested that the US government should simply default on its debt held by the Fed. Who would care, they ask? This would solve two problems at once:
1) It would lower the federal government’s debt obligations by $1.7 trillion
2) It would eliminate the need to sell this back into the private economy, thus potentially causing a downdraft in prices and a spike in yields.
But even the monetary base doesn’t shrink without tears. Every dollar of that money had friends and neighbours. The resulting low interest rates make it easier for borrowers – most notably the federal government and Wall Street speculators – to take on even more debt.
This debt, in turn, funded jobs, spending, capital investments, speculations, public works and private leisure. When the Debt Planet blows up it will be sorely missed.
There are a lot of ways debt can die. Some quick and humane. Some long and painful. For the moment, we are pulling the Band-Aids off slowly in the private sector (at least in the US, until very recently). In the public sector, we are plastering more over every scratch… and boo-boo.
As the debt bubble grows, more and more sticking plasters are needed to stop the bleeding. This won’t work forever (as you’ve heard me say for what must seem like… well… forever). But all bubbles burst. This will be no exception.
And when that happens those who lent unwisely… those who bought stocks that depended on debt expansion… those who said we ‘owe it to ourselves’… those who claimed we could ‘grow our way out of debt’…those who sold their gold because they asked ‘what could go wrong?’…those who lost fortunes: I just want to see the looks on their faces…. and I hope I will not be looking in a mirror!
Our advice: Hold plenty of gold. It’s still the best disaster insurance we know. Also, maintain allocations to other tangible assets. Real estate is one of our favourites. But anything you can stub a toe on will do. We also favour stocks that control large energy and natural resource reserves. But these are long-term plays. A couple of years is nothing on a family office’s timeline.
Here’s to your family wealth.
for Markets and Money
From the WWD Archives…
John Robb on iWar and the Modern Nation State
2-04-2014 – Bernd Struben