Yellen’s Legacy: The Greater Depression

What a week. Brexit has come and gone. Markets have settled. The world is not coming to an end…at least not yet anyway.

The Brits defied the polls and bookmakers, opting out of the failing European experiment. Good on them, I say.

The world has not come to a grinding halt. People will still trade. There are many bruised egos in the corridors of power, but life will go on.

The initial reaction from markets was predictable…volatility. Gold powered up to US$1,358 per ounce. Share markets beat a hasty retreat. The British pound was trampled in the rush to the exit. Bond markets were the safe haven for liquidated capital…pushing interest rates even lower.

US billionaire (and investor extraordinaire) George Soros tells us Brexit is the beginning of the end.

In my experience, the well telegraphed events are very rarely the major turning points for markets. It’s the stuff that comes out of left field — like a Lehman Brothers failure — that really shakes markets out of their stupor. These events usually elicit a response along the lines of ‘What the hell…we didn’t seeing that coming…’ Then the proverbial hits the fan.

The reality is that a struggling Europe needs the UK slightly more than the UK needs Europe. They will cobble together a working relationship for both their sakes. The pre-voting doomsday predictions from politicians and central bankers will be revealed for what they were — self-serving hype to keep the insiders’ club together.

For all their bluster on how they’ll huff and puff and blow the Brits house down, Merkel, Junger and Draghi know Europe needs to trade with the well-heeled Brits. They’re not about to put bullet holes in the feet of Europe; or at least I don’t think they will.

The central banks will marshal their stimulus forces to support markets…again. They’ll lead with the predictable big guns of money printing and lower interest rates. Although the Japanese may ‘surprise’ us and reveal a more unorthodox stimulatory weapon. After all, Japan is the frontrunner on how to (mis)manage a deflationary economy. Anything new and creative from Japan is destined to be in our future…unless of course the whole thing blows up beforehand.

And that gets us to the big picture: The increasing debt toxicity in the system.

The real issue has not gone away — and that is the absolute dependency the global economy has on debt to generate GDP growth. More and more debt is required to generate economic growth.

According to McKinsey Global Institute, global debt levels have increased more than US$60 trillion since 2008. Whereas, over the same period, global GDP is up only US$15 trillion (from US$63 trillion to US$78 trillion).

It now requires around US$4 of debt to create US$1 of growth. Whereas 40 years ago, US$1.50 of debt generated US$1 of growth.

Exponential debt is not a sustainable trajectory. However, the powers that be obviously think otherwise. Which is why the cost of debt keeps sinking lower.

Negative interest rates are a clear indication of how wacky the whole system has become in its frenetic and irrational need to inject increasingly larger doses of debt into its veins to remain functional.

Without a continued and rapid accumulation of debt, the whole system is under threat of shutdown. That is not hyperbolic scaremongering; it’s a fact.

A debt to growth ratio of $4 to $1 is a compounding nightmare.

A 2% growth rate on current global GDP (US$78 trillion) equates to US$1.6 trillion. Achieving this growth target requires US$6.4 trillion (four to one) in newly created debt.

In 20 years’ time — assuming a constant 2% growth rate — global GDP would compound to US$116 trillion. Maintaining a 2% growth rate on that number would require around US$10 trillion in new debt to be added.

More debt…on more debt…on more debt.

Trees do not grow to the sky.

Pushing interest rates deeper into the negative has a limited lifespan. Negative rates, literally, have a negative feedback loop. If investors are paying instead of receiving interest, you have a dwindling capital base to reinvest. This makes no sense in the longer term.

Also, if rates remain permanently and deeply in the negative — to aid and abet the uptake of more debt — all other income producing assets will be priced accordingly. Eventually we would be investing in a world where income is virtually non-existent. This too is an illogical outcome.

Increasing debts and decreasing returns.

We are locked on a path of self-destruction.

How did all these economic PhDs not see the fatal flaw in their master plan?

It’s not like they weren’t warned.

Interest and Prices

Source: Wikipedia
[Click to opn in new window]

In 1898, Knut Wicksell wrote Interest and Prices.

Perhaps the economic academics judged the book by its very plain cover and decided the content was not sufficiently interesting for them.

Wicksell, a Swedish economist, was recognised as the economists’ economist.

Whereas dubbing today’s crop of economic academics an economists’ bootlace would be flattery.

Anyway, behind that very vanilla cover was Wicksell’s theory of interest.

Wicksell’s theory was based on what he described as the ‘natural rate of interest.’ An optimal interest rate — not too high and not too low — would maintain price stability and steady long term growth.

According to Wicksell, determining the optimal rate of interest was rather straightforward. He compared market rates to GDP.

If the market rate to GDP was too high, an economy would languish. Which is precisely what happened when the US Fed raised rates to 18% in the early 1980s. This resulted in the 1980–1982 recession.

Conversely, if rates were lower than GDP, it would lead to excessive borrowing, misallocation of capital, speculative investing and, in due course, economic adversity.

According to research group 720 Global, the average adjusted rate (interest rate less GDP) for the US since Paul Volker was appointed US Federal Reserve chair in 1979 has been:

  • Volker (1979 to 1987): Plus 2%
  • Greenspan (1987 to 2006): Minus 1%
  • Bernanke (2006 to 2014): Minus 2%
  • Yellen (2014 to present day): Minus 3%


Notice the pattern?

Once he settled into the chair, Greenspan started playing around with adjusted negative interest rates to ignite the credit boom, and his successors have followed suit…notching the adjusted rate lower each time.

Back in 1898 Wicksell could only theorise about the impact the ‘unders’ and ‘overs’ of rates, compared to GDP, would have on an economy.

Practice has proven Wicksell’s theory correct.

Negative rates during Greenspan’s tenure gave us the Dotcom bust.

The combined efforts of Greenspan and Bernanke produced the US housing crisis and subprime debacle; aka the Global Financial Crisis.

What will Yellen’s legacy be? My theory — as yet to be proven — is that Janet will preside over ‘The Greater Depression’. A credit crisis without peer.

Only a fool would believe debts can continue to rise, as rates head lower, without severe repercussions.

Unfortunately, we are being ruled by fools.


Vern Gowdie,
Editor, Markets and Money

Vern Gowdie has been involved in financial planning since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners. His previous firm, Gowdie Financial Planning was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser (IFA) magazine as one of the top five financial planning firms in Australia. He has been writing his 'Big Picture' column for regional newspapers since 2005 and has been a commentator on financial matters for Prime Radio talkback. His contrarian views often place him at odds with the financial planning profession. Vern is is Founder and Chairman of the Gowdie Family Wealth advisory service, a monthly newsletter with a clear aim: to help you build and protect wealth for future generations of your family. He is also editor of The Gowdie Letter, which aims to help you protect and grow your wealth during the great credit contraction. To have Vern’s enlightening market critique and commentary delivered straight to your inbox, take out a free subscription to Markets and Money here. Official websites and financial eletters Vern writes for:

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