Tag Archive for: FederalDebt

Weekend Read: A Witches’ Brew of Negative Trends

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Estimated Reading Time: 7 minutes

So, the witches’ brew in summary is sky-high stock valuations, extraordinarily high debt burdens, rising interest rates, rising inflation rates, inverting yield curves, a bond bear market, supply chain crisis caused by lockdown, energy price shock, food price shock, war, radical social change, monetary regime upheaval, and poor political leadership.

 

 

Having spent almost all of a professional career in financial services dealing with clients, it is easy to attest that almost all periods of time have hazards for the investor. It was always worthwhile to remind investors, who longed for what they thought were the “good old days” that it always has been difficult.

There are always adverse trends and perverse political developments. But within that, there continues to be human progress. Much of it has been technological, but unfortunately little of it has been social or moral progress.

Living through this period was instructive, but if you are younger, you will need to read some history to fully understand.

Just a brief history should remind us all that the “good old days” were full of difficulties such as raging inflation and war in the 1960s and 1970s.  Remember how unsettling The John Kennedy, Martin Luther King, and Bobby Kennedy assassinations were? You can add to that race riots, Watergate, defeat in Viet Nam, the Iran hostage crisis, and the Crash of ’87?

Or how about the Russian default, the Thai-Baht crisis, the collapse of Long-Term Capital Management, the tech bubble of 1999, or the crash of 2007?

Along the way, we had several large wars in the Persian Gulf.

You might remember we got a twofer in 2007-2008, the dual pleasure of a housing bust and banking crisis, followed by a stock market bear crash.

Go back even further and you have Sputnik, the U-2 incident, the Suez Crisis, Hungarian Revolt,  the Korean War, and two World Wars.

The stock market peaked in 1966 and did not return to those highs in inflation-adjusted constant 1966 dollars until 1995. Much of this occurred in what many regard as a better time in the country’s life.

In an earlier period, if one had purchased stocks in 1928, it took until 1956 to break even in inflation-adjusted terms.

Since the crash of 2008, we have had an uncommonly good run in stock values, including inflation-adjusted levels. The last few incredible years are not even shown on the chart.

The point is the “triumph of the optimists” has always carried both the stock market and economy eventually higher, although the progress was uneven. Sometimes there is a pause for years, even decades. Only in hindsight does it seem easy.

Thus, in the long term stocks, and the nation, have persevered. But there can be setbacks that take years to mend. This is particularly dangerous for older people who don’t “have the long term.”

Markets cycle. That is what they do. They go up and down, but generally more up than the down. The same is true of the economy in general.

Having set the context, we admit it would be hard to think of a similar period that had more toxic trends to deal with than the one we face today. And remarkably, almost all of them are the product of deliberate policy choices.

The question before us then is this: will this toxic brew of problems seriously set back the stock market?

What is truly scary is that any one of the trends we are about to mention, by themselves, has often caused a recession. But rarely do we see such a cluster of such potentially powerful adverse trends together, reinforcing one another when just one of these is dangerous enough on its own.

Right now, investors face a historically overvalued stock market and real estate market. Yes, expensive markets can surprise and just get more expensive. But expensive markets are also vulnerable and once they turn, the downside risk is magnified because of the gross departure from reasonable historic value.

If there is one “iron law” in market history, it is a reversion to the mean. Remarkably, so far the stock market still hovers not far from its highs and has taken only a mild correction.

Rapidly rising interest rates, especially when accompanied by inversion of the yield curve (short-term rates move above long-term rates), have reliably signaled recession. We are now seeing that as the FED must regain some credibility after uncorking the worst inflation in 40 years. Either they raise rates sufficiently high to kill off inflation by reducing demand (a recession), or we let the inflation fires burn uncontrollably for years. This is not a very good set of choices.

The rise in rates has been so far been largely disregarded by the stock market but the bond market is being hit hard. The bond market is much larger than the equity market so this loss is certainly just as important as what goes on in the stock market. But, it does not get the attention of the public.

Debt levels are far worse than they were 40 years ago. In 1980-1982 when Reagan and Volker were driving rates to nose bleed levels, Federal debt as a percentage of total output was about 30%.

Today, debt to GDP is 130%, or more than four times greater relative to output, and in many countries, it is substantially higher than that.

The cost of debt service is a function of two things: the amount of debt and the interest rate paid to borrow. Today the amount of debt is so much higher than before that interest rates well below the 1980 peak could clobber the economy and the Federal budget. How high do they go before they hurt?  Who knows?

Whether the borrower is a government or a business, or a homeowner, rising rates on a huge pile of debt normally create default at the margin. Credit spreads (the interest rate between secure paper and speculative paper), are widening, indicating rising rates are beginning to bite and induce distress.

So far one country, Sri Lanka, has gone bankrupt. We fear they won’t be the last or the biggest.

During the prior periods previously mentioned, the world went through several flu epidemics and the polio crisis. The government never quarantined the healthy, such as the lockdown policies we have seen over the past two years. We also never saw the government print $7 trillion dollars and hand out money to anyone who could fog a mirror.

Lockdown has royally screwed up the world’s supply chain because except for perhaps Sweden, most of the world followed the U.S. model, which in turn, followed the model of China. As the West now emerges from lockdown, China, the manufacturing hub of the world, is once again going back into lockdown in their most populous city. That is not going to help the supply chain crisis.

Then along came Russian aggression in Ukraine, which is upending the world’s energy and food markets, and increasing defense spending. Usually, a rapid rise in energy costs alone can cause a recession. Now we get to add to that a food crisis.

For reasons cited in previous articles, the West’s response to Russia, the sanctions but particularly the seizing of central bank assets, is likely to induce a change in the international monetary structure. Once again, simply this painful adjustment, has often by itself, been sufficient to cause a recession.  The monetary crisis of 1971, preceded the 1973-1974 stock market crash, which was the worst at the time since the Great Depression of the 1930s.

Again, it is not surprising that these difficulties came during a time of political upheaval (Watergate). Weak political leadership often occurs during economic crises. Inflation raged under Carter, a weak and indecisive President.

Clearly, political leadership is weak today, or perhaps even worse, it is senile.

We won’t even go into social and moral upheaval although many students of history point to 1966-1968 as a similar period. As mentioned before, the stock market peaked and did not recover to its previous highs for almost 30  years. We seem to be moving from men and women wanting to have sex without restraint (the sexual revolution born in the late 60s) to the abolition of what male and female even mean. Where will this trend end and how much damage will it do to society?

The changes in social conditions in “The Roaring Twenties”, also gave birth to the sober 1930s with the onset of the Depression.

Do social and moral upheaval cause these economic problems? It is unlikely they are the cause, but moral confusion does seem to accompany economic upheaval. We will leave that one to the social historians but that the two trends tend to come together is of concern.

So, the witches’ brew in summary is sky-high stock valuations, extraordinarily high debt burdens, rising interest rates, rising inflation rates, inverting yield curves, a bond bear market, supply chain crisis caused by lockdown, energy price shock, food price shock, war, radical social change, monetary regime upheaval, and poor political leadership.

If that list is not sufficient, we have one more to add that seems unique to economic history. In the past, when faced with difficulties, political parties tended to compromise for the benefit of the country and its citizens.  After all, people elect politicians and politicians often are pragmatic.

Today’s Democrats are such harsh ideologues, especially the fanatical environmentalists, that things we could normally do as a society to ease the pain (such as drill for more energy while Russia is using energy as a weapon), cut more timber to lower construction costs, plant more acreage to grow food, and mine more metals to reduce our dependence on hostile sources like Russia and China, are taken off the table. They simply can’t be considered for ideological reasons.

Today’s Democrats would rather starve the world than bend at all on their quasi-religious belief that all climate change is caused by man’s activities. There is a strong anti-human element that has converted reasonable conservation into a religion that puts the earth first and mankind second.

Their central planning instincts have gone manic. Hubris has run amok. Unable to even clean up homeless encampments or keep the streets safe, or stop the spread of Covid, they earnestly believe they can actually change the climate of the earth in 100 years. That the earth’s climate is always changing for a variety of reasons is lost on them. They believe that they, and they alone, are responsible for altering something as complex as the earth’s temperature cycles.  

Their false belief that our economic activity is an existential risk to the earth is now a real existential risk to our safety,  freedom, national security, and standard of living.

Can you imagine during World War II, a political party arguing that we should not produce more energy because losing to Hitler is better than increasing carbon emissions? But indeed, Democrats are maneuvering us into energy and mineral dependence on both Russia and China, which will sacrifice our freedom and standard of living, to their earth god.

Whether they intend this policy straight jacket or even realize this, is immaterial. But their heated and fervent resistance narrows greatly possible responses to problems.

This development imposes a paralysis on possible policy options that transcends political disagreement and gets into the realm of religious war. It is hard to compromise on religious beliefs especially when they become government policy and are thus forced on others by law. Indeed, that is what has caused religious wars.

What is also baffling is that their religious practice is imposed on us, while giving rivals like China, Russia, and India a free pass. Why is Chinese carbon better than ours?

This is hardly helpful in dealing with the toxic brew of negative trends that we must respond to. Dealing with inflation has always been difficult enough without the complication of religious war over the earth god. The price of energy is being deliberately driven higher, and thus inflation higher, to force the world to adopt the policy proscriptions of the rabid environmentalist.

If the stock market can get through recent highs, and the nation avoids recession, it will be remarkable. The question remains:  is that a bet we are willing to make?

 

 

 

 

The Urge To Spend

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Estimated Reading Time: 3 minutes

Loma Verde, California is building a $24 million recreation center with a pool . Forest Lakes , Minnesota is getting a $1.5 million golf clubhouse, while San Antonio is purchasing a $15 million theme park.

These may seem frivolous when rampant inflation is threatening, but never mind, they’re all “free“, a synonym for “paid for by the feds“.

America is awash in cash. Hundreds of other communities are enjoying similar goodies. States in no fiscal difficulty whatsoever have been given billions in budget boosts. 

Checks for thousands of dollars have gone to citizens not even claiming to be in need.  Millions of Americans receive enough government cash that they can now avoid the inconvenience and degradation of work.

These are outcomes from President Biden’s $1.9 trillion dollar American Rescue Plan, although the link to Covid may seem obscure to some. But the bigger point is that our governing culture today sees government spending as a positive good, which may be prompted by any excuse or none at all.

This is a continuation of the age-old argument over the role of government. For those who see government as a benign force that can efficiently, by use of its taxing power, address the common welfare and assure equitable outcomes, every dollar transferred from private to public hands is a positive.

Moreover , Big Government clearly increases the power and prestige of government officials. It creates beneficiaries highly likely to vote for those politicians who “cared“ enough to send Other Peoples’ Money their way.

Vastly expanded government has also affected the attitudes of Americans toward the role of government in their lives. To an extent unthinkable to earlier generations, Americans now assume the federal government will take responsibility for such matters as healthcare, education, childcare and aging parents.

The founders of our Constitution would not be pleased. Their original intent was to create a more just and independent society than the autocracies which had plagued mankind for millennia. Regrettably, Americans have blandly looked on while much of their birthright has been stolen. 

Much of the recent confiscation of our nation‘s economic output has come under the pretext of Covid spending. But remember that the Covid financial crisis was a self-inflicted wound. The lockdowns were unprecedented and proved ineffective as a pandemic response strategy, but they precipitated a huge expansion of government power.

America has so far spent $6.4 trillion in Covid relief bills. The $1.9 trillion in the 2021 American rescue plan alone was enough to buy every Covid vaccine, ventilator and hospital in existence. But much of the money went to beyond-obvious pork and to support Democratic political constituencies.

New York, among others, is reportedly sitting on $12.7 billion in unneeded Covid funds that they hope will revert to “unassigned“ dollars. The money was pushed out so carelessly that the Labor Department IG estimates $163 billion of the $872 billion in Covid unemployment funds were dissipated in fraud.

The consequences of all this unnecessary spending are predictable and enormous. In 2009, then-President Obama warned against continuing deficits when the debt had doubled from $5 trillion to  $10 trillion under his predecessor.

It was $20 trillion by the time he left office, stands at $30 trillion today and will reach $45 trillion by 2032 according to Biden’s own budget projections.

But trifles like stifling debt and lack of need can’t suppress the political urge to spend. With Covid receding and no extraordinary expenses pending, Joe Biden’s new budget proposal rings in at $5.8 trillion, fully 31% higher than in 2019.

Federal revenues rose 18% in 2021, then 26% this year but it’s not enough. Biden‘s $2 trillion projected deficit means the debt will have climbed $7 trillion in just the last three years. Multi- trillion dollar deficits have effectively been normalized.

It could be worse. We narrowly escaped passage of the $3.5 trillion Build Back Better boondoggle. Yet now Biden has the gall to demand $30 billion more for Covid expenses when at least $500 billion from the last Covid relief bill is still unspent.

The mindless, immoral imperative to spend more knows no bounds. Time is running out to reverse course. When will we come to our senses?

*****

Thomas C. Patterson, MD is a retired Emergency Medicine physician, Arizona state Senator and Arizona Senate Majority Leader in the ’90s. He is a former Chairman, Goldwater Institute.

 

 

Has The Federal Reserve Broken The Economy?

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Estimated Reading Time: 5 minutes

Book Review: The Lords of Easy Money: How the Federal Reserve Broke The American Economy

Christopher Leonard. Published by Simon and Schuster

Upon receiving the book, at first, a bit of eye-rolling occurred as the dust jacket touts “The New York Times Bestselling author of Kochland.” He also authored Meat Racket, which takes a critical look at the corporate concentration taking place in the food industry. Perhaps Mr. Leonard sees himself in the mode of the socialist Upton Sinclair of a previous era. At any rate, the professional Left has had issues with the Koch brothers because of their occasional support for conservative or libertarian think tanks and efforts.

To be sure, the perspective in this book is that of a journalist left of center.  In many ways, it echoes William Greider, a left-leaning journalist in the late 1980s who voiced similar concerns about the Federal Reserve in his books Secrets of the Temple and later, Who Will Tell the People.

At least traditional Liberals of the day and Conservatives shared a concern about the concentration of immense power in the hands of an unelected elite, that has close ties to Wall Street interests.

Leonard is particularly concerned with the development of Quantitative Easing, the Federal Reserve operation to buy large quantities of government debt to be held on its own balance sheet and its close association with ZIRP, or zero interest rate policy.

To tell his story, he concentrates on following one of the few FED governors who often dissented, Thomas Hoenig of the Kansas City Fed. To some extent, it is the tale of the clash between professional economists like Ben Bernanke and actual bankers like Hoenig. Also getting an honorable mention is Richard Fisher of the Dallas FED.

What Leonard sees as a problem is that Quantitative Easing morphed from being a program to deal with financial emergencies to a policy that is used in good times as well. The background to the latter really was pushed by Bernanke, who felt the Fed needed to move to stimulate the economy because Congress was unable to act.

It is a story of mission creep. The FED by law is supposed to deal with somewhat two contradictory goals derived from the errors of Keynesianism. It is supposed to balance price stability with full employment. These are the primary goals enshrined in law.

It was felt that higher inflation must be tolerated to get full employment as per the Phillips Curve. We say the errors of Keynesianism because the stagflation of the 1970s and 1980s showed that high unemployment and slow growth could coexist with high inflation, and full employment could exist with low inflation in the 2000s,  which is not at all the relationship Keynesians espoused.

Nevertheless, there is a structural political risk when an unelected board decides to take bold actions that affect every American (and the world) because that agency feels Congress is dysfunctional and cannot act appropriately. No one voted for them to fill the void. And there is an additional risk when Congress imposes more tasks on the FED such as engaging in the Left’s view of social justice and environmental reforms.

The FED is supposed to be independent of such things, but increasingly it is simply becoming another institution corrupted in its purpose by the Left.

QE as it is called injects bank reserves and lowers interest rates, giving retail banks, investment banks, and hedge funds an ever-increasing supply of cheap capital, thus enriching the financial food chain that lives off the nourishment of the FED.

This allows for leverage deal-making, huge stock buybacks that support equity prices, as one investment banker washes the hands of another.

Thus, a whole industry, that can direct the investment direction of the country, grows in wealth and power from the actions of an unelected board of so-called experts at the FED. These experts in finance migrate back and forth from the financial industry to the regulatory body that supervises them, demonstrating “regulatory capture.” It is hard to know where the role of the FED begins and the power of Wall Street ends.

A good example is the current Chair of the FED, Jay Powell. He formerly was a Wall Street lawyer and leveraged deal maker with Carlyle Group. Ironically, Powell at times was critical of QE and he is now in the uncomfortable position of trying to reign it in.

QE makes asset price inflation possible, something the FED actually promotes because it is supposed to create a “wealth effect.”  However, other than making a certain class of asset owners famously wealthy and powerful, there is scant evidence it has helped the entire economy grow.

Asset price inflation is hard to contain as it can spread and now has spread to consumer price inflation. Consumer price inflation impacts the masses.

Zero interest rates do more than that, however.  Leonard spends considerable time discussing arcane things such as “leveraged loans” and “collateralized mortgage obligations.”  In short, the FED has supplied the cheap and copious quantities of money for all manner of financial engineering, which has made hedge funds like Bain and Carlyle (both close to political power) very rich, while promoting the offshoring of American jobs to Mexico and China.

He gives some case studies such as Rexnord, an industrial firm from Milwaukee, that is leveraged up multiple times by investment bankers (Jay Powell himself), all the while shutting down production in the US.

He follows the experience of John Feltner who worked as an engineer for Rexnord, became a union leader, and later lost his job as the plant closed when the jobs were shipped to Mexico.  Feltner as a union man is shown hoping that a Republican Donald Trump, might be able to save his job.  Who looks after the interests of the working man?

This is one of the areas where at least the moderate Left and the MAGA right have interests that intersect. The MAGA right also worries about such power in the hands of unelected elites and does not think it acts in the interest of America. America and American workers should come first, not hedge funds creaming profits from leveraged buyouts.

Both sides worry about asset bubbles created by the FED, and both sides worry about the concentration of political and economic power in the hands of a few bureaucrats and big businesses.

The MEGA right believes in free enterprise, not cartels that get special favors and cheap capital from quasi-government agencies.

Neither side has given enough attention to this problem.  If the government was forced to borrow in the markets the huge deficits it is generating, interest rates would already be higher.  The FED by buying all this debt, and covering up the negative consequences, has enabled a spending drunk Congress to massively increase the size of government. The liberal sees the same process and sees increased corporate power. In a sense, both are correct.

It has made the asset owners of stocks, bonds, and real estate richer while making those that rent poorer, those that use bank deposits poorer, and those on fixed incomes poorer. In short, the FED has engaged in a massive transfer of wealth from the poor to the rich, all while following the orders of Congress and politicians from both parties that claim laughably that “they are for the little guy.”

So, if you are a moderate liberal or a conservative with populist leanings, this book offers arguments and case studies where the two sides might agree more than one might think.

One certainly walks away with a better understanding of how the FED has become the secret arsonist that works for the fire department.  They get to blow huge financial bubbles and then are tasked with cleaning up after them and then remarkably, they get to start the process over again. The arsonist is never arrested.  All this, of course, is in the name of “financial stability” and oversight by experts.

Although the book can’t cover the entirety of this great monetary experiment, the book narrowly focuses on the U.S. While the FED is the central bank of the U.S., it also actually functions as the central bank of the world, lending money to foreign banks in trouble through swap lines and intellectual leadership. Yet all major economic systems from Japan and China to the UK and the EU, are pursuing similar policies. The lords of easy money rule most of the world. Unfortunately, they may be breaking more than just the American economy.

One can’t know for sure, but because of certain shared viewpoints, one would suspect Christopher Leonard and former Congressman Ron Paul might very much enjoy having a discussion over a cup of coffee, or something stronger.

 

 

 

 

The Interest Rate Puzzle

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Estimated Reading Time: 5 minutes

The financial markets swooned in January in response to the statements and growing perceptions that central banks must soon begin the painful task of slowing inflation. The old saw on Wall Street is, “as goes January, so goes the year.”  If so, we are in for a very volatile year.

The irony is, of course, it was those very central banks by their own actions, and their politically motivated maneuvering, which freed legislators around the world from the painful tasks of keeping a rational budget.  If markets had to absorb all the debt created by governments, and if that debt were not purchased by central banks, rates would already be higher than they are now.

As it is, the bellwether 10 year US Treasury yield has swiftly moved up about a half percent in the past months or so,  even before the Federal Reserve has officially started tightening.

This is a product of bipartisan failure. One of the serious deficiencies of the Trump Administration is he did not deal squarely with the deficit issue when he had the opportunity. In his defense, it has been quite some time since the Republican Party was the party of fiscal rectitude and sound money.  We are not sure even today if those attitudes are all that prevalent even among those who support the MAGA agenda.

To be sure, the Covid crisis added some momentum to the already accelerating debt problem, but Democrats seized on the crisis to ram through additional programs which had little to do with Covid relief.  It had more to do with their socialist agenda. Now we have a national debt crossing above $30 Trillion.

And it was a choice, largely accepted by both parties to address the Covid crisis through lockdowns, which created economic turmoil. We now know, based on the recent study released by Johns Hopkins, that we suffered grave economic damage with very little to show in terms of reduced mortality. It is true though, that Republicans were earlier to move away from lockdown while Democrat-dominated areas still embrace the concept.

Further, many other nations copied the lockdown modality and some like  China, Germany, Austria, Australia, and New Zealand went even further than the US.

Like other sectors of society, we did not understand at first exactly what we were facing when the Chinese virus hit our shores. But at The Prickly Pear, we always mentioned we were opposed to lockdowns measures because we felt it was ignorant of the many trade-offs and was anti-democratic to its core. We think the Johns Hopkins study recently released vindicates our position and that of countries like Sweden and American Republican governors and mayors who exercised lockdown with a much lighter touch.

But as they say, “it is what it is.” World leaders chose Fauci’s lockdown and huge bailout spending based on deficit finance. Covid did not do this rather we did it to ourselves. This added huge amounts of debt to an already teetering debt structure built after the 2008 financial crisis bailouts and more socialist programs. Now, we must all face the consequences.

The Economist recently ran a study on what minor increases in interest rates will have on the global economy, given this overhang of debt. They looked at 58 of the world’s largest economies and attempted to derive an estimate of what the global interest bill would be under various interest rate scenarios.

It is important to understand their numbers are based on the very unusual and historically unprecedented condition of not only almost zero interest rates but negative rates on a huge swath of the world’s bonded indebtedness.

At present, the Economist estimates the current interest rate tab to be $10 trillion dollars or about 12% of global GDP. To give you some measure of scale, the total of US output is in the range of $23 trillion.

However, since the global debt burden is now 355% of GDP, and is much larger than it was during the inflation crisis of the 1970s, any incremental increases in rates will have a magnified effect on the economy. The boomerang effect of pushing growth through debt issuance is that the whole debt structure becomes much more sensitive to small changes in rates. They estimate that just a one percent change in rates translates to a jump to a $16 Trillion global interest payment. That is a 60% change from where we are today! A two percent increase in rates pushes the global interest tab to $20 Trillion, a doubling of current costs.

The higher the debt payments, the less money available for investment or consumption. This will prove to be equivalent to the nutritional issues faced by a hungry snake that is swallowing its own tail.

The more debt, the less growth. The less growth, the lower the ability to service the expanding debt.

Moreover,  the structure of the welfare state itself magnifies the risk. If the economy slows, less revenue flows to the state, just when more people start making additional claims on welfare state programs such as food stamps, rent subsidies, and unemployment insurance. Thus, fiscal deficits during recession grow and they must be financed by the private sector, by the Fed, or more money printed out of thin air.

As the economy slows, debt may well become unstable, as some marginal borrowers will likely be unable to service interest and principal payments, triggering more welfare state bailouts for “favored” businesses like autos, airlines, and banks.

Interest rates serve like traffic lights, directing the flow of capital. Projects that look favorable under one interest rate do not look the same under another.  Economists call this the misallocation of capital.  In part, that is what recession does.  It corrects errors made during the boom phase.  However, if the government constantly intervenes, those misallocations of capital accumulate like the dead under brush in a forest.  If enough dry undergrowth is allowed to accumulate, any economic or political spark can set off a conflagration hard to contain.

We are not sure where this leads us since this level of debt and the extremely low-interest rate regime has no real historic precedent. Push rates up to even “normal” historical levels, and the global debt burden soars, sucking more money out of productive activity. But if you don’t push rates higher, inflation can wipe out both the middle and lower classes of society, leading to political instability and perhaps violence.  Inflation acts as a compound interest curve in reverse.  If inflation were to stay in the present range of 7%, the value of money will fall in half in just 10 years.  Try to plan a retirement around that!

It has long been felt by the dominant economics profession, that the free market was unstable and that balanced budgets and a gold standard put governments in a bind to deal with an economic crisis. Better to have large central planning agencies like the Fed and Treasury Department, guiding the economy with the input of giant international corporations. Davos man knows best!

Well, we have had more than a half-century now of depreciating money, chronic budget deficits, and active central planning by government and its “experts.”. As James Grant has put it, we have substituted the Ph.D. standard for the quiet automatic discipline of the gold standard.

The risk now is, central planners have created a situation where either a debt crisis, an inflation crisis, or both, will engulf us.

How far do interest rates need to go to choke off inflation?  How high do they go before interest costs undermine growth?

It looks like we will soon find out.

Needles and Bubbles

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Estimated Reading Time: 5 minutes

Last August we presented a two-part series about the investor’s dilemma (The Investor’s Dilemma: Part 1, The Investor’s Dilemma: Part 2).

That series was intended to warn our readers that the level of speculation in various investment sectors had reached what appeared to us to be a fever pitch and that it was unnaturally supported by a torrential flow of money coming from fiscal policy (huge government spending and deficits) and easy money policy from the Federal Reserve (zero interest rates and Quantitative Easing). We did not think it would be sustainable.

We also mentioned there were serious divergences developing inside the stock market. To be sure, the market continued to power higher.  But internally, fewer and fewer stocks were participating. The S&P 500 was becoming the S&P 5, as just a handful of behemoth tech stocks that are overweighted in the index, were painting a false picture of market health.

Finally, we mentioned that while investors had little choice to participate in markets because the Federal Reserve has destroyed safe investments that pay interest (like insured bank deposits), the dilemma was we are playing with a late-stage, overvalued bull market that was now confronting serious inflation. But those same investors would have to face the consequences, which are almost impossible to time, for market excesses and the likelihood that the FED at some point would have to fight incipient inflation and “take the punch bowl away.”

Inflation can come in two forms: asset inflation and consumer price inflation.

The FED has actively encouraged asset price inflation. The price of stocks, bonds, art, real estate, cryptocurrencies, SPACs, NFTs, have all been climbing steadily. This created the “wealth effect” the FED was seeking. It also makes wealthy the small number of well-heeled citizens that can afford to own and leverage assets. This also conveniently tends to be the donor class, that is the very people politicians need for big campaign donations.

Consumer price inflation is not harmful to the donor class because even with increased costs, there is no problem with a large budget paying for necessities like auto repair, food, rent, and gasoline. But it is very harmful to most of us. Consumer price inflation affects the vast bulk of people and hence can create swift and punishing political blowback.

It is clear that when Quantitative Easing was extended from being an emergency measure to deal with the Crash of 2008 by then-Fed Chairman Ben Bernanke to a policy used to accommodate a spendaholic Congress, it drove income inequality to extremes. That in turn, has much to do with the “populist” political revolt.

The Biden Administration and the Fed both also said inflation was “transitory”, and would go away soon. It didn’t.

As the traditional year-end rally approached, the markets surged into January even as the FED began to make noises that they were now concerned about inflation and would soon start to raise interest rates and reverse Quantitative Easing with Quantitative Tapering.

Now, The Prickly Pear is not an investment publication and the last thing we want to do is start to make market calls, which is an undertaking guaranteed to make one look foolish. But we are concerned that market busts spread economic pain, economic trauma creates political tensions and extremism, and frankly can harm the finances and liberty of our readers. Thus, while we make no claim to timing markets, it was clear last summer that investors and the country were headed for trouble. We just did not know when.

There is no way to cut back the torrential flow of money without changing the investment landscape, and perhaps the real underlying economy. That is especially so when the levels of speculation, the widespread use of leverage, and public mania that we described last summer have reached such fantastic levels.

The “when” seems to have been early January. Most markets had their typical “Santa Claus rally” that runs usually from Thanksgiving into the first few days of January. After a few days into January, markets became quite unsettled and started to decline.

Although the FED as yet has done nothing concrete yet, interest rates are already rising and the crunch is being felt.

The markets are off-balance, which is one of the problems when you have a central planning agency like the FED running things, rather than the natural supply and demand of the free market.  Now, every statement by the FED Chairman, or a voting member, or an arch of an eyebrow, can send the markets into a tizzy. 

Stocks, as measured by broad averages right now look like your typical “correction.” A correction usually is defined as a decline of less than 20%, that occurs within an ongoing bull market advance. So, if you looked at say the NASDAQ, you will see a nominal decline of 17%, and the big cap S&P is down a little more than 11%.

However, underneath the surface, there is considerably more pain. In the tech-laden NASDAQ, 42% of the stocks within the index have fallen 50% or more. Thus, a number of stocks are suffering more than a correction, they are in a bear market. Individual sectors have been hit hard. One of the hardest to be hit are the healthcare stocks, with 70% of them down 50% or more.

We have also seen some impressive and violent volatility, as markets try to figure out how serious is inflation, how serious is the FED, and how much economic growth is just a natural spring back from the economy being shut down and how much is sustainable. On January 24th, the S&P plunged 4% inter-day only to later close up on the day. That is a whiplash worthy of hiring an accident attorney! This kind of action will tend to grind up the speculator using heavy leverage and scare even the long-term holder.

Cryptocurrencies, which we also have warned about, have suffered enormous damage. According to data from CoinMarket.com, after reaching a market capitalization of $3 Trillion or so in October, they are now down to about half that amount. Bitcoin, the leader of the pack is down over 50% from its November high while Dogecoin is down over 70% from the high last spring. Such extreme volatility makes their claim to be a “currency” hardly defensible.

Real estate is not “marked to the market” every day like stocks, so price data is slower to accumulate. The Federal Reserve Bank of St. Louis reports the median price of new houses sold in the U.S declined to $377,700 in December, the second consecutive month of decline. Inventories appear to be increasing. While that is not enough data to constitute a “trend”, it seems more than coincidental with weakness in other parts of the “everything bubble.”

Even gold, which tends to be a safe haven when markets plunge, dropped from the $1840 level back below $1800. This was a bit surprising since gold actually declined last year and did not seem to participate in the generalized surge in asset prices.

Many of the “technical” people we read suggest the stock market has fallen too far, too fast, and is now “oversold.” Such conditions normally create a rally. If this rally can return the market back above moving average and linear trend, perhaps the worst has been seen for a while. Failure to do so may signal more correction to follow, maybe even pulling the markets into official bear territory.

All of these gyrations could prove to be temporary. The mantra of the last decade has been “buy the dip.” Without question, that has been a strategy that has worked.

It is when “buy the dip” no longer works that we know we are in big trouble.

The FED is starting the tightening process behind the curve. It is also starting the process with the lowest sustained period of interest rates in history intersecting with the highest inflation in four decades. Debt at all levels; government, corporate, and household, are all greater than they were in the early 1980s. Public participation in markets has been huge. Monetary flows into Wall Street last year equaled the previous 12 combined. We don’t have Paul Volker and Ronald Reagan at the helm either. In fact, national leadership appears quite weak and confused.

The optimists on Wall Street seem to feel that Jay Powell, the current Chairman of the FED can “thread the needle”, that is successfully cool off inflation without wrecking either the markets, the economy, or both.  

There is one problem with the needle threading metaphor. You really don’t want needles anywhere close to financial bubbles.

America’s Most Dangerous Unknown Man

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The US Senate will soon vote on Federal Reserve Chairman Jerome Powell’s nomination to a second term. One of the senators opposing Powell is Elizabeth Warren. I don’t often agree with Senator Warren, but I do agree with her assessment that Powell is “dangerous.” However, Warren actually doesn’t understand what makes Powell, or any Fed chairman, intrinsically dangerous to liberty and prosperity.

Warren thinks Powell is dangerous because she thinks he will not be supportive enough of imposing her desired new regulations on banks and other financial institutions. Senator Warren, like most progressives, clings to a fantastical notion that regulations benefit workers, consumers, and small businesses. The truth is most regulations benefit large corporations by imposing costs that big businesses can easily absorb, but that their smaller competitors cannot.

Powell is a threat to the American people. Under his tenure, the Fed has kept interest rates at or near zero. The Fed’s balance sheet has grown to over eight trillion dollars. This has caused prices to climb at a rate America has not seen in several decades.

At his nomination hearing before the Senate Banking Committee, Powell reiterated the Fed’s intention to fight inflation by reducing its monthly 120-billion-dollar purchase of Treasury and mortgage-backed securities. Powell also stated that the Fed is planning to increase interest rates this year. However, even if the Fed follows through on this, interest rates will remain at historically low levels.

Powell, like Elizabeth Warren and other progressives, dangerously believes that the Fed should go “woke.” However, Powell is still not “woke” enough for progressives who lobbied President Joe Biden to replace Powell with Fed board member Lael Brainard, the biggest supporter of Elizabeth Warren–style regulations on the Fed board. Brainard is more committed than Powell to using monetary and regulatory policies to advance the “woke” agenda. President Biden did end up nominating Brainard to become vice chairman at the Fed.

A Powell-Brainard Fed would likely use “social and climate justice” as a justification for expanding the Fed’s easy money policies. President Biden has recently nominated Sarah Bloom Raskin to the Fed board, who also has advocated for the Fed to use its power to fight climate change.

A central bank committed to the social justice and climate change agendas will inevitably increase the Fed’s “inflation tax.” Contrary to the claims of some progressives, lower-income Americans are primary victims of this hidden and regressive tax.

Powell prefers to push his rather zealous and extremist philosophies behind the scenes. Thus, not surprisingly, he is a leading opponent of Audit the Fed. Powell claims that bringing transparency to the Fed’s conduct of monetary policy would somehow jeopardize the Fed’s independence. Powell’s claim is truly fake news. There is nothing in the Audit the Fed bill giving Congress or the executive branch any new power over monetary policy.

Any group of individuals given the power to manipulate the money supply, and manipulate the interest rates that are the price of money, poses a threat to our liberty and prosperity. The solution is not to replace Powell with a “better” Fed chairman or to force the Fed to follow a “rule” that still allows it to erode the dollar’s value. The only way to protect the people from dangerous individuals like Jerome Powell, Lael Brainard, and the rest of the Fed board is to audit and then end the Fed.

*****

This article was published by Mises Institute and is reproduced with permission.

What I See for 2022: Interest Rates, Mortgage Rates, Real Estate, Stocks & Other Assets as Central Banks Face Raging Inflation

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An extra-special cocktail of three powerful ingredients with no cherry on top awaits us in 2022.

Super-inflated asset prices such as housing, stocks, and bonds; massive inflation; and central banks that have started to react.

Many central banks have started pushing up interest rates; others have ended asset purchases. And Quantitative Tightening (QT) – central banks shedding assets – is on the table.

Rising interest rates in the US won’t catch up with raging inflation in 2022 – CPI inflation is now 6.8%, the highest in 40 years.

But unlike 40 years ago, inflation is now on the way up. In the early 1980s, it was starting to head down. We need to compare the current situation to the 1970s, when inflation was spiraling higher. So we’re entering a new environment where the economy will be doing things we haven’t seen in many decades. It will be a new ballgame for just about everyone.

Inflation has now spread deep into the economy, with services inflation picking up, and there are no supply-chain bottlenecks involved. This includes the inflation measures for housing costs. Those housing inflation measures have begun to surge.

We know that the figures for housing inflation, which account for about one-third of total CPI, will surge further in 2022, based on housing data that we saw in 2021, and that is now slowly getting picked up by the inflation indices. They started heading higher in mid-2021 from very low levels, and they’re going to be red-hot in 2022.

This is inflation is fueled by enormous monetary and fiscal stimulus, globally, but particularly in the US – with nearly $5 trillion in money-printing since March 2020, and over $5 trillion in government spending of borrowed money.

The stimulus has broken price resistance among businesses and consumers. Enough businesses and consumers are willing to pay even the craziest prices – a sign that the inflationary mindset has taken over for the first time in decades. All this stimulus has broken the dam.

Inflation is not going away until central banks remove the fuel via QT to allow long-term interest rates to rise, and by pushing up short-term interest rates via rate hikes, and until these policy actions are drastic enough to shut down the inflationary mindset and reestablish price resistance among businesses and consumers.

Central banks around the world react

The Bank of Japan ended QE in May 2021 – the longest-running money-printer has stopped printing money.

The Fed started tapering QE in November and doubled the speed of the taper in December. If it doesn’t accelerate it further, QE will end in March.

The Bank of Canada ended QE in October. The Bank of England ended QE in December. The ECB announced that it would cut its huge QE program in half by March. Several smaller central banks that did QE have ended it.

Central banks in developed markets already hiked rates:

  • The Bank of England: by 15 basis points, in December, for liftoff.
  • The National Bank of Poland: three hikes, totaling 165 basis points, to 1.75%.
  • The Czech National Bank: five times by a total of 350 basis points, to 3.75%.
  • Norway’s Norges Bank: for the second time, by a total of 50 basis points, to 0.5%.
  • The National Bank of Hungary: many small hikes totaling 180 basis points, to 2.4%.
  • The Bank of Korea: twice, by 50 basis points total, to 1.0%.
  • The Reserve Bank of New Zealand: twice, by 50 basis points total, to 0.75%.
  • The Central Bank of Iceland: four times, by 125 basis points in total, to 2.0%.

Central banks in developing markets have been much more aggressive in hiking rates to get inflation under control and protect their currencies; a plunge in their currencies would make dollar-funding very difficult. They’re trying to stay well ahead of the Fed. Among them:

  • The Central Bank of Russia: seven times, totaling 425 basis points, to 8.5%.
  • The Bank of Brazil: multiple huge rate hikes, by 725 basis points since March, to 9.25%.
  • The Bank of the Republic (Colombia): three hikes totaling 125 basis points, to 3.0%.
  • The Bank of Mexico: five hikes, totaling 150 basis points, to 5.5%.
  • The Central Bank of Chile: four hikes, 350 basis points in total, to 4.0%.
  • The State Bank of Pakistan: three hikes, totaling 275 basis points, to 9.75%.
  • The Central Bank of Armenia: seven hikes, totaling 350 basis points, to 7.75%.
  • The Central Reserve Bank of Peru: five hikes, totaling 225 basis points, to 2.5%.

There are some exceptions, particularly Turkey, which has embarked on an all-out effort to destroy its currency via inflation and is succeeding in doing so by cutting rates. Over the year 2021, the lira has collapsed by nearly 80% against the dollar, with inflation raging at over 20%.

But in the US in my lifetime, there has never been a toxic combination of interest-rate repression to near-0%, amid 6.8% inflation, as the Fed’s money-printing continues for now.

*****

Continue reading this article at  Wolf  Street.

Covid-19 Economic Zombification

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Editors’ Note: Discussion of “Minsky Moments” may strike the reader as obscure. However, it is noted in this article that the whole world, including real estate much of the private corporate sector, has become more leveraged than before the 2008 financial crisis. With the sharp rise in inflation,  global central banks have the difficult choice of either letting the inflation run, or increasing interest rates and reducing money supply growth, the very fuel which is supporting the record-setting debt expansion. Either choice could be upsetting to financial markets. Economic trauma always takes on greater power when financial leverage is excessive. Just as debt expansion fuels the boom, its contraction can fuel a bust. Thus, for those of us with money in markets, either building our estates or living off our estates in retirement, this issue becomes very immediate. Economic theory cannot time these events precisely but it can tell us the kind of environment in which we are operating. This level of debt, coupled with a sharp rise in inflation, suggests some sort of confrontation is ahead with serious consequences for investors. That confrontation is the Minsky Moment, and it can be very real for those with money at risk.

Economists and finance specialists are warning of the potential arrival of a new “Minsky moment” in increasing numbers. The last time this term was used with such conviction was in 2008, at the onset of the Great Recession. It seems that 2021–22 could have some parallels with the world’s last severe recession.

The Twentieth-First Century: The Century of Debt

Until now, the 21st century could be called the century of debt, and if things continue the way they are, it could well be called the century of the great debt default. At the beginning of the century, extremely low-interest rates promoted by central banks in practically the entire developed world caused a frenzy of private credit creation and a gigantic financial and real estate bubble that exploded in 2008 with dire consequences for the world economy.

Central banks, heavily pressured by politicians, redoubled their commitment to low-interest rates, causing public overindebtedness to a degree unprecedented in times of peace. In 2020, when the growth model based on the accumulation of public debt and low interest rates seemed to start to weaken, the Covid-19 recession arrived. The worldwide excess of public spending in 2020 has not been corrected, and it does not appear it will be corrected anytime soon. The new public debt is adding fuel to the fire. And the accumulation of it (and also private debt, especially that issued by companies) could be reaching the point of no return.

Global debt reached $200 trillion at the beginning of 2011, while global GDP was $74 trillion (275 percent debt/GDP). In the second quarter of 2021, global debt reached almost $300 trillion with a global GDP of $83.9 trillion (330 percent debt/GDP).

What Is a Minsky Moment?

Hyman Minsky was a post-Keynesian economist who developed a very insightful taxonomy of financial relationships. According to him, the finances of a capitalist economy can be summarized in terms of exchanges of present money for future money. The relationship proposed by Minsky is as follows:

Present money is invested in companies that will generate money in the future.

When companies make a profit, they return the money to investors from their profits.

Income or profit expectations determine the following:

  1. The flow of present money to companies
  2. The price of financial assets such as bonds and stocks (financial assets that articulate the exchange of present money for future money)

Present business income, meanwhile, determines the following:

  1. Whether expectations about past income (included in already-issued financial assets) have been met
  2. How to modify expectations about future income (and therefore, indirectly, the flow of present money to companies and the price of financial assets issued in the present)

Minsky articulates three possible types of income-debt relationship in companies (although he extends the analysis to all economic agents):

  1. Hedge. Hedge finance companies can meet all of their debt obligations with their cash flows. That is, their inflows exceed their outflows. Such companies are stable.
  2. Speculative. Companies can pay the interest on their debt but cannot pay down the principal. They are forced to constantly refinance. These companies are unstable, as any minor problem can bankrupt them.
  3. Ponzi. Ponzi companies do not generate enough income to pay down the principal or pay the interest. They must sell assets or issue debt just to pay the previous interest on their debt. They end up defaulting on the new debt sooner or later. Their chances of survival are minimal.

According to Minsky, when things are going well in an economy and income expectations are met, corporations begin to err on the side of optimism and excessively increase their debt. This causes a shift from a stable situation (in which hedge companies are the norm) to an unstable one (in which Ponzi companies are the norm). In a Ponzi situation, the economy will experience widespread defaults and a financial and economic crisis.

An economy is said to be in a Minsky moment if debtors are unable to pay down their debts (a speculative situation) or unable to pay the interest and the principal (a Ponzi situation).

Minsky was partly right. He accounts for a common truth of financial crises: issuance of debt was abused in previous periods. As a caveat, though, taking into account monetary and financial state interventions—mainly but not solely those of central banks—perhaps the cause of this degradation of debt quality is not a market problem, or at least not exclusively. The crisis may be exogenous to the market (caused by public authorities) or endogenous but amplified by exogenous factors (public authorities contribute to it).

The Economy Has Been Zombifying for Two Decades

As already discussed, global debt has grown more rapidly than the global economy over the last ten years, so it seems credit quality has indeed degraded. The income needed to pay off debt is growing much more slowly than is the debt itself.

An additional piece of evidence to support this argument is the increase in the number of “zombie companies.” A zombie company is one whose earnings before interest and taxes are less than or equal to its debt service (it coincides exactly with Minsky’s definition of speculative and Ponzi companies, taken together). A zombie is a wonderful metaphor because a zombie moves and appears to be alive but is in fact dead. A zombie company also moves and appears to be alive—it generates activity, employs workers, and produces goods—but in reality is (almost) dead. It is (almost) certain to die given its inability to pay its debt with its own means. The number of zombie companies has increased exponentially in the United States in recent years, according to a Bank for International Settlements (BIS) report. Furthermore, the probability of remaining in a zombie state has increased. And in fact, zombification is a reality in almost every part of the world.

Figure 2

Source: Banerjee & Hofmann

Figure 3

Source: Banerjee & Hofmann

However, the BIS data end in 2017. What has Covid-19’s impact been on an already-zombified global economy?

Covid-19 Hit a Zombie Economy: Now What?

The most recent data on company interest coverage (financing cost/earnings) are from the Fed, and refer to the North American economy. In the figure below we can see that the median coverage ratio began to fall at the end of 2018, which is consistent with our hypothesis that the economy’s growth model, based on cheap debt, was beginning to run its course. The pandemic has hammered the median coverage ratio. Although the ratio has been recovering since the second half of 2020, it is currently at the level seen in 2009, in the middle of the Great Recession.

Even more revealing is the interest coverage ratio of the companies in the first quartile (that is, the 25 percent of companies with the lowest ratio). This indicator has been below 1 since 2012; in other words, zombification has accelerated since then. Keep in mind that a ratio lower than 1 means that a company’s profits are insufficient for it to pay its financing costs (it is a Ponzi company).

The interest coverage ratio for companies in the twenty-fifth percentile reached almost 0 just before the pandemic (their profits had almost disappeared). Since then, the ratio has been negative (these companies recorded losses). Observe that these companies have not recovered, while companies in other quartiles have. Their ratio is currently just above −1, which means that their losses (before interest) are nearly equal to their financing cost. This is a total disaster. At least 25 percent of US companies are financially dead.

Valuation of Zombified Companies

One would expect that these companies would begin to go bankrupt, and this is indeed what is happening. According to the Fed, 2.5 times more zombie companies (as a fraction of all companies) went bankrupt in 2020 than in 2019 (<2 percent in 2019 and around 4.5 percent in 2020).

Curiously, the zombie companies that survived 2020 are seeing their valuation skyrocket. Their aggregate value already exceeds $6 trillion, while in 2019 it was close to $2 trillion.

Figure 5

Conclusion

Markets are now extremely complacent. The fundamentals do not seem to justify their optimism. Zombie companies, which were already a problem in 2019, have not been killed off; indeed they have multiplied. The zombie apocalypse could be closer than we imagine.

*****

This article was originally published by AIER, American Institute for Economic Research and is reproduced with permission.

Our Top 21 Fiscal Charts of 2021

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2021 was a busy year for fiscal policy, which gave us ample opportunities to conduct substantive policy analyses using charts and tables. This year, we published over 210 papers, blog posts, and other products. As we get ready to pop the champagne and ring in the new year, here are our top fiscal charts of 2021.

1. The National Debt is High and Rising

In July, the Congressional Budget Office (CBO) projected debt would rise from 100 percent of Gross Domestic Product (GDP) at the end of Fiscal Year (FY) 2020 to a record 106.4 percent of GDP by 2031. Under an alternative scenario where policymakers extend most expiring tax cuts and grow annual appropriations with the economy instead of inflation, debt would reach 122 percent of GDP by FY 2031. 

Since this chart was published, we revised our debt projections to account for the enactment of the Infrastructure Investment and Jobs Act (IIJA), changes to Supplemental Nutrition Assistance Program (SNAP) benefits, and a lower-than-expected deficit in FY 2021. We estimate that under current law debt will reach a record 107.5 percent of GDP by the end of FY 2031.

Debt Will Reach New Record by 2031.jpg

2. The Budget Deficit Totaled $2.8 Trillion in 2021

In July, CBO projected the FY 2021 deficit would total $3.0 trillion. From there, CBO projected the deficit would fall to $1.2 trillion in FY 2022 and $753 billion in 2024 as COVID relief winds down and then rise gradually to $1.9 trillion by 2031. Since this chart was published, CBO updated its FY 2021 deficit figure to reflect the actual year-end deficit of $2.8 trillion.

Deficits Will Remain High.jpg

3. Major Trust Funds Are Approaching Insolvency

In our paper “The Case for Trust Fund Solutions,” we estimated the Highway Trust Fund would become insolvent in FY 2022, the Medicare Hospital Insurance (HI) trust fund in FY 2026, the Social Security Old-Age and Survivors Insurance (OASI) trust fund in calendar year (CY) 2032, and the Social Security Disability Insurance (SSDI) trust fund in CY 2035.

Since this chart was published, the Medicare and Social Security Trustees released their annual reports. Now, the HI trust fund is expected to be insolvent in CY 2026, the OASI trust fund in CY 2033, and the SSDI trust fund in CY 2057. On a theoretical combined basis, the Social Security trust funds will be insolvent in CY 2034. Meanwhile, the insolvency date of the Highway Trust Fund has been pushed back due to enactment of the Infrastructure Investment and Jobs Act.

Insolvenecy Looms for Trust Funds.jpg

4. Trust Fund Solutions Would Be Pro-Growth

Making the Social Security, Medicare, and highway trust funds solvent would not only prevent sharp benefit cuts and improve the fiscal outlook, but would actually grow the economy. We found that trust found solutions would increase economic output by between 3.5 and 9.0 percent and reduce debt by between 65 and 80 percent of GDP by 2051.

*****

Continue reading this article at CRFB, Committee for a Responsible Federal Budget.

No Pain Free Way Out

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The average person does not understand and could care less about Fed policy, Government budget deficits, and the National Debt. All he wants to know about “finance” is how much he earns and how much he has to spend to maintain his lifestyle.

Be that as it may, these big picture items have a major impact on our lives.

When the Government spends more money than it takes in, that requires the overspending to be financed by borrowing. When the Government borrows, it adds to the National Debt. The government borrows by issuing interest-paying bonds. Someone has to buy those bonds. As the National Debt grows, buying the Treasury’s bonds is seen as riskier for the investor. Would you rather borrow from someone heavily in debt or from someone with less debt?

In order to entice reluctant potential bond buyers, the seller has to raise interest rates.

However, the Government does not want to have to raise interest rates, because it means increasing its cash outlays, even more, compounding its deficit problems.
What has been happening is that the Federal Reserve (the Fed) has been buying government bonds that the public does not want. If this strikes you as just the left-hand selling to the right-hand, you are correct.

Most of the ever-increasing Government deficit is currently financed by the Fed buying the Treasury’s bonds. A lot of this was done under various crisis programs called “Q.E.” (Quantitative Easing), which were intended to be temporary in order to spur public spending and avert a recession. The Fed would now like to sell some of those bonds in the private market, but since those bonds were issued with low-interest rates, there is not much demand for them other than a discounted price. That means selling at a loss.

What happens to any losses suffered by the Fed? Answer: They are transferred to the Treasury. (Remember the part about the left hand and the right hand?). Losses transferred to the Treasury increase the National Debt still more.

The Fed also is involved with controlling interest rates. Although it does not set all interest rates, its actions have an enormous impact. At the moment, a 30-year Government bond pays an interest rate of less than 2%. With inflation running at over 6%, that means an investor buying these bonds gets a real rate of return of around minus 4%. It should not be hard to understand why investors don’t want to buy Government bonds currently.

To counter this reluctance, the Fed wants to restore interest rates to a normal level. They have kept interest rates low for a long time to counter various crises over more than a decade. It is time to get things back to some sort of “normalcy”. Otherwise, the problem of financing the Government’s enormous debt will only get worse, eventually causing inflation to spiral out of control. This happens because a Government bond is “money”, and when money loses value, that is the definition of inflation.

Wait a minute! There must be other solutions. Government spending could be reduced. Lots of luck on that one! Two-thirds of the economy is powered by consumer spending. A large amount of that spending is supported by “transfer payments”, which means Social Security, Medicare, Medicaid, unemployment compensation, and other welfare payments. Transfer payments are part of Government spending.

Taxes could be raised. Unfortunately, it would take increases that are politically unacceptable. Even if virtually all of the wealth of the billionaire class were confiscated by taxation, it would only make a dent in the problem. Nearly half the population already pays no income tax, and Social Security and Medicare taxes are inarguably insufficient at current levels. To massively increase taxes on the “hard-working” middle class would cause a revolution.

We could default on the Debt, which is what many other countries have done in the past. They were not all poor countries. Countries like France and Spain, which were at one time the most powerful in the world, defaulted on their debts, costing them their pre-eminence.

Default is not an option for the United States. It would lead to the collapse of much of the world’s economy since economics is now a global issue.  We issue the “reserve” currency of the world, held globally in bond form.  A US default would trigger a worldwide financial panic.

The Fed is trying to navigate a fine line. They realize that they cannot permanently tolerate a bond market that offers negative returns. That means higher interest rates. They would like to reduce their bond holdings before they raise rates, in order to keep their value from plummeting. They also understand that raising interest rates too fast will crash the stock market since stock prices intrinsically reflect the discounted present value of future earnings. Discounting recognizes that the current value of profits earned in future years is not worth as much today as are current earnings.

More spending that is not properly funded (i.e., using the phony accounting employed by both Parties to sell their programs to an unsophisticated public) is only going to exacerbate the problems.

I was once told by my Congressman that the lack of financial understanding by members of Congress is appalling.

The hope is that the problems will disappear if the economy grows enough, and that justifies still more Government spending to stimulate growth. That would be fine if the evidence did not show that increased levels of government debt have diminishing returns. In other words, each level of new excess spending produces less and less growth over time. Wishing that was not the case does not make it so.

The Fed will likely adopt a gradual approach to reducing their bond-buying and the raising of interest rates in order to avoid spooking the financial markets. (Markets can handle anything except sudden changes in any direction of anything affecting them.) Their difficulty is doing it if inflation gets too high for too long. In that case, public and political pressure to “do something” will cause them to “go big” and in so doing crash the markets.

Of course, those on the Left would cut military spending in order to free up funds for their favorite projects. This would be a temporary solution until China attacks Taiwan, Russia attacks Ukraine, or Iran starts bombing Israel. The difficulty with being the world’s hegemon in a globally connected world is that we cannot simply sit back and say that whatever happens in the world is of no concern to us. Had we done that in WWII, might we all be speaking German today?

Another approach that might be employed that has not been suggested so far is to mandate that pension funds and insurance companies buy a certain percentage of Government bonds. That is not unusual in a number of countries. Of course, it means that returns on those assets are lower since Government bonds have lower percentage returns than private investments, but that disguises the problems from a politician’s point of view since the negative impact is spread over a much larger base. Of course, most pension funds are extremely underfunded today and are struggling to earn enough to enable them to meet their current obligations.

There are those who say, “To hell with financial markets. They only benefit the rich people.” However, that ignores the majority of people with 401(k) or other pension plans or savings that depend on investment performance for retirement security, as does Social Security itself. If financial markets plummet, the rich will find a way to protect themselves; the rest of us will suffer.

This budgetary conundrum sounds negative because there appear to be no pain-free choices.  There must be other solutions that shift the pain to someone else or make it disappear in a magical cloud.

Unfortunately, the only real solutions are a much more prosperous economy that generates the revenue and taxes to support what we want, or else we have to reduce our perceived needs to the level of our ability to pay.