“De-leveraging” discussions have been intriguing. Hedge fund manager Ray Dalio has been public with his framework. According to Mr. Dalio, deleveraging can be broken down into three processes: Austerity, debt restructuring and money printing. He has even referred to the ongoing “beautiful deleveraging” here in the U.S. that has supposedly found the right mix of austerity, restructuring and printing appropriate to ward of deflation while promoting slow growth.
As one would expect, most financial market operators focus their analysis on the financial aspects of so-called “deleveraging.” And, no doubt about it, the titans of today’s gigantic global leverage speculating community are precisely those players that have most adroitly played the ongoing cycle of global central bank reflationary policymaking. Their astounding financial success provides them a public forum in which to shape both the analytical debate and general viewpoints.
I tend to believe that conventional thinking – albeit from central bankers, bond and hedge fund kings, or FT and WSJ columnists – is wrong on deleveraging. Deleveraging is not predominantly a financial issue. Economic structure matters – and it matters tremendously. Importantly, true deleveraging requires that system debt loads are reduced to a level supportable by the capacity of an economy to produce real wealth. A system can achieve stability and robustness only when a sound economy supports a manageable amount of system financial assets. Yet with a highly unsound economy, ongoing rampant inflation of non-productive debt and highly unstable financial markets, from my framework our system remains very much in a financial leveraging Credit Bubble Cycle.
Today, a consensus view holds that money printing will inflate incomes and prices to levels that reduce the overall burden of system debt. The belief is that a doubling of federal debt in four years has supported private-sector deleveraging – in the process creating a more robust system. Higher risk asset prices are viewed as confirmation of the adeptness of this policy course.
And while it’s widely recognized that we are witnessing experimental monetary management, few seem to appreciate that we are similarly watching a historic experiment in economic structure. Never before has a world-leading economy been so dominated by consumption and services. This is especially noteworthy in terms of historical comparisons of deleveraging cycles. I would strongly argue that if policymakers throw Trillions of fiscal and monetary stimulus at a maladjusted consumption and asset inflation-based economy – the end result will be an only more distended maladjusted economy.
“Inflationists” have again come to Dr. Bernanke’s defense, and it’s worth noting that some don’t hesitate taking shots at the “liquidationist” naysayers. And if I were writing my CBB back in the late-twenties, I would be categorized as one of those dreadful liquidationists - and one of Dr. Bernanke’s “Bubble poppers.” My argument is along the same lines as those economic thinkers that believed that either a Bubble economy and associated price levels be allowed to settle back to sustainable levels - or a runaway inflation of Credit would risk systemic collapse. Historical revisionism notwithstanding, those knucklehead “Bubble poppers” had the analysis right.
Historic Bubbles require a spectacular backdrop. The ongoing Bubble period and the “Roaring Twenties” share important similarities, especially in the realm of extraordinary technological advancement. Epic periods of innovation significantly impact the evolution of economic structures, while they also tend to stoke optimism as well as policy mistakes. Resulting booms spur Credit, economic and speculative excesses. And while such environments beckon for tighter monetary management regimes, during the twenties and throughout this prolonged Bubble policymakers administered the opposite. The confluence of economic and financial complexities was beyond the grasp of policymakers.
Contemporary economies have an unprecedented capacity to absorb inflating Credit/purchasing power. Apple expects to sell 10 million iPhone 5’s this weekend. Throw more Credit and higher incomes at our economy, and folks can acquire more cool technology products, enjoy more downloads, do more laser treatments or dine at more upscale restaurants. Literally Trillions of deficits and Fed monetization can be readily absorbed with hardly an impact on CPI. A services and consumption-based economy is – at least during a Credit cycle’s upside - something to behold – and confound.
Our economic structure certainly enjoys unmatched capacity to absorb Credit excess without engendering traditional consumer price inflation. Yet there is indeed a huge problem that no one seems to want to recognize: Our system also has an unprecedented capacity to expand Credit that is backed by little in the way of wealth-creating capacity. Our government literally injects Trillions into the economy – Credit that inflates incomes and sustains consumption and elevates asset prices. The downside of this economic miracle is that, at the end of the day, there’s little left to show for the whole exercise except for an ever-expanding mountain of suspect financial claims. Moreover, market values of these claims are sustained only by the unrelenting expansion of additional claims/Credit concurrent with increasingly radical monetary management. This is Minsky’s “Ponzi Finance” at a systemic level.
A real deleveraging would see the economy and financial markets weaned off of rampant Credit growth. Non-financial Credit growth averaged about $700bn annually during the nineties. This inflated to about $2.4 TN at the Mortgage Finance Bubble pinnacle in 2007. As I noted above, we’re currently running at an annualized Credit growth rate of nearly $2.0 TN. This is posing great unappreciated risk to system stability.
A real deleveraging would see price levels (and market-based incentives) adjust throughout the economy in a manner that would spur business investment – in the process incentivizing sound investment-based lending and resulting job growth. Real deleveraging would see a shift in the economic structure from Credit-fueled consumption to savings and productive investment. Real deleveraging would give rise to our endemic trade deficits shifting to surplus. Real deleveraging would see a meaningful reduction in non-productive debt. Real deleveraging would see market prices dictated by fundamentals rather than governmental intervention, manipulation and inflationism.
The “raging” debate is whether recent elevated unemployment is a “cyclical” or “structural” phenomenon. Academic “white papers” not required. After all, find a system that doubles mortgage Credit in about six years and then proceeds to double federal debt in four - and you'll no doubt locate a deeply maladjusted economic structure. Such gross financial imbalance ensures economic imbalance. And, importantly, the longer such imbalances are accommodated/incentivized by loose fiscal and monetary policies the deeper the structural impairment. Throw massive fiscal stimulus and monetize Trillions and such a structure will surely demonstrate historic deficiencies and fragilities.
Deleveraging – the process of unwinding the economic damage wrought from years of excess - will be a quite arduous economic process; one that will commence at some unknown date in the future. Oh, I guess I failed to mention that total (financial and non-financial) Credit ended Q2 at a record $55.031 TN, or 353% of GDP. And Rest of World holdings of our financial assets ended the quarter at a record $19.100 TN, a $3.860 TN increase from the end of 2008.
