The Peak Debt Twilight Zone

Updated April 2014

In light of the fact that we are now facing yet another debt ceiling brouhaha and with the Fed grappling with its own tapering issues at the same time, I thought that a few quotes from David Stockman's "The Great Deformation" are particularly pertinent.  Given that the mainstream media is playing up the political divisions over this issue rather than the practical problems that ever-mounting debt will place on the economy and that it is wonderful that the stock market is reacting positively to the continuation, however brief, of QE, we are being distracted from the real and very serious issues that are looming.

For those of you who aren't aware, David Stockman was the former Director of the Office of Management and Budget under the Reagan Administration from 1981 to 1985.  He was very controversial in Washington, resigning in August 1985 over his views that government should be smaller and that government spending growth should be reduced in line with decreases in taxation.

Let's open with some excerpts from an interview on Mises.  In that interview, Mr. Stockman notes that the Federal Reserve, under the guidance of both Mr. Greenspan and Mr. Bernanke have turned America's central bank into "a machine for fine-tuning every aspect of the economy" through an acceleration of the money supply as we can see here:

 ...and here:

In its original form, the Federal Reserve was to function as the "bankers' bank" rather than functioning as an organization that manipulates everything from mortgage rates to employment levels to economic growth as it does under its current Chairman and his predecessor.  Mr. Stockman claims that the financial crisis of 2008 - 2009 was, in large part, the product of the Fed's bubble policy.  He refers to the panic of September 2008 as the "Blackberry Panic" where Washington policy makers watched the value of Wall Street stocks plummet on their smartphones.  In reality, the impact of those falling prices had little to do with Main Street America, rather, it impacted the one percent.  Here's a quote from his Mises interview:

"The panic and bailouts that followed were really about protecting the bonuses and incomes of very wealthy and politically well-connected managers at banks and other heavily leveraged businesses that were eventually deemed too big to fail. What followed was a massive transfer of wealth from the taxpayers and middle-class savers, in the form of bailouts and zero interest rates on bank deposits imposed by the Fed, to the so-called One Percent.

As I show in my book, none of this was necessary to save the larger economy, since the losses that would have taken place as a result of the collapse would have been largely limited to Wall Street. What the bailouts did was preserve the wealth of wealthy and powerful Wall Street players. Meanwhile, we’ve seen no real economic recovery in the rest of the economy.

This transfer of wealth continues, by the way, in the form of relentlessly low interest rates, and an ongoing war by the Fed on safe and stable investment tools such as savings accounts and low-risk bonds. Indeed, this is a deliberate policy to get people away from these safer investments, and to get them investing in more volatile and higher yield investments. The idea is that the Fed can somehow force bigger returns on these riskier investments, and this will lead to a wealth effect. People will then think they’re richer, and we can then spend ourselves into a recovery. This is a terrible doctrine, but that’s what rules Washington right now. It actively works against middle-class people who want to work and save and invest their money responsibly and conservatively."

Now, what does Mr. Stockman have to say about the looming debt ceiling issue.  Here is a quote from his book:

"The proximate cause of this recession waiting to happen is the federal government’s unfolding encounter with Peak Debt. The latter is not a magical statistical point such as a federal debt ratio of 100 percent of GDP, but a condition of permanent crisis. From the failed election of 2012 forward, every dollar of additional borrowing will induce new political and financial pressures while every dollar of spending cuts and tax increases will further impair the rate of GDP growth.

The mainstream notion that there is a choice between fiscal austerity and fiscal stimulus is wishful thinking. It does not recognize that owing to the triumph of crony capitalism and printing-press money America has become a failed state fiscally. Deficits and debt have now reached the point where they are too large and too embedded in social, economic, and political realities to be resolved. Accordingly, what passes for fiscal governance will become a political gong show that will make the New Deal contretemps pale by comparison.

What lies ahead is a continuous, mad-cap cycling back and forth—virtually on an odd-even day basis—between deficit cutting and fiscal stimulus to the GDP. Thus, deficit cutting will be in play every twelve months or so in order to purchase enough “conservative” votes to raise the federal debt ceiling by another trillion dollars or so. Yet every upward increment will become harder to pass in the House and Senate, ever the more so as the debt ceiling soon breaks above the $20 trillion mark and begins to soar well above 100 percent of GDP.

The fact is, the great unwashed masses on Main Street know full well that Washington is trifling with national bankruptcy, so the debt ceiling votes have become the one clarifying legislative moment in which they can demand a halt to the madness. Accordingly, the template from the August 2011 debt ceiling crisis will become the recurring framework of fiscal governance: in return for more debt ceiling, the reluctant House and Senate majorities which are finally assembled will get a new package of fiscal restraint in the form of targets, promises, and processes to develop plans to implement budget savings.

Before the ink is even dry on these deficit reduction packages, however, they will become part of the permanent, rolling “fiscal cliff”; that is, a recurrent series of pending tax and spending shocks that would cause negative GDP prints and adverse job reports if implemented. In effect, the Main Street economy will appear to be continuously confronted by the prospect of a “fiscal recession” or a dip in activity because it will be viewed as too weak to absorb the tax increases and spending cuts needed to close the nation’s yawning and unshakeable budget gap."

In large part, the Fed's near-zero interest rate policies have allowed Washington to borrow as though there is no tomorrow.  Here is a graph showing the average interest rates on United States federal debt between 2000 and 2013, using the month of October since it is the end of the fiscal year (except 2013 when August was used):

Congress is living in a low interest rate fantasy world, being lulled into a false sense of reality thanks to the Fed's long-term bailout of Wall Street and the nation's banking sector.  Even a small overall interest rate rise of 1 percentage point would, at the current debt level, add $167 billion in interest payments owing annually on the current stock of debt.

You will note that Mr. Stockman uses the term "Peak Debt" and notes that it is not a "magical number" like 100 percent of GDP.  Rather,  he suggests that it is a permanent crisis brought on as every dollar of additional federal borrowing for stimulus creates pressures at the same time as cuts to spending and tax increases are a necessity created by the mounting debt levels.  Stimulus measures will consume what little debt ceiling headroom there is and deficit reduction packages will result in both lower economic growth and dismal jobs reports.  At the same time, households may become increasingly concerned about their own futures in this uncertain economic environment and, out of fear for their futures and the future of the social safety net, may push the savings rate back back up to the double digit levels seen in the 1980s as shown here:

This will put additional pressure on economic growth.  If the savings rate rises to its 8.5 percent historical average from its current level, approximately $600 billion annually will be removed from disposable personal income, adding to the problem.

Thanks to the Fed and Washington, it certainly appears like we are on the threshold of the Peak Debt Twilight Zone where one economic policy interacts synergistically with another, creating an even worse crisis than one would normally expect.