Wednesday, January 27, 2016

The Debt Trap - This Time It Really Is Different

With the volatility in the world's stock and commodity markets being foremost on many investors minds, I wanted to take a look at some recent comments by William White, a Canadian economist.  His main claim to fame are his prescient views on the debt crisis of 2008.   He is currently the chairman of the Economic and Development Review Committee at the OECD, a position that he was appointed to in 2009.  He was the Head of the Monetary and Economic Department of the Bank for International Settlements from May 1995 to June 2008 and spent 22 years in various positions at the Bank of Canada, rising to the position of Deputy Governor of Canada's central bank.  For those of you who are not aware of the Bank for International Settlements or BIS, it is a Basel-based organization that  was founded in 1930 and is owned by 60 of the world's largest central banks whose home nations make up 95 percent of the world's GDP.  The BIS' mission is to act as a central bank for central banks and it functions under a high level of secrecy.

As far back as 2003, Dr. White observed that there was a real estate bubble developing in the United States, and that there was simply too much cheap money available to consumers.  With the economy bursting at the seams with money "printed" by the Federal Reserve, America's banking system had to find somewhere for all of that money to go, thus, the invention of increasingly imaginative (and ultimately toxic) financial products.  At the time, central bankers universally agreed that if there was no inflation, there was no problem, totally ignoring the development of asset bubbles.  Dr. White suggested that interest rates should be raised even when the economy is in good shape and there is no sign of inflation since this would counteract the formation of asset bubbles and will allow central banks to rearm their monetary policy "tool kits" so that they can lower interest rates when the economy inevitably turns down.  His suggestion would have prevented the Federal Reserve and other central banks from painting themselves into a policy corner as they have now with their prolonged period of near-zero interest rates.

Now, in light of the volatility in the world's markets, let's look at some of Dr. White's more interesting comments from one of his recent speeches.  Here are some excerpts from a speech entitled "False beliefs and unhappy endings" given on December 11, 2015 in Canada.  Any bolds are mine:

"In a nutshell, central bankers in the major advanced economies have been pursuing increasingly risky policies for some time. In large part,this reflects the political reality that monetary policy is the “only game in town”. Yet, in no small measure, it also reflects some long held, but false, beliefs about how the economy actually works. Moreover, absent any discipline imposed by an international monetary system (we have in fact a non-system), virtually every central bank around the world is now engaged in a process of unprecedented monetary easing. As a result, I think the global economy could now be in an even more dangerous situation than it was in 2007...

It is now impossible to deny that something has gone seriously wrong with the global economy. Moreover, for most economists, it seemed to come out of nowhere and its effects have lingered far longer than most originally anticipated.

While recognizing the great contribution of central banks to restoring financial stability, early in the crisis, there are good reasons for doubting that monetary policy will prove effective in stimulating aggregate demand over time. Much of what has been done recently smells of panic. Arguably, by increasing uncertainty, it might even have encouraged people, both companies and households to hunker down and spend less rather than more. What is more certain is that easy money works by bringing spending forward in time. However, by definition, tomorrow eventually becomes today and it is payback time. In short, inciting more spending through taking on higher levels of debt simply cannot go on forever.  And not only has debt accumulation been accelerating for over thirty years, in the advanced market economies, but global debt ratios (non-financial debt) have even risen substantially since 2007...with US interest rates so low and the dollar falling in value (up to mid 2014), much of the borrowing was in US dollars. With the dollar now rising, a mismatch problem could threaten barring an adequate level of prior hedging. Finally, much of the proceeds went into enlarging the capital stock in sectors (like property) where profits are already under strong downward pressure.

As for the unintended consequences, we are observing sharp declines in productivity growth almost everywhere and a slowdown in the formation of new businesses. I think it is not implausible that easy money has encouraged the “evergreening” of zombie companies by zombie banks which has led to this outcome. Moreover, we are all aware of how the prices of almost all assets, financial certainly but also property in many cases, have been bid up to levels where potential future losses might conceivably be severe. Who will suffer and what might be the systemic implications? We simply do not know. Monetary policy has led us into truly uncharted territory. Perhaps when (if?) the Fed starts raising rates, we will get more clarity on these issues, though we might not like what we see.

Finally with respect to unexpected consequences, the health of many financial institutions (especially in the advanced market economies) are also under threat. Bank profits, needed for capital accumulation, are being reduced by low credit spreads and low term spreads. Pension funds and insurance companies, whose liabilities tend to be of longer duration than assets, are similarly threatened and fearful of their longer term solvency. Everywhere, there is the temptation to “gamble for resurrection”, again with unknown consequences.

To boil down Dr. White's comments to one key point, he is concerned about the massive growth in debt, particularly toxic debt, over the last eight years because of near zero interest rates.  Let's look at a few examples:

1.) Here is a graphic from Vox showing how Europe's non-performing loans by country have risen since 2008:

2.) Here is a graphic from McKinsey showing how the global sovereign debt-to-GDP ratio has risen by measuring the change in debt-to-GDP ratio from 2007 to 2014:

The ratio of debt-to-GDP has risen for all advanced economies since 2007 and has fallen or remained steady for only six developing economies.

3.) From Visual Capitalist, here is a graphic showing the percent of total global debt by country, current to August 2015:

While the United States economy makes up 23.3 percent of the world's GDP, it has 29.1 percent of the world's total sovereign debt.  Japan's economy makes up 6.18 percent of the world's GDP but has 19.99 percent of the world's total sovereign debt.

4.) Here is what has happened to non-financial corporate debt levels in the United States since 2007, keeping in mind that a great deal of this debt is considered "junk":

While there was relatively modest corporate debt deleveraging during and immediately after the Great Recession, non-financial corporate debt is now $1.403 trillion or 21 percent higher than it was in the third quarter of 2008.  This is due, in no small part, to ultra-low interest rates on corporate paper.

It has become increasingly apparent that the next recession could well be different.  All levels of the economy have leveraged up as central bankers have prolonged their long-term interest rate experiment.  Governments, businesses and individuals (particularly in nations like Canada) have lined up at the trough, eagerly availing themselves of ultra-cheap credit without thought for the long-term ramifications of their foolishness.  As Dr. White noted so aptly, central bankers have failed to realize that the nature of the global economy is far too complex to be well understood.

Let's close this posting with a recent quote that Dr. White gave to the Telegraph:

"It will become obvious in the next recession that many of these debts will never be serviced or repaid, and this will be uncomfortable for a lot of people who think they own assets that are worth something." 


  1. My Father would have held "A Political Junkie" in high regard.
    If he were still alive today he would be celebrating his 112th Birthday in April.

    He was a Russian Immigrant who arrived in America with his parents, worked like a slave, as did most of the immigrants of his generation, and eventually, by attending NYU College and NYU Law School at night, pulled himself up by his bootstraps and made "good" in his adopted country.

    His entire Family lived in a run down tenement building such as one can observe in ancient antique photos of "Old New York".

    They occupied a one room, fifth floor walk up, cold water flat, whose lighting was provided by gas lamps. Electricity was still a luxury in those early days.

    At five years of age it became his responsibility to descend into the bowels of the basement, fill a battered old pail to the very top with coal and then lug that heavy bucket up five flights of stairs. The contents of that coal pail served to keep the family's pot bellied stove burning. That stove was their sole source of hot water and warmth in the winter.

    From the age of 13 my Father, working three jobs, had already constituted the economic mainstay of his entire Family, both parents and his two sisters and younger brother.

    By the Summer of 1929 he had actually amassed a modest but respectable portfolio of Stocks, especially considering he was only 25 years old and far wiser in the ways of the world than his boyish demeanor would hint at.

    Like a certain "Political Junkie" my Father, as young as he was, sensed that things were not quite right in America and perhaps all throughout the world.

    When things seem too good to be true, that is when one needs to start worrying. The Roaring Twenties kept roaring along. Everyone was putting every last dollar they could lay their hands on into the Stock Market even buying on Margin whenever they could.

    No one wanted to miss out on the chance to make easy money and it seemed the party would go on forever.

    But my Father sensed a major disaster in the air. He had purchased two books and read them carefully, cover to cover. One was titled: "A Stock Market Crash is Coming". The other book was titled simply: "A Stock Market Crash is NOT Coming". It was the second book which everyone decided was more correct. After all who wants to hear bad news.

    Are people any different today ??


    The week before Black Tuesday, 1929 my Father decided it was time "to get out" and tried in vain, to convince other people, to do the same.

    Then one day, Black Tuesday, the world ended, just as if someone had turned off the light, and everyone just fell out of bed.

    It all happened so fast and so furiously that no one could even grasp it was actually happening. But it was true, the Stock Market had completely crashed into a million pieces.

    Thousands gathered in the streets around the Wall Street Stock Exchange. The look on people's faces was one of utter disbelief and absolute shock. People refused to accept the fact that it could be true. How could a person's entire nest egg be wiped out in the space of a few hours ?

    But no Party lasts forever. Not even in America.

    Perhaps the only reason we have not yet seen the repeat of a 1929 type crash, as yet, is because "hidden hands" have been manipulating the Markets for a very long time. Who knows how many trillions have been artificially injected into the Stock Market to keep things rolling along as if everything was "all right with the world".

    But can "hidden hands" keep the Party going forever. Does any sane person really believe one can keeping kicking a tin can down the road forever. You can kick that tin can down every road all around the entire world but eventually you will still have to end up just where you started.

    The government keeps those printing presses going at full speed, 24/7. The only cost is the ink and the paper. But how long can such a solution sustain itself.

    One day I believe we will face another Black Tuesday. Just as in 1929, it will all happen so fast that at first no one will even be capable of digesting the event.

    But as the next Big Crash unfolds and seeps its way into people's brains the reality of the seriousness of the situation will gradually sink into people's brains. And they will understand that what they thought could never happen, what people fully believed was not possible to happen- will have happened.

    People, just as in 1929, have had their heads buried in the sand for a very, very long time.

    It is not a Myth that in 1929 people were leaping out of Wall Street windows. My father told me he knew a few who did that and a few who went to the nearest NYC beaches and just swam as far out as they could until their strength gave out and they disappeared below the waves.

    Few people are likely aware that all over America, local National Guard bases have been stock-piling hundreds of millions of rounds of ammunition.

    Why do you think they are doing that ?

    No one can predict when "the Great Judgment Day" will come.

    But an edifice built out of a deck of cards can only stand for so long and then one day, totally without warning, it all comes crashing down.

    The week before Black Tuesday in 1929, my Father's gut feelings and predictions were clearly in the minority. But that did not make him any less correct.

    And am I not my Father's Son ?

    1. Great story, most investors think that even if things go downhill fast that they will be smart enough to get out of the markets. After the debacle in 2008 where they saw the market do nasty and violent swings they learned a few things, this time they figure they will make the right moves before it is to late. But what if it hits like the flash crash on steroids?

      For a long time I have been trying to develop a scenario for a market "super crash" and a reasonable map leading to such a situation. Below you will find more on why this scenario could happen. We know that can't happen because circuit breakers have been put in place, but imagine a market that falls, trade is halted, and the market simply does not reopen for days, or even weeks.

  3. I'd say Mr. White knows what he's talking about. Debt is not always bad, except when it gets too big, it's a problem.

  4. I do not understand this debt thing. If you owe me a million dollars and I owe Fred a million dollars and Fred owes Bill a million dollars and Bill owes you a million dollars, we are all broke but in reality we can simply cancel the debts and suddenly we start over with no one out a nickle. When a monopoly game is finished, you simply shuffle the cards, give everyone new money and start over. If the banks go broke, who cares? Those that owe the bank money don't have to repay it as there is no one there to repay. The government starts a new bank, stocks it with new money, hands out a basic amount to everyone who lost money when the banks went under and the game continues. I realize this is nonsense but I don't know why. Can you explain?

    1. Because money not backed by anything (precious metals, etc..) will lose all value.

  5. Low interest rates and easy lending standards have exploded debt and much of it will turn bad. Writing off bad debt will be a painful process and I don't mean for the debtor, but for the creditor the person, business, or institution that holds the paper. It generally constitutes an unplanned and involuntary financial adjustment.

    We have seen increased speculation that propels the creation of leverage or carry trades that multiply risk. Growing debt also tends to move demand forward and cause an increase in the improper allocation of capital, both of these action have a way of causing problems that linger for years. The article below looks at how this massive debt hangs above our heads as a Hindenburg in search of a spark.

  6. I think what happens is that debt loads can get too high and become unsustainable. Interest always has to be paid.

    That means debt default, which leads to economic depression, as (the mostly imaginary) wealth leaves the system.

    Governments may try to deal with this situation by printing money, which leads to hyperinflation.

  7. My guess is it implodes and we go back to a gold based currency. Not a 1 for 1 of coarse maybe 100 to 1 or 1000 to one but a currency based on a nations physical gold holdings. It would seem if you look behind the scenes a lot of countries are setting themselves up for that to happen. Not sure how long the system will take to implode though.