My brother Darryl and my brother Darryl – and we’re all in this together: Part Deux Are there limits? Have we already past them?

Forget party politics. The Obama administration is borrowing money only because it is the only option to stave off short term ruin. His predecessor along with congresses controlled at times by both parties spent tax money they did not have like drunken sailors on a bender. Let’s go back in time and visit with Niall Ferguson, author of the Ascent of Money via an interview he gave Vanity Fair in January of this year.

These measures that we’re taking at the moment are preventative measures. They’re really designed to prevent a complete implosion of the economy. That’s why I call this, the “Great Repression,” with an “R,” because we are repressing this problem. But, that’s not the same as a cure. And what we’re going to see will look very disappointing, because we’ll be comparing it to the recovery of the sort that we used to see. In a traditional post-war recession, there would be a shock; the Fed would cut rates; there would be some kind of fiscal stimulus; and the economy would quite quickly recover.

The reason that won’t work this time, and this is the key point, is that the whole U.S. economy became excessively leveraged in the last ten years. The debt burden, as a proportion of G.D.P., is in the region of 355 percent. So, debt is three and a half times the output of the economy. That’s some kind of historic maximum, and those debts aren’t going away.

So we’ve all been bingeing on money that we didn’t have?

That we borrowed. And we borrowed it from abroad, ultimately. This has been financed by borrowing from petrol exporters, and borrowing from Asian central banks, and sovereign wealth funds. But yeah, whether it was the people who refinanced their mortgages and spent the money that they pocketed, or banks that juiced their returns by piling on the leverage, the whole system became excessively indebted. And notice: what is the policy response? You guessed it, more debt. And, now it’s federal debt.

So you end up in a situation where you’re curing a debt problem with more debt. Is that going to bring about a sustained recovery? I find that hard to believe.

So I guess the unanswerable question is, what could you do to solve this problem?

Well I’ll tell you what you have to do—you actually have to cancel the debt. There are historical precedents for this.

Excessive debt burdens in the past tended to be public sector debts. What we’ve got now is an exceptional level of private debt. There’s never been an economy in history that’s had so much private debt. Britain and America today lead the world in the indebtedness of the household sector and the banking sector and the corporate sector. But debt is debt; it doesn’t even matter if it’s household debt or government. Once it gets to a certain level, there is a problem.

In the past, when excessive debt burdens were accumulated by government, they tended to do one of two things: either they defaulted—this is the Argentine solution—where you say, “Ah, I’m sorry, I’m afraid we’re not going to be able to meet the interest payments this month, and never again will we make the interest payments.”

The other scenario is inflation, where the real debt burden is eroded because the money that it’s denominated in loses value.

I don’t think we’re really going to be out of the woods here until something of that sort happens to the huge debt burdens of the U.S. economy. Either these debts will have to be fundamentally written off in some way, or inflation will have to reduce the real burden.

Against that backdrop following is a link that a college finance professor sent Russell and I to financial expert John Mauldin’s paper, Buddy, Can You Spare $5 Trillion? which tackles 3 topics I found very interesting including the whitepaper by Themis Trading, titled “Toxic Equity Trading Order Flow on Wall Street.”

So first the under the radar inside fix:

Basically, they outline why volume and volatility have jumped so much since 2007; and it’s not due to the credit crisis. They estimate that 70% of the volume in today’s markets is from high-frequency program trading. They outline how large brokers and funds can buy and sell a stock for the same price and still make 0.5 cents. Do that a million times a day and the money adds up. Or maybe do it 8 billion times. It requires powerful computers, complicity of the exchanges (because the exchanges get paid a lot), and highly proximate computer connections. Literally, the need for speed is so important that to play this game you have to have your servers physically at the exchange. Across the river in New Jersey is too slow. Forget Texas or California. This is a game played out in microseconds.

The retail world doesn’t get to play. This is a game only for big boys who can afford to pay for the “arms” needed to fight this war. But the rest of us pay for the game, as that half cent is like a tax on transactions, not to mention the increased daily volatility, which skews pricing. Think it doesn’t affect you? That “tax” is paid by mutual funds, your pension fund, and every large institution.

Next back to excessive debt and why we should heed the Japanese lessons learned from their lost deacde before it’s too late:

Ok, let’s go over these points:

Japan’s population is shrinking, and the number of workers per retiree is rising. Japan has the highest ratio of debt to GDP in the developed world. And that debt is growing by 7-8% a year, and does not include local debt. Interest rates cannot go lower. Savings are falling rapidly and will not be able to cover the need for new debt issuance, by a long shot. Within a few years, because of the aging of the population, savings will go negative. Social security payments are rising. GDP is shrinking, and export trade is off about 30-40%, depending on the industry. Machine tools are down 80%!

If rates were to go up by 1%, let alone 2%, over time Japan’s percentage of tax revenue dedicated to interest payments would double to 18% and then to 40% and then just keep going up. It is conceivable that it will take 100% of tax revenues in less than ten years, at the current trajectory. Why? Because Japan is going to have to start to compete with the rest of the world to sell its bonds. Who but the Japanese would buy a Japanese bond at 1.3%? From a country that is rapidly going to 200% of debt-to-GDP? Doesn’t really seem like a smart trade to me. And as the data shows, the ability of the Japanese consumer to buy more debt is rapidly waning.

The Japanese government is coming to a crossroads with no good exits. Cut the budget drastically in the face of a deflationary recession? Monetize the debt and let the yen go the way of all fiat currencies? Can someone say Zimbabwe? Increase already high taxes in a very weak economy?

Mauldin concludes:

Japan is the second largest economy in the world. There is a rule in economics: “If something can’t continue, then it won’t.” Japan can’t continue down this path. All the trends are going against them. Sadly, Japan is going to hit the wall, maybe some time in the next few years. This will be very bad for the world, as they have financed much of Asian growth. They do in fact buy a lot of world goods, and their buying power is going to fall. This is going to mean fewer US and European jobs. Not to mention fewer jobs in the countries that are Japan’s neighbors.

And unless we change things in the US, this will be us in less than ten years. As in hit the wall, serious depression, etc. I am hopeful that we can actually get our act together. But then I am an eternal optimist.


One thought on “My brother Darryl and my brother Darryl – and we’re all in this together: Part Deux Are there limits? Have we already past them?”

  1. Sop, a very meaningful post. We are on a very dangerous road in this country. If we do not quit spending the future is very ugly.

    We have a lot of people born in this country after 1970. They only know low interest rates and “put it on the card”. Many of us still remember the late 1970’s when a mortgage was 15%-20%. These folks don’t realize what that means.

    I am afraid the current administration really intends to fund this massive debt with a devalued dollar. They have no other options because if unemployment goes where it is likely to go, there will be no tax revenue.

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