pulling together some of what i've been mulling over lately.
THE DEBT SUPERNOVA
One supernova mechanism: After the core of an aging massive star ceases generating energy from nuclear fusion, it may undergo sudden gravitational collapse into a neutron star or black hole, releasing gravitational potential energy that heats and expels the star's outer layers. [wikipedia]
the debt supernova: after a financialized economy ceases to be able to generate growth from increasing debt, it collapses via debt deflation until social and market forces produce an inflationary explosion.
here's what happened in argentina when its dollar-pegged borrowing could no longer be supported by its export earnings.
of course, the u.s. is not argentina. also it enjoys the "exorbitant privilege" of having its debts denominated in its own currency. and it maintains its persistent trade deficit by exporting tbills, not automobiles. thus it is accumulating an external debt, the interest payments on which add to domestic deflationary forces. ever shortening average duration on the debt, combined with zirp, restrains this factor.
over time, as the u.s. economy has accumulated both private and public debt, an ever increasing amount of debt has been required to grow gdp.
the compounding nature of that debt adds to the parasitic effect of debt service on the economy. financial services drain an ever increasing rent from the real economy. financial services originally served the real economy. as financial services have grown, that relationship has been reversed. a parasite that grows too much will eventually kill its host.
The gravitational contraction of the economy in debt deflation: both at the national account level, and at the individual worker level, debt service drains potential demand from the economy, and retards growth or promotes contraction. if debt is used to fund investments which produce income at a rate higher than the interest payments on the debt, then the debt can be repaid. but 80% of bank credit in the u.s. and u.k. has been going to real estate, not industry. there has been no real wage growth since 1968. family incomes rose because women went to work. "the 1%" makes its money not from wages, but from interest, dividends, and capital gains. workers spend 40% of their income on housing [much in the form of interest, either directly on a mortgage, or via their landlord's mortgage], 15% goes to social security [counting the employers' share], 10% to other credit payments [credit cards, student loans], 10-15% to other taxes. what's left to produce demand in the economy?
The conditions for the mathematical impossibility of paying down debt: if debt is growing faster than income, it can never be repaid.
austerity amplifies the economic contraction, speeding the process. austerity reduces incomes in the economy, while increasing the tax burden. the debt, however, remains and its burden increases as the income to service it declines.
i had a question arise in my mind: why aren't i fantasizing about a cheap vacation in greece, or even buying a villa in greece? usually countries in those straits become bargains. but as part of its austerity program, greece has been forced to raise taxes dramatically, making travel there less attractive. social instability and pictures of riots aren't attractive, either. if greece had its own currency, it would have devalued, and travel there would be cheap. a tourism boom would help its balance of payments. the domestic inflation greece would have experienced in this scenario, as the price of imports like oil skyrocketed in terms of their hypothetical devalued currency, might have produced social instability, however. witness the food riots around a the world a few years ago after commodity prices spiked. but i doubt it would have been worse than what they have in fact experienced.
The process by which confidence is lost: look at spain. the ecb's 2 ltro's funneled money to spanish banks [among others], which were then compelled to use it to buy spanish sovereign debt. in fact, they bought 110% of the debt being issued over that period, as private investors used the opportunity to unload some of their holdings. thus, the ltro's failed to provide the confidence required for all debt holders to at least keep their pre-existing positions, let alone add to them.
why are investors fleeing spanish debt? spanish unemployment is 25% iirc, youth unemployment is 50%. spain had an enormous real estate bubble, and the uneconomic housing inventory is enormous. the economy is contracting, not growing. thus tax revenues are shrinking and social expenses rising. were this merely a cyclical recession, observers could predict a cyclical recovery. but the imbalances here are much larger than a mere cyclical recession, and the eurozone political-economic process appears set to further turn the screws. how can spain service its compounding debt?
first come the denials: "spain is not greece." then the inadequate bailout plans, like the ltro's. there have already been demonstrations bordering on riots. then, not quite yet, the shtf. spain appears to be following the same trajectory as greece, but a couple of years behind. spain is too big to fail, but too big to bail. more and more spanish debt is being accumulated by governments, national central banks, the ecb, spanish banks. soon there will be few private investors left to take haircuts if a greek-style restructuring is to occur. so a greek style restructuring won't occur. something else must happen instead: either all those official entities take haircuts, and then they themselves have to be recapitalized by the european governments, or the ecb must in some fashion print.
the process which leads to this will likely follow the path blazed by greece: ratcheting up interest rates as current debt holders dump their positions, accompanied by skyrocketing cds prices. note that in the u.s. the fed both controls the short end of the yield curve, and has been buying long-dated treasuries to control the rates at the other end of the curve.
[john mauldin's letter this weekend mentions that there are 23 members of the ecb board, and only 2 are from germany. i.e. the board may choose to print over german objections. pure speculation: this might provide the impetus for germany to leave the euro, allowing the euro to plunge and providing the devaluation that most euro members need.]
back to the u.s., its debts, and its status as the world's reserve currency: no one official has yet had the need to say: the u.s. is not greece. [though when i google "the u.s. is not greece" i get 22,000 hits. when i google "the united states is not greece" i get 25,000.] but our own debt dynamics- both domestic and international - combined with the mild austerity that appears in the works, will continue to strengthen the gravitational undertow of debt deflation.
in the metaphoric supernova, there is a collapse and subsequently but instantly, an explosion.
1. the ows demonstrations of last summer, eliciting an overly zealous official police response [oakland and nyc come immediately to mind], might have been the start of social unrest. this coming summer we must take note of their reappearance, or lack thereof, as a measure of broad domestic confidence in the economy, or lack thereof.
2. the fed has been the buyer of last resort for treasuries.
[good thing there's no inflation, huh?]
the increasing absence of other buyers for treasuries, either private or from surplus nations, is another trend to watch.
3. can the fed lose control of the long end of the treasury yield curve? the fed has been buying about 80% of issuance, but it hasn't been forced - like the spanish banks were after ltro - to buy 110%! when or if the fed is buying over 100%, we will know that current bond holders, private and/or foreign-official are starting to dump positions. this would represent a real inflection point, after which the process will accelerate. alternatively, if the fed gives up on controlling the long end, and rates spike, that too would signal the same thing.
kapoom- ej made up this word in 1999 to name a contraction and then explosive expansion of money/prices/inflation, such as occurred in argentina. the mechanism he described then was that foreign dollar- holders would see the value of their hoards collapsing, and rush for the exits. dollar velocity would accelerate rapidly as dollars were unloaded to buy other assets as quickly as possible. we've seen the beginnings of this in the fact that china's holdings of treasuries have ceased to expand, even as it continues to generate trade surpluses with the u.s. so where are its surplus dollars going? to buy other currencies and real assets all around the world. that moves the dollars to other foreign entities. as foreign entities in general cease to see the dollar [in its concretized form as a treasury instrument] as a desirable asset to hold, they will turn around and as quickly as possible buy something else with those dollars. that is, until they refuse to accept dollars in the first place. so where will there be asset holders who will be willing to sell assets for dollars? the u.s. the dollars will come home to the u.s. to buy up u.s. assets. the stock market will surge IN NOMINAL TERMS as equities are purchased. real estate, collectibles, commodities, will all be the target of trillions of dollars, previously frozen in the form of treasuries held abroad, now unleashed as a tsunami of liquidity hitting american shores.