the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles.”
The Economic Singularity
Singularity was originally a mathematical term for a point at which an equation has no solution. In physics, it was proven that a large-enough collapsing star would eventually become a black hole, so dense that its own gravity would cause a singularity in the fabric of space-time, a point where many standard physics equations suddenly have no solution.
Beyond the “event horizon” of the black hole, the models no longer work. In general relativity, an event horizon is the boundary in space-time beyond which events cannot affect an outside observer. In a black hole it is “the point of no return,” i.e., the point at which the gravitational pull becomes so great that nothing can escape.
This theme is an old friend to readers of science fiction. Everyone knows that you can’t get too close to a black hole or you will get sucked in; but if you can get just close enough, you can use the powerful and deadly gravity to slingshot you across the vast reaches of space-time.
One way that a black hole can (theoretically) be created is for a star to collapse in upon itself. The larger the mass of the star, the greater the gravity of the black hole and the more surrounding space-stuff will get sucked down its gravity well. The center of our galaxy is thought to be a black hole with a mass of 4.3 million suns.
We can draw a rough parallel between a black hole and our current global economic situation. (For physicists this will be a very rough parallel indeed.) An economic bubble of any type, but especially a debt bubble, can be thought of as an incipient black hole. When the bubble collapses in upon itself, it creates its own black hole with an event horizon beyond which all traditional economic modeling breaks down. Any economic theory that does not attempt to transcend the event horizon associated with excessive debt will be incapable of offering a viable solution to an economic crisis. Even worse, it is likely that any proposed solution will make the crisis more severe.
In Endgame, we explored the idea of a Debt Supercycle, the culmination of decades of borrowing that finally ends in a dramatic bust that unfortunately is almost by definition deflationary. Unfortunately, much of the developed world is at the end of a 65-year-long Debt Supercycle – and thus we approach our economic singularity.
A business-cycle recession is a fundamentally different thing from the end of a Debt Supercycle. A business-cycle recession can respond to monetary and fiscal policy in a more or less normal fashion; but if you are at the event horizon of a collapsing debt black hole, monetary and fiscal policy will no longer work the way they have in the past or in a manner that the models would predict.
There are two contradictory forces battling in a debt black hole: expanding debt and collapsing growth. Raising taxes or cutting spending to reduce debt will have an almost immediate impact on economic growth. But there is a limit to how much money a government can borrow. Clearly that limit can vary significantly from country to country, but to suggest there is no limit puts you clearly in the camp of the delusional.
When unproductive debt (Minsky’s Ponzi finance) takes over, velocity will continue to fall until you clear up the debt. Debt overhang must be dealt with. One of the amazing things about Irving Fisher is that he did not have access to the data we have today, but he inferred the entire process from having lived through it during the Great Depression. It is Friedman who compiled the data. (Friedman also said that Fisher was the greatest economist.) One of the critical things Fisher understood was that extreme over-indebtedness was the prime problem, and falling velocity was merely one of the symptoms. Velocity’s falling as precipitously it has in the last decade is a warning sign that we are on the wrong track.
A great deal of the blame for slower growth can be laid at the foot of debt. As Lacy Hunt writes this week:
Over the latest five years ending June 30, 2014, real GDP expanded at a paltry 2.2% annual rate. In comparison, from 1791 through 1999, the growth in real GDP was 3.9% per annum. Similarly, real per capita GDP recorded a dismal 1.4% annual growth rate over the past five years, 26% less than the long-term growth rate. A large contributor to this remarkable downshift in economic growth was that in 1999 the combined public and private debt reached a critical range of 250–275% of GDP. Econometric studies have shown that a country’s growth rate will lose about 25% of its “normal experience growth rate” when this occurs. Further, as debt relative to GDP moves above critical threshold levels, some researchers have found the negative consequences of debt on economic activity actually worsens at a greater rate, thus becoming non-linear. The post-1999 record is consistent with these findings as the U.S. debt-to-GDP levels swelled to a peak as high as 360%, well above the critical level noted in various economic studies.
The modern economic equivalent of the Flat Earth Society is the Flat Debt Society, whose members contend that there is no negative impact no matter how large the debt gets. They point to Japan and note that their debt has risen to 250% of GDP – and the country still exists. The fact that nominal GDP is where it was 20 years ago is only evidence to them that Japan has not spent enough. But Japan is not a special case. They’re going to have to deal with a great deal of pain in absorbing their debt back into the central bank. It is going to dramatically impact the value of the yen, hurting retirees, pensioners, and consumers. There is no free lunch.
The boom of the last 60 years roughly correlates with ever-increasing debt. History teaches us (with over 200 incidents to learn from) that there is an endpoint beyond which debt becomes destabilizing and has to be dealt with, generally through a period of great destabilization.
An Exogenous Cause of the Next US Recession
I (and others) have argued that while the US is in a slow-growth period, there is nothing internal that could push us into recession. Rather, the catalyst for recession would have to be something from outside the country – what economists call an exogenous event. The two primary risk factors I see on the horizon are China and Europe having crises of their own that seriously affect the world.
I argued last week that we are moving into a far more deflationary environment, brought on by a rising dollar. Above, Charles Gave pointed out that in a deflationary environment the typical causes of business-cycle recession are no longer the primary culprits. Let’s review this paragraph from Charles:
When there is no inflation, the choices are between a deflationary boom and a deflationary bust. And the sober reality is that we move from one to the other only when the stock market crashes. What creates the recession are not excess inventories or capital spending as in an inflationary period but the collapse in asset prices which had been pumped up by the general mood of optimism.
In one of the great ironies, if he is right, it is precisely the inflation of assets brought on by QEs 2 and 3 that has put us in the greatest danger of another recession. The parallels with the 1920s and ’30s is an obvious but not very pleasant one. Growth in leverage and asset inflation during the ’20s led to the crisis of the ’30s.
Rather than using the time that monetary policy has bought us to restructure our fiscal policy, we have doubled down on increasing government debt and student loans. Can anyone seriously argue that transfer payments and other government debt are productive debt? We are already seeing current consumption seriously impacted by student loans.
If Charles is right, then we (I include myself in this group) are looking for the cause of the next recession in exactly the wrong place. The argument many economists and analysts have been making it that since there is nothing fundamentally wrong with the economy, any correction in the stock market is simply a pause on the way to further bull-market highs. What Charles is saying is that the correction itself leads to the recession in a deflationary environment.
This is something that no developed-market participant has any personal experience with. The last time we saw a true deflationary environment was in the 1930s. Charles argues that at the zero point, at the zero bound between inflation and deflation, there is a change in the forces that drive economic growth.
This is as profound a change as the one that occurs when liquid water turns to ice. Except that we know precisely the temperature at which water starts to freeze. Unfortunately, our measures of inflation are nowhere near as precise as our measures of temperature. Our measures of inflation are subjective (as I have shown in numerous letters) and are only generally useful in getting the direction right. Different measurement and analytical techniques might show strong inflation or outright deflation, based on the same underlying data.
While I can find no rhyme in Charles’s assertions, I can certainly see the rhythm, a simple synchronicity. It is exactly what you would expect to happen at the end of an Debt Supercycle. And it is precisely that relationship among debt, asset prices, and deflation that the Flat Debt Society will tell you does not exist. They will tell you the chance of too much debt creating a problem has precisely the probability of hell freezing over. It is just that in their theory hell never gets to 32°. Classical economists, on the other hand, do see the potential for too much of the wrong kind of debt to freeze up the markets. Minsky Moment indeed!
It is not just in the US that there are problems. The problems of Europe, Japan, and China have all been chronicled in this letter. Michael Pettis has been arguing for some time that the world must be seen in the context of global imbalances. For instance, if China is consuming 60% of the world’s iron ore production, that is not a sustainable trend. Ore production has risen to meet demand, but as China inevitably begins to rebalance, it is causing iron ore demand to collapse (and Pettis thinks it has further to go); and that deep dip in demand is putting pressure on the economies of countries like Australia and Brazil that produce iron ore. There are scores of such imbalances that have built up in the world. In his latest blog, Pettis writes:
“[But I do think that the framework [the imperative of global rebalancing] I have used over the past decade has been useful, at least to me, in understanding both the rebalancing process in China and the events that led up to the global crisis of 2007-08. And I think it continues to be useful in judging the adjustment process – or, more likely, the lack of adjustment – that explains why we still have a rough ride ahead of us. This framework has made it relatively easy to make predictions, sometimes “surprising” ones, because by working through the imbalances and assuming – safely, I think – that deep imbalances always eventually reverse one way or the other, we can work out logically the various ways in which this rebalancing must take place.
I have argued that since the 2007-08 crisis we have seen some adjustment in the US, very limited adjustment in China or Japan (except to the extent that Beijing under Xi Jinping has stopped imbalances from getting worse), and worsening imbalances in Europe, and it is for this reason that I have never been impressed by the strong market recoveries we saw around the world. If I had to summarize the key points about the framework I use, I would make four main points:
- The adjustment process. All growth creates imbalances, and in every case these imbalances will eventually reverse. What really determines a developing country’s long-term success, I believe, is not how well it does during the growth years, but rather how well it manages the subsequent adjustment. Growth miracles are very common, but real success stories are rare. The reason, I would argue, is that developing countries too easily reversed the great gains they made during the good years because the adjustment turned out to be far more costly than anyone had anticipated. It is far more important, consequently, for economists and policymakers to understand how to manage adjustment and minimize adjustment costs than to figure out how to generate rapid growth.
- Debt and balance sheets. Probably the single biggest sources of adjustment costs are the amount and structure of debt, or, more generally, the structure of balance sheets. Economists must understand (but almost never do) national balance sheets and sovereign financial distress as well as corporate finance specialists understand business balance sheets and corporate financial distress.
- Savings imbalances. The purpose of savings is to fund productive investment, and while the amount of productive investment opportunities is probably infinite, institutional constraints in every country significantly can reduce the ability of productive investment fully to absorb the total amount of savings created within an economy. These constraints vary from country to country, and until we understand how to remove these constraints, rising income inequality and mechanisms that repress the growth of median household income (relative to GDP growth) often result in what I would call excess savings. The consequences of excess savings include speculative asset booms, trade imbalances, unemployment, and unsustainable increases in debt.
- Globalization. In a “globalized” world, no country, not even the US, can protect itself from the consequences of imbalances elsewhere. The global economy is a system in which certain types of imbalances are impossible. I especially focus on the requirement that global savings and global investment always balance, but there are others. Because an imbalance at the global level is impossible, if there are imbalances in one country or region, there necessarily must be the opposite imbalances in another, and the more open an economy, the more likely it is to respond to imbalances elsewhere. It is impossible, in other words, to understand any non-autarchic economy in the world except in the context of global imbalances.
This rebalancing process that Pettis describes (we will review his new book when
