What Happens To Credit When Interest Rates Rise

“The biggest political upset in American history” muttered Clintonite George Stephanopoulos repeatedly as the election returns came in. The pundits and the polls had dismissed Trump’s presidential aspirations as a publicity stunt. In July of 2015, the betting markets gave Trump a 5% change of winning the nomination, much less the presidency.

Yet it was around this time that Myrmikan began arguing that Trump’s victory was historically inevitable. The American Constitution was modeled on the Roman Republic, and we all know (or should know) what happened to Rome. As the republic turned to empire, credit levels exploded, widening the gap between rich and poor. A citizenry composed of small landowners was transformed into a plantation system, more efficient but less flexible, able to sustain the populace through government handouts, but destructive of civic virtue: latifundis perdidere Italiam.

Similarly, credit growth in our own time has replaced a bourgeois society, comprised of small capitalists, into an employee society, where the mass of people owe their existence to large institutions, be they big business or big government. Indeed, aware of the corrupting influence of credit, in 1785 Congress declined to renew the Bank of North America’s charter on the basis that “they had no banks in Rome during the Republic.”

Meanwhile, the elites who controlled the two major political parties, the Popularis and the Optimates, the Democrats and Republicans of their day, battled over who could extract more wealth from their positions of power, which generally involved alliances with the large landowners, crony capitalists. The plebeians, crushed under the weight of debt and graft, yearned for a champion. They got it in the emperors.

The emperors drew their power from the little people and were thus hated by the intelligentsia, the reason the famous historians made them out to be crass, obscene, belligerent, and insane, more or less the attitude of the press towards Donald Trump. Even if these exaggerated characterizations contained some truth (for commoners like to think of the emperor as one of their own), it didn’t matter: it turned out that monopoly in graft is self-limiting, since it is in the interest of the single emperor to keep the host alive and strong; whereas competitive plundering focuses on extracting
as much as possible before the host dies.

This may be the reason why the Romans, a most practical people, accepted the demise of political freedom in exchange for economic stability, but it does not explain why they chose it—for ex ante the benefits were unknown. They chose it because the status quo of oligarchic oppression had become intolerable, as it has in our own time. The George Soros’s, and Lloyd Blankfeins, and Janet Yellens, the Davos Crowd and big businesses pushing corporate welfare under the guise of free trade, the Ford, MacArthur, Clinton Foundations, big media—who could oppose them, but one of their
own who had even larger ambitions and audacity. Trump’s argument to the black community was the same as to blue collar workers in the rust belt: what do you have to lose? It worked: the latter showed up at the polls and the former didn’t, confounding the press and handing Trump victory.

And now what? The establishment Trump attacked confidently predicted gold $100 higher and a crashing market, the unraveling of the current order, both of which occurred the election evening. But then an extraordinary thing happened: by morning the market had regained its loses and gold had collapsed, and everyone is wondering why.

The financial media has settled on three reasons. First, Trump has proposed lowering tax rates on individuals and dramatic cuts to the corporate tax rate. The value of business cash flows will increase, boosting corporate valuations, the stock market, capital investment, and future growth.

Second, Trump has proposed $1 trillion of infrastructure spending over the next 10 years, in addition to a military build-up. Why not put all those unemployed people and all that overcapacity to work? especially when they can be financed with interest rates around zero? Copper absolutely loves the idea, and much of the 24% rally since late October has occurred since the election. This stimulus-by-another-name will happen: Democrats love to talk “government investment,” and the Republican Party is always willing increase government spending as long as its done on their watch.

Third, Trump has promised to dismantle the Dodd-Frank Act, which prohibits banks from engaged in proprietary trading, among other things (though the exact details of his plan remain murky). Perhaps even more revealing are rumors Trump’s finalists for Treasury Secretary include 17-year Goldman Sachs veteran Steven Mnuchin, JPMorgan Chase CEO Jamie Dimon, and billionaire Jon Gray from the Blackstone Group, putting a fox in charge of the hen house.

Capital markets are understandably ecstatic about these priorities, for they are likely to pass the Republican-controlled Congress without too much dilution (a few bridges in sensitive districts will do the trick). They are all fuel for credit expansion—the KBW Nasdaq Bank Index has surged 18% since the election—and, as Myrmikan continually points out, gold hates the upside of a credit expansion, which may explain the collapse in gold prices since the election.

Financial news chatter has it that Trump’s program is the same as Reagan’s, who revitalized the economy by slashing taxes and regulations, spending on the military, nor, like Trump, did he care about the deficits: “I am not worried about the deficit. It is big enough to take care of itself,” he quipped. Reagan’s policies ushered in a generation of rising stock prices, declining inflation, and a falling gold price.

If only it were so easy to achieve national greatness! Reagan’s program came at a particular moment in time: the trough of a credit cycle. Interest rates were at cycle highs, exceeding 20%, and the sum of government and private debt added to only 150% of GDP. The Federal Reserve’s hoard of gold backed its liabilities by 92%. These were ideal conditions to commence on a credit expansion, the longest and largest history has ever known.

President-elect Trump faces very different conditions. Rates are at cycle lows and the total debt-to-GDP ratio is recorded at 338% (likely a good deal higher). Medicare, Medicaid, and Social Security alone consume 10.4% of GDP—compared to 5.4% in 1980—and are projected to grow to 13.5% by the time Trump finishes his first term. Add military spending at the lowest levels since World War II and interest on the debt at historically low interest rates, and expenditures already exceed current revenues, even at Obama’s tax rates, leaving nothing for anything else. Unless he’s going to somehow
slash entitlements, which he promised not to do, Trump has no revenue to redirect. Any spending above military, interest, and entitlements must come from borrowed money. And any increase in interest rates widens the deficits, requiring the issuance of more Treasuries, which will increase rates even further, in a positive feedback loop.

The U.S. Treasury market has had an enormous reaction to the prospect of large new issuances from deficit spending, wiping out well over $1 trillion in the bond market since the election.

Interest Rates

Interest Rates

The chart above right puts this surge in yields in perspective—they have merely returned to where they were at the beginning of the year. But, as Ludwig