And that brings us to the Debt Supercycle. Let me quote a few paragraphs from my book Endgame:
“When we mention The Endgame, you’ll immediately want to know what is ending. What we think is ending for a significant number of countries in the “developed” world is the Debt Supercycle. The concept of the Debt Supercycle was originally developed by the Bank Credit Analyst. It was Hamilton Bolton, the BCA founder, who used the word Supercycle, and he was referring generally to a lot of things, including money velocity, bank liquidity, and interest rates. Tony Boeckh changed the concept to the simpler “Debt Supercycle” back in the early 1970s, as he believed the problem was spiraling private-sector debt. The current editor of the BCA, Martin Barnes, has greatly expanded on the concept. (And of course Irving Fisher talked about the long debt cycle in his famous 1933 article.)
“Essentially, the Debt Supercycle is the decades-long growth of debt from small and manageable levels, to a point where bond markets rebel and the debt has to be restructured or reduced. A program of austerity must be undertaken in order to bring the debt back to acceptable levels. While the focus of BCA has primarily been on the Debt Supercycle in the US, many of the countries in the developed world are at various stages in their own Debt Supercycle.”
A Debt Supercycle is not some new thing. Rogoff and Reinhart write about 266 such events in the past few centuries in their epic work This Time Is Different. It seems to be part of the human condition. We increase the amount of debt in a system until there is too much debt. Each and every time, the people and leaders in a country convince themselves that “this time is different” and the debt is not a problem to worry about. And that is true until some moment in time when the markets lose confidence in the ability of governments or businesses to service the debt.
Professor John Cochrane of the University of Chicago has written a series of brilliant papers and articles on this problem, forcefully demonstrating the math that interest rates are partially a reflection of the risk that investors perceive concerning the potential for returns on their money. When they begin to lose confidence that a government (or business) will be able to raise enough revenue to pay off the debt at some point in the future, interest rates begin to rise. At first, there are all sorts of reasons given. Then there is a moment when the bond market simply walks away. Rogoff and Reinhart call it the “Bang Moment.”
Once that confidence has been lost, it is not easily regained. “A program of austerity must be undertaken in order to bring the debt back to acceptable levels.” Governments or businesses have to demonstrate that they can get their budgets under control in order to get renewed access to the bond market. And make no mistake, austerity is a path for slow growth and/or recessions.
We are used to countries like Argentina having their problems. But in the 1990s we saw what happened to both Canada and Sweden as they had to deal with that lack of confidence. While they had different answers, they came through their respective crises, although there were clearly economic costs, higher unemployment, losses, and very difficult decisions made. It is not just “banana republics” that have debt problems.
Only a few years ago, European regulators were allowing European banks to leverage as much as 40 to 1, gorging themselves on sovereign debt, because everyone “knew” that sovereign nations in a modern world would not – indeed could not! – default; so why worry about leverage on government debt? Until Greece and then Ireland and then Portugal and now Italy, etc. I was writing early last year that Greek bonds would lose 90% of their value. This week we read that Greece indeed wants private investors to agree to a 90% write-off. Soon it will be public bond holders like the ECB that will take haircuts.
No country starts borrowing money with the thought that they will keep on borrowing until there is an economic collapse. It all starts with good intentions. No bank lends money not expecting to have it returned. Then things change over time. Since there seemed to be no problem with the current level of debt (and spending), why can’t we increase it a little more?
There are countries that can keep their budgets and debt under control (like Switzerland and others). But politicians like to promise benefits today and pay for them with debt that future generations must incur (like the US and countries all over Europe). Or they try to spend their way to prosperity and growth (like Japan).
And of course they promise that “in the very near future” they will get the deficits under control. “We will grow our way out of the problem. We will limit the growth of spending next year, when the economy is better. We can always raise taxes on the rich. Or increase consumption taxes. Or create some taxes somewhere.” Whatever it takes to convince the bond market to keep on funding their spending.
And so the choices to provide this benefit and that program, each justified by some reason and desired by some group of voters, add up over time. Everything goes well until there is a recession. Then revenues go down and costs go up, because unemployment benefits rise. But because the natural business cycle leads to recovery and growth, things soon get better and the game continues.
But then the accumulated debt becomes too much to handle when the next recession comes along. And bond investors lose confidence and the Bang Moment has arrived. Cochrane shows that there is no magic number or formula, no way to know in advance when that moment will be. Unless a country chooses to deal with the pain of cutting spending and raising revenues, eventually there is a true crisis, resulting in massive dislocations and losses. Bond holders lose a large percentage (if not all) of their investments. That moment is often precipitated by a credit or banking crisis. And when the banking system freezes up, businesses lose access to capital, and the recession can turn into a depression if not dealt with aggressively. But that means pain.
Let’s jump ahead to an illustration we will refer to again later. In the late ’70s, inflation in the US rose to over 14%. I remember borrowing money at 18%. The stock market lost about 40% in just 18 months. Unemployment was high and rising.
It was the single largest failure of US monetary policy since 1950. While some blamed it on high oil prices, or speculators, or greedy businesses or unions, the fact was that the Fed printed money to allow the government to run large deficits. And US politicians supported the policy because it allowed them to spend money.
And then came Paul Volcker. He is now credited with almost singlehandedly forcing the inflation genie back in the bottle. He is everyone’s hero. But back then there were plenty of people who did not like what he was doing, because he precipitated two major, back-to-back recessions, in 1980 and 1982 (as bad or worse than what we just went through). Unemployment climbed above 10%. The stock market got hammered even further. We look back now and say “It had to be done.” That is great with hindsight, when we are long past the recessions. But it was tough in the middle of the recessions to explain just why we needed a tighter monetary policy in the face of 10% unemployment.
What if there had been no Volcker? No one to stand at the door of the Fed and say “No more!” What if the Fed had continued to print? Then inflation would have risen even more. 25%? Bank loans of 35%? Higher? Who knows?
At some point, the math, even for the US, does not work. There is a limit to what a government can borrow and a central bank can print without a total collapse of the economy. There would have been another depression at some point. There would have been no Reagan Revolution, because to cut taxes when inflation was 25% and deficits were higher would have been unthinkable. We would have stumbled from crisis to crisis, cutting spending and programs only to have revenues fall and costs rise. It becomes a debt spiral that always ends badly. Would Reagan have tried, anyway? I think so, as that was part and parcel of his philosophy. But he would have been blamed for the recessions, and not Volcker. And in the midst of a crisis, how do you get Congress (or any politician) to make the right decisions?
Volcker chose a hard path. But it was a better path than the one we’d been going down. He hit the reset button. But did it seem like a better path at the time to anyone who could not find a job? To those on a fixed income? To the business owners who lost everything? To investors who gave up faith in the stock market?