Turbulent Times Ahead
How the world’s financial markets, combined with enormous government debts, will soon trigger another financial crisis
Thanks to media-induced hysteria over SARS-COV-2, politicians around the world have scrambled to introduce ever-more-harmful policies that have wrecked economies, thrown hundreds of millions of people into penury, and created enormous (and totally unsustainable) levels of government debt.
Since World War II, Western governments have learned that the best game in town is to bribe voters with their own money. “Vote for me and I’ll create jobs!” “Vote for me and we’ll locate our new development in your town!” “Vote for me and I’ll cut taxes!” All these claims, and a great many more, are all predicated on the fact that ordinary people have no understanding of even the most basic economic realities. Thus people vote for politicians who promise them more free ice-cream than the other candidates.
How all that free ice-cream will be paid for is something that never troubles the minds of the vast majority of voters.
Not surprisingly therefore, government debt as a percentage of GDP has relentlessly increased since 1945, despite the fact World War II itself created hitherto unsurpassed levels of government debt. So we went from significant debt to even more significant debt. But thanks to the wonders of modern marketing, with its reliance on empty soundbites designed to appeal to people’s ignorance and worst instincts, we’ve done so much better than that over the last few decades.
In the 1980s Ronald Reagan showed how to increase debt while making people believe ever-increasing debt was actually a good thing. Remember all those fatuous claims about “trickle-down economics” and the Laffer curve? Of course, wealth doesn’t trickle down and debt only generates future growth if it is incurred for projects that are viable. Nearly all debt was actually incurred to buy votes and thus depressed rather than nurtured growth, because capital was diverted from more productive uses.
In the 1980s, people learned to worry about debt-created inflation, and high interest rates were understood to be the painful medicine necessary to bring inflation down into the 2% range. Inflation is a disaster for economies because it makes forward planning and investment almost impossible. Companies can’t borrow to invest if tomorrow the interest rates they pay on their debt will increase yet again. And people would rather spend money today, while it’s still worth something, than to save for the future — which starves banks of capital and thus reduces lending even to companies willing to invest for tomorrow. So high inflation destroys economies. Just look at the Weimar Republic in Germany in the 1930s, or at Zimbabwe, or at Venezuela.
Under successive Republican administrations, US debt increased relentlessly after WWII. Although the Clinton administration succeeded in reducing US debt and enabled four years of surplus (where tax revenues exceeded budget spending) the Reagan tax cuts and G.W. Bush’s tax cuts combined with massive debt-financed spending on various unnecessary invasions meant that US debt ballooned out of control. Republicans, of course, supported all this debt because it was incurred by Republican administrations. In the USA, debt is only bad if it’s incurred by Democrats.
So while Clinton sought to reduce the national debt when it stood at 63% of GDP in 1993, and enabled four straight years of budget surplus, Trump massively increased the national debt so that it now stands at 130% of GDP. Tax cuts for the ultra-rich combined with ever-greater borrowing to pay for pork-barrel projects has put the USA into a completely unsustainable position. Today, interest rates are nearly at zero, yet the USA spends more than $300 billion per year just servicing its existing debt. This is more than it spends, for example, on low-income housing.
An increase of just one percentage point on interest rates will double this yearly outgoing, so that merely paying interest on the national debt will cost as much as the entire US defense budget. The US deficit is $27 trillion dollars. Trump’s tax cuts for the ultra-rich created a $3 trillion increase in debt in his last year in office alone.
Republican voters are naturally oblivious to the fact their Party says one thing and does the precise opposite, because who can be bothered with mere facts when the soundbites are so beguiling? Remember: you can’t trust Democrats with your tax dollars but Republicans are the Party of responsible government!
Soundbites for the simple-minded aside, it’s obvious that this level of debt — which is being mimicked by other Western countries as they deficit-spend in a vain attempt to offset some fraction of the astonishing harm they’ve created through their panic-induced covid-19 restrictions — is completely unsustainable. At best it guarantees decades of stagnation, as the Japanese can attest because they faced precisely the same situation more than twenty years ago and have never recovered from it.
But this is actually quite good news compared to the situation we see when we look at the financial markets.
When interest rates are at near-zero, banks can’t generate income via their usual means. Normally, banks attract savings because they can pay what appears to be an adequate rate of interest (most customers being unable to calculate the difference between nominal and actual rates) while lending out the money at higher rates of interest. This spread between borrowing their customers’ money and lending it to companies usually enables banks to make adequate returns on their capital base. But in a world of near-zero rates this game stops dead. Any person or organization looking to invest surplus cash won’t find near-zero rates attractive because they mean in real terms a loss of capital. If inflation is at 1.75% and bank interest rates are at 0.25% then savers are losing 1.5% of their capital in real terms every year.
Investors chase returns; they can hardly do otherwise. But when interest rates (and hence also Treasury bonds and corporate bonds) are unappealing, this forces investors to put their money into much riskier vehicles. In theory the risk premium compensates them for the risk they take, but like all averages this general notion disguises the fact that while on average the idea is OK, in practice investors will either do well or get burned.
To see why this is, let’s imagine we have two companies. Company A looks like investors may earn 5% thanks to the company’s shares continuing to rise. Company B likewise seems to be a reasonable bet due to the frothiness of the marketplace. So Mary puts $10 million to work and buys Company A’s shares. Joe puts his $10 million to work and buys Company B’s shares. Company A’s shares end up rising by 3%, so Mary cashes out with a modest gain of $300,000. But Company B tanks when the bubble bursts, and Joe loses $500,000. On average, the two investors have only lost $200,000 but in reality all the losses are born by Joe and Mary’s gains are hers alone to enjoy.
Unfortunately in real life the sums being gambled are far larger and the risks far greater. This is because in real life Mary and Joe don’t buy shares outright. What they do is purchase options to buy and to sell. This enables them to leverage their money, so that if they win the payout is far larger than their capital stake would otherwise permit. But if they lose, it means their losses can be enormous.
Here’s a simplified example of how leverage works: Mary uses $300,000 to purchase a series of options that require her to buy $30 million of shares within the next 60 days at a fixed price of $3 per share, because today’s share price is $2.95 per share. If the price goes up to $4 per share, Mary will make a profit of over $10 million because thanks to her options contract she can buy ten million shares at $3 per share and sell them immediately at $4 per share, whereas if she’d simply bought outright at $2.95 and sold at $4 without leveraging, she’d make only $105,000. Leverage is therefore extremely attractive to investors willing to undertake some amount of risk. The people selling their shares to Mary want the security of knowing that they will get at least $3 per share within the next 60 days, so they’re willing to forgo potential gain in order to avoid making a loss. In the jargon, Mary is risk-positive while the sellers are risk-negative.
Now let’s look at Joe. He takes $300k and purchases a series of options that requires him to buy $30 million of shares within the next 60 days at a fixed price of $3 per share. But instead of going up, the shares Joe buys plummet to only $1 per share and when Joe is forced to pay $30 million to buy $10 million of shares, he makes a paper loss on the transaction of $20 million. But Joe doesn’t actually have $20 million, so he fails to buy the shares. At this point the financial system goes into panic mode. The banks, who’ve loaned Joe the $300,000, see they’re going to make a loss. The people who sold Joe the contract to buy at $3 per share see they’re going to make a $20 million loss. Everyone tries to dump the shares in order to get whatever they can in order to minimize the inevitable loss they will now make. As people panic and try to unwind their positions, the share price goes from $1 to $0.50, further increasing the losses everyone involved will now incur. Worse yet, investors flee shares in companies that look like the company Joe invested in, so those companies see their share prices fall, which spurs more investor panic, which pushes more shares down, which created even more panic, which results in people dumping even more shares, and so on in a glorious race to the bottom that can destroy trillions of dollars of value in a matter of hours.
In our examples of Mary and Joe we’ve been talking about tiny sums of money. In real life, people are gambling hundreds of billions of leveraged dollars every day. The last financial crisis in 2008 was caused by leverage, and the next financial crisis that will strike will likewise be caused by leverage.
Today, however, we’re in a world in which government debt is so huge that, unlike in 2008, governments can’t just print money to bail out the financial system. Unlike last time, government debt is now so great that any rescue attempt would cause the markets to dump government debt, thus pushing even the US government into insolvency. Who cares about the US government printing dollars in an attempt to save the financial system when people look at dollars and say (as they did in Weimar Germany and as they said in Zimbabwe and as they’ve said in Venezuela) “this is just worthless paper.”
In theory all of this was avoidable. But the classic combination of human folly, greed, endless political duplicity, and a culture of “let’s just keep kicking the can down the road” means that we will soon experience a financial collapse that will make the 2008 crisis look like small change.
And no, buying gold or Bitcoin won’t help, despite the claims of tricksters and a seemingly endless river of delusional naive folk.
But the good news is that we won’t learn from next time either, so we’ll be able to play the game over and over and over every decade or so, just because it’s such jolly good fun. And the only people who really lose are you and me, the small people who don’t count, because we can’t afford to buy politicians to write laws that allow us to play the leverage game to our hearts’ content, with other people’s money.