Government growth, corporate debt a Faustian bargain
Guggenheim Global CIO Scott Minerd to Appear on CNBC”quick moneyon Friday nights. The show starts at 5 p.m. EST.
“In Goethe’s 1831 drama “Faust”, the devil persuades a bankrupt emperor to print and spend large amounts of paper money as a short-term solution to his country’s fiscal problems. As a result, the empire eventually crumbles and descends into chaos.Today, governments that have relied on quantitative easing (QE) instead of undertaking the necessary structural reforms have struck arguably the biggest Faustian bargain ever. financial history.” — Scott Minerd, “Global CIO Outlook”, August 21, 2012
As the global economy slides into recession and many economists estimate that second-quarter US GDP growth will fall by 15% or more, the world is facing the worst slowdown since the 1930s.
In the post-Keynesian era, the standard policy solution to a downturn in the business cycle has been for governments to temporarily offset any decline in demand with increased fiscal stimulus and easy money. This prescription provided for less significant and less frequent slowdowns. The ultimate consequence is that businesses and households bear higher indebtedness and reduced cash reserves in the belief that policymakers will limit the severity of the consequences created by any economic shock.
This process of accumulating larger debt balances after each successive downturn is often referred to as the great debt super cycle. Over the past few decades, the successful use of Keynesian stabilization policies has increasingly bolstered the confidence of investors and creditors in the government’s ability to successfully mitigate the downsides of any recession.
The massive indebtedness of US households as a result of accommodative monetary policy and easy credit led to the housing bubble. The collapse of this bubble destabilized the global financial system and could only be stopped with unorthodox monetary policy and fiscal programs that led to the partial or total nationalization of many financial institutions and industrialists.
As a result of this crisis, governments themselves have become heavily indebted, requiring near-continuous support from central banks to acquire this debt in order to keep interest rates low to support growth. The average public debt-to-GDP ratio for G-7 economies reached 117% in 2019, up from 81% in 2007. Any attempt to reduce or reverse the accumulation of public debt or other assets is quickly reversed as financial markets become unruly and economies slow.
Now faced with the exogenous shock of the COVID-19 pandemic, policymakers are reverting to the same tools used during the financial crisis ten years ago. They are desperate for programs that will fill the demand gap created by mass shutdowns and travel restrictions while simultaneously finding ways to support businesses that are largely over-leveraged due to artificially low interest rates in the last decade.
The ultimate political objective is to stabilize the economy by saving the industries that will have to provide jobs when the pandemic ends. Given the high level of indebtedness of these companies, any cash shortfall will prevent many companies from servicing their debt. Total US non-financial corporate debt has increased by about $6 trillion since 2007, while cash on hand has increased by only $1.7 trillion. One of the main drivers of this debt growth has been share buybacks.
Lending more money to these companies will only compound the long-term problem resulting from excessive debt and make the companies even more vulnerable to long-term failure.
We are living through the end of the great debt super cycle. As the private sector has become increasingly over-indebted, the baton has passed to the public sector where resources are so stretched that the printing press has become a last resort. At 4.6% of GDP, the US federal budget deficit in fiscal year 2019 was larger than anything we’ve seen outside of a recession or war.
The truth is that the only political solution besides socialism is to accomplish a great transfer of wealth from investors to debtors. In the normal course, businesses reorganize and creditors cut debts on a case-by-case basis. However, this process is time consuming and expensive. Given the systemic nature of the current crisis, the sheer volume of reorganizations would overwhelm the financial and legal systems and major defaults would be followed by asset liquidations that would reduce the value of collateral backing other loans and likely trigger a downward spiral. .
Another answer is negative interest rates, where creditors accept a slow erosion in value. The hurdle to successfully implement this solution quickly seems totally unrealistic. Reaching levels of negative interest rates that would provide a solution would require a rapid move to a global cashless society and an overhaul of regulations affecting pension funds and the insurance industry, not to mention the logistical challenges of immediate implementation of the systems throughout the financial sector. .
Of course, there remains a tried and true method of carrying out this policy: debasement. The process of inflating prices would result in a transfer of wealth from investors to creditors. Many believe that inflation is dead and that such a policy would not work. The question of how to successfully raise the price level is more a degree of commitment than ability.
By rapidly spinning the printing presses, global central banks are expected to provide reserves at a faster rate than the velocity of money is collapsing. It is a delicate and difficult exercise to carry out.
Risks on both sides are not moving fast enough and are overdoing it. If too little money is made available, the prices of assets used as collateral for loans will soar. If there is too much, inflation will spiral out of control.
Almost eight years ago, I wrote about the Faustian bargain that policymakers had engaged in to resolve the financial crisis. The terrible consequence of these policies is that the bill could now be due.