Outside the BOX: Bubbles, Part II
Surely you’ve seen all the charts and heard all the analogies, but let’s put this in simple terms: debt is helpful to a point, but once it becomes too large it transforms into an anchor on growth, and all because of the costs of rising interest rate payments. Despite all of our fantastic innovations and efficiencies, it has been our country’s increasing debt that has fueled much of the misleadingly false prosperity we have witnessed over the last three decades, as well as the increase in wealth inequality. Of course, I could refer back to the creation of the Federal Reserve System in 1913 and the subsequent abandonment of the gold standard nearly four decades later on August 15, 1971, as the key turning points in U.S. monetary policy that set us on this path, but for now let’s just focus on the recent history — that which most of us can remember.
This lack of fiscal discipline, divorced from a pay-as-you-go lifestyle, was perverted by the rolling of debts into lower rates and shorter maturities year after year
For most Americans’ lives we have lived in a world of falling interest rates. Thirty year fixed mortgage rates that topped out at 18.45 percent back in October 1981 have, for the most part, been on a steady decline since, allowing for the illusion of prosperity to take hold in the American psyche. When “What does it cost?” was replaced with “What is the monthly payment?” not only on car showroom floors, but within the halls of government at every level, the financial cancer of debt began to thrive. This lack of fiscal discipline, divorced from a pay-as-you-go lifestyle, was perverted by the rolling of debts into lower rates and shorter maturities year after year. The extra savings, which should have been used to pay debts down and build surpluses for a rainy day (as Keynes advocated) instead became the exploding consumer spending juggernaut constantly touted about on the CNBCs of the world. Regrettably, it also enabled the unchecked expansion of the government’s military and entitlement spending.
But what would happen if interest rates were to rise? Rising rates could consume every bit of extra cash the consumer has left. State and local governments, lacking the ability to print money from nothing — as only the federal government can do — could see themselves descending into Greece-type scenarios. Housing markets across the country could find themselves falling once again, and corporate balance sheets would start to deteriorate as increasing interest payments eat into profits. It is the inability to roll large debts over into lower rates that will be the turning point for most entities. Higher interest payments will leave little extra cash for that American consumer who previously could always be counted on to spend greater amounts of money every year, financed through cash-out refis and expanded credit lines. The spending patterns of the past will diminish as a national retrenching begins.
By now you might be asking yourself, What is the Fed to do in the face of all these risks? I believe that the Federal Reserve will do what most countries do when faced with the pain of paying down debt and raising taxes, it will resort to full-blown monetization. This would most likely lead to a currency debasement and subsequent rise in rates beyond the Fed’s control, further resulting in spiraling bond losses. History is littered with examples of this, and unfortunately, we as a nation are not prepared to face the real hard work and pain of repaying what we owe. But don’t take my word for it. Read what Paul Krugman had to say back in 2003 when it was a Republican at the presidential helm:
But my prediction is that politicians will eventually be tempted to resolve the crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt.
Interesting how Krugman changed his tune once there was a Democrat in office, but I’ll save that for another day. In the end we are left with the same misguided manipulations of monetary policy that led to the dot-com bubble and real estate bubble. The Fed never seems to learn from its past mistakes, continuing to blowing bigger and bigger bubbles that endanger us all.
