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US Debt In The Age Of Unrestrained Central Banking

Submitted by Eugen Bohm-Bawerk

We have shown in the previous three episodes (episode 1, 2 and 3) how the US economy structurally changed after Nixon took the US off gold, letting the Federal Reserve do what it does best. Obviously, with the “hard” anchor of the US dollar cut loose, the rest followed suit. It is telling that the so-called post-Bretton Wood “gold standard” of all currencies, the Deutsche mark lost 65 per cent of its purchasing power from 1971 to 1990.

Also note that the French, with its inferior Franc lost 84 per cent of its purchasing power over the same, time hated the Germans for it. As a “victorious” nation of the Second World War, the French had a right to veto German unification, and would only agree to re-merge east and west if the Germans would give up their coveted mark and join the euro.

But we digress, in the this episode we will focus on debt levels within the context of unrestrained central banking.

Throughout history the US economy used to be leveraged, on average, 1.5 times GDP; total credit market debt fluctuated more or less within a tight range of maximum one standard deviation from its long term mean. Prior to 1971 the only time debt levels really got out of hand was during the Great Depression on back of a 45 per cent decline in nominal GDP. Total outstanding debt, in dollar terms actually fell by 12 per cent over the same time span.

So, the US economy was leveraged 1.5 times its annual output from 1840 to 1971 before fundamentally changing its trajectory. Needless to say, this low debt period was also when the US economy became the world’s largest and most sophisticated (see here) and ultimately a global hegemon.

Growth, on the other hand have moved inversely to the debt level. On a decennial CAGR basis growth in 2015 is only beaten by 1935 in terms of under-performance.

So why did debt levels rise so dramatically after the final central bank restraint was removed? It is essentially due to the massive subsidy central bankers provided. If you tax a thing you get less of it (think all the tax on labour) but if you subsidise it you will get more of it. As time went by, debt obviously grew ever larger and eventually large enough to become an integral part of the business cycle. In other words, central banks could not stop the subsidy for fear of creating, well, a 2008 financial meltdown.

So every time spending growth came to a halt, the central banks would step in and lower rates and consequently also debt servicing cost. With more money in consumers’ pockets spending could resume.

As debt continued to grow, debt servicing cost obviously rose along with it, and the high in interest rates could never reach its previous peak before a new slump in spending occurred. In addition, the central banks always had to lower rates to a lower level than in the preceding cycle to reinvigorate spending.

When debt funded spending could not be stimulated even at zero rates the necessary deleveraging started with devastating consequences for global finance, trade and output.

This process, which Stockman refers to as dishonest market pricing, had even more perverted effects than just rising the overall debt level. It allowed the emergence of debt that consumed current resources without adding to future production. The massive increase in mortgage loans (which per definition must be repaid out the production of the mortgage holder) and financial sector debt helped increase what we call counterproductive debt.

While we get much pushback on this concept – a house is claimed to be productive as it provides housing services – the point is simply that the future productive stream of goods and services needed to repay the resources used in the process to build the house cannot come from the house itself. Taken to its logical extreme, a two week vacation in Spain to recuperate, paid for by consumer debt is also productive in the sense that its can help bring forth a more motivated worker upon return.

The jet fuel, food and services consumed during the two week vacation on the other hand is consumed and can only be repaid by future production; but it did nothing to actually provide the means for which future production can emerge. Unless paid for by prior production, through honest savings, debt funded consumption make society poorer and less capable of meeting its future liabilities. That this is lost on the Keynesians in charge has led to more destruction than any war have ever done.

It is the same with a mortgage. Allocate too much resources to the building of houses paid for by promises to repay from future production and the promised income stream will never materialise, because the means it was predicated upon are no longer available to make the investments necessary. They were consumed in the process of building the houses.

Whilst counterproductive debt rose exponentially from the 1970s, debt taken on with the intent of making a subsequent sale on the other hand remained relatively constant. Productive debt, presumably the kind that is self-liquidating, did not take the central bank subsidy bait to the same extent.

Combining zero interest rates and a massive pile of counterproductive debt leads to a very toxic mix for sound and sustainable growth. Central banks, shell-shocked by the fact that they cannot goose spending at zero interest rates fear peak debt will lead to a massive deflation, starts programs to fund their governments, which can spend.

And spend they do. Government debt is under the category we call destructive debt, pure consumptive in nature without even leaving traces of wealth behind. Mortgage debt, while counter-productive,  at the very least leave behind a house.

As the counter-productive part of the outstanding debt went into free-fall, the government, funded by its central bank, started spending and bailing out the very same counter-productive debt. In this phase of the global debt debacle, destructive debt rises to maintain the status quo. This is obviously also the very last stage as there will be no one to bail out the governments of the world when the next deflationary down-leg starts.

It is also worth noting that velocity of money falls when counter-productive debt rises too high in proportion to society’s productive capacity. By this logic, peak debt was actually reached as early as in the mid-1990s, but ever lower central bank rates, the emergence of China with its massive recycling of dollar inflation (more on this later) helped postpone the day of reckoning.