The primary problem for the global economy today is a massive amount of debt and deficits: money has been “free” for far too long. In 2022, the plug was pulled on the zero-interest-rate policy (ZIRP), which was leaned on to revive the economy after the Great Financial Crisis of 2008. Initially temporary, it ended up lasting almost 15 years, fuelling a historically long bull market. Now, total debt-to-GDP ratios are at record highs thanks to massive fiscal stimulus that was poured out during the pandemic. This debt-mongering wasn’t problematic as long as interest rates stayed low, but now, public finances and our banking system are feeling the strain.
“Debt Matters!” is an excerpt from our May 2023 Special Report, ,Deeper Into the New Era – Navigating the Shifts & Turning Points Ahead,, and specifically from the Chapter entitled “The End of ZIRP”, page 18. You can download and read the entire report by visiting the following link: ,https://www.bficapital.com/specialreport2023. If you would like us to send you a physical copy, feel free to send your request to us at ,email@example.com along with your mailing details.
The world is drowning in debt. Financial profligacy is not sustainable. When interest rates were close to zero or negative, they no longer performed their critical economic mechanism of fiscal discipline and pricing of risk. The consequences are now finally obvious.
The dangers of excessive debt and deficits are well documented. History tells us, again and again, that continually piling up more and more debt, under the political pretense or well-intentioned hope of fixing economic and social problems, always backfires.
Until recently, central banks had unsuccessfully attempted to increase inflation in advanced economies. But deflationary forces were too strong and the inflation goals of 2% were not reached. This strengthened the seriously misguided belief that, particularly in response to the corona crisis, monetary and fiscal expansion can be ramped up almost indefinitely without the negative consequence of price inflation. This dangerous but politically convenient misconception was academically packaged as “Modern Monetary Theory” (MMT) and popularized by Stephanie Kelton’s book, “The Deficit Myth”.
MMT is largely based on the notion that advanced economies are different from their emerging market counterparts, and therefore could operate under a different set of economic laws. At the core of this thinking lies the idea that debt does not matter in America, or Europe, because central banks can create sufficient money, at any given time, to pay off their debt. However, rising inflation and interest rates have rapidly changed the economic landscape as well as the outlook for financial markets. With their return, reality has set back in.
THE RETURN OF RISING INFLATION AND INTEREST RATES
Inflation returned with a bang. Both US as well as European inflation shot up to over 5% within a timespan of two years, starting from close to zero in 2021. Advanced economies had not been confronted with this kind of inflation for decades.
The outbreak of the coronavirus and the global response to it inflicted substantial damage within an unbelievably short period of time – economically, financially, and socially. Similarly, the Russian attack on the Ukraine had an instant impact, with energy prices spiking and Germany being impacted the most due to its heavy dependence on natural gas supplies from Russia. From 2010 to 2018, Russia went from supplying roughly 25% of Europe’s natural gas to over 40%.
European leaders have been pursuing an uncoordinated set of domestic energy policies, increasing their dependence on Russian natural gas. Instead of shoring up reliable energy production, Europe spent much of the past decade pandering to special interests and ideological agendas. This led, for instance, to Germany’s decision to turn off the dependable energy source of nuclear fission. The last three nuclear plants were taken off the grid in April of this year because of incumbents lobbying for their own political survival and environmental zealots failing to understand, or care about, the economic and geopolitical consequences of a failing energy system.
THE SHOCK OF LIQUIDITY DETOX
2022 unloaded another layer of distress for the global economy. The proverbial moment of truth arrived. With the return of rising inflation, the Fed did the unimaginable, switching from quantitative easing to quantitative tightening.
From outright money printing, we have gone to an unusually fast withdrawal of liquidity. If ZIRP was the drug, the addiction it created in the corporate world has become obvious by now: growth at all costs, over hiring, overpaying, and corporate glut.
Figure 11: From Deflationary Trends in the Past Decades, to High Inflation in Three Years
Source: Refinitiv Datastream / ECR Research
The incredible injection of liquidity during the pandemic fueled bubbles across financial assets, particularly in technology and cryptocurrencies. With M2 growing at a whopping 27% at the peak, US monetary growth was put on par with that of Peru.
With the arrival of rapidly rising inflation, the Fed and other central banks started a concerted effort to withdraw liquidity from the global economy. Money supply, as measured by M2 growth, turned negative for the first time in modern history.
Data for March showed a negative growth rate of 4.05% versus a year ago, the biggest year-over-year decline on record.
Figure 12: US Money Supply (M2) Growth YOY (Feb. 1960 – Dec. 2022)
Source: Bloomberg, Federal Reserve Bank
Within a few short months, almost 50% of all countries faced inverted yield curves due to the rapid shift. The sudden withdrawal of global liquidity was considerably greater than that in 2000, when the internet bubble burst, or in 2008, when the housing bubble popped. Suddenly, the economy and financial markets addicted to excess and cheap liquidity were abruptly forced into detox – and detox is painful!
“There is no means of avoiding the fiscal collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved.” ~ Ludwig von Mises
THE BANKING CRISIS IS NOT OVER!
From history, as seen during the Weimar Republic, we know that the unwinding of excessive debt never happens in a predictable or orderly fashion. It is characterized by ups and downs, by bouts of inflation, followed by disinflationary phases. This time will be no different. The bank failures are the first symptoms of an economic sea change. Higher interest rates will have a growing impact on a global financial system that is no longer accustomed to paying for credit.
The reasons for the recent bank failures, starting with Silicon Valley Bank, and spreading to the much larger and system-relevant Credit Suisse, were not identical. However, they all had to do with the quick rise of interest rates and a widespread loss of trust, which led to a rapid and fatal level of deposit withdrawals. In essence, the survival of commercial banks, as well as the future of the USD-based global banking system, is based on TRUST. When trust is broken, the fragile house of fractional reserve banking cards can collapse in the blink of an eye.
Figure 13 displays the % interest differential between a 10-Year and 2-Year Treasury. The differential has gone negative by a considerable margin of over 1%. This is reminiscent of the US savings and loan crisis in the 1980s, when interest rates were quickly and sharply increased to get a grip on rampant inflation.
Figure 13: US Yield Curve (% Interest Differential Between 10-year and 2-year Treasury)
Source: Federal Reserve Bank of St. Louis
For some time now, banks have been able to employ the simple model of maturity transformation. That is when banks finance themselves short-term – say, through deposits or short-term loans – and lend it out long-term, profiting from the interest margin. That recently became much more difficult. The reason is the shape of the yield curve in the US. Normally, the long-term yields are higher than the short-term rates. Since the summer of 2022, this is no longer the case.
The phenomenon has been closely watched, as it has preceded past recessions. And the yield curve inverted further after Powell’s comments hinting at raising rates higher than previously anticipated, all as a response to recent data showing that growth and inflation remain strong despite the barrage of rate increases over the past year.