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BFI Perspectives 

  • Sune Sorensen

The Problem with Sandcastles

During the last 8 decades, mankind has been on a pretty good run. Much has been achieved but there is a circularity to human history, and it would appear we find ourselves in the midst of a major turn – a departure from that which has been our reality for the last 4 decades. Many of the foundations underpinning our security and technological developments were built under dynamic US leadership that started around 8 decades ago and much of the global framework for our economic and financial reality was built on a US template that took its final form around 4 decades ago. Many of the foundations underpinning our security and technological developments were built under dynamic US leadership that started around 8 decades ago and much of the global framework for our economic and financial reality was built on a US template that took its final form around 4 decades ago. The last decade has been one of drift, not thrift. Hubris has built up. What was, has begun to falter, often with little pragmatic thought for what should come next. The great feats of engineering that set us on this trajectory of advancement has all too often been replaced by the more combustible and illusory art of financial engineering. The zeitgeist gradually moved from the mentality of the stakeholder to that of the shareholder before exploding onto the ‘burn it all down’ stage. In his 1805 book titled, An Inquiry into the Permanent Causes of the Decline and Fall of Powerful and Wealthy Nations, William Playfair stated, “The general conclusion is that wealth and power have never been long permanent in any place…and that they travel over the face of the earth, something like a caravan of merchants. On their arrival everything is found green and fresh, while they remain, all is bustle and abundance, and when gone, all is left trampled down barren and bare.” In short, the sandcastles of man are no match for the waves of history. Either the slow but insidious effects of the sun will dry away the cohesiveness of our great constructs until the smallest grain of sand suddenly slips away setting off a cascade of lasting change, or more abruptly and immediately consequential, the tide of time appears out of nowhere to wash away our efforts. You can ignore reality, but you can’t ignore the consequences of ignoring reality…or can you? In my last writing, Under the Macroscope; The Decade Ahead, I explored some of the current dynamics and what the path ahead may bring. Here, I will continue that exploration by taking a look at the financial realities facing the US federal government. I focus on the US, as it is still the most powerful node of the operating system and wires much of the global economy and financial system.

Each year, the US Congressional Budget Office (CBO) publishes a report presenting its projections of what federal deficits, debt, spending and revenues would be for the next 30 years if current laws governing taxes and spending did not change. Each year the members of Congress tend to ignore it – the one area that both parties are aligned on.

The numbers in the latest (2020) report may be beyond ignoring, yet all of the “noise” in the media, academia, financial & corporate circles, and amongst political leadership on both sides of the aisle appear to be doing just that, turning the volume up to numbers last seen during the desperate times of WWII and beyond.

In the CBO’s projections, deficits increase from 5% of GDP in 2030 to 13% by 2050 – larger in every year than the average deficit of 3% of GDP over the last 50 years. By the end of 2020, federal debt is projected to equal 98% of GDP. The projected budget deficits would boost federal debt to 104% of GDP in 2021, to 107% of GDP – the highest amount in the nation’s history – in 2023, and to 195% by 2050. This is without factoring in any further major stimulus programs. Any economy with such high levels of debt is vulnerable to even the smallest increases in interest rates and, as such, would face a very difficult choice if ever faced with rising inflation.

Do you combat inflation by raising interest rates, thereby increasing the amounts required to service all the debt? This would then force the decision makers to choose between the following:

Increased spending with the hope of spurring economic growth – You can earn your way out of a debt and deficit situation, but it requires real leaps of productivity and often population growth. Without the two, added government spending is just pushing on a string and ‘green shoots’ quickly turn to dust and into further deficits and debt. The CBO report projects US GDP growth potential for the next 3 decades to be slower than it has been at any time since 1951. This slowdown is driven mostly by declining labor force productivity as well as the decreasing size of the potential labor force.

Austerity – cutting away at public services and raising taxes to free up funds and raise revenues for servicing the increasing interest payments. This will be done sparingly but to great fanfare by politicians looking to score easy points via some virtue signaling. However, the math doesn’t work, at best you would be saving/raising billions to deal with debts in the trillions.

Default – it would clear the immediate issue but leave you out in the cold and facing much higher interest rates upon any attempt at re-entry into the halls of so-called civilized society. It would amount to a mere cleansing of the palate before having to sit down to eat humble pie – not the choice of most leaders who has a choice.

Or do you embrace the more subtle path of inflation accompanied by increasing levels of financial repression and eventually the social repression measures required to force upon the population default by another name? In doing so you would not just punish those who held the debt but more insidiously and with broader and more lasting effects, you would be destroying our collective measures of value and the underpinnings of civil society. History is littered with examples of these dynamics playing out to different degrees and while the paths may vary, the key ingredients and the outcomes tend to be the same.

A history of hopes & promises…

In his excellent book, Civilization & Capitalism 15th-18th Century: The Wheels of Commerce, Fernand Braudel provides some illuminating perspective on these timeless dynamics: “State expenditure always ran ahead: all rulers hoped to catch it up, but with very rare exceptions, never succeeded. So there was only one solution: The state had to borrow money. (..) The real novelty – the long-term loan – caught on slowly. (..) The long-term debt converted itself almost spontaneously into a perpetual debt. This was the miracle: the state never repaid the loan, but the lender could recover his money whenever he wanted.”

This ‘miracle’ has been embraced by politicians and electorates ever since as it seemed to have overcome the conundrum that had been the stone in the shoe of many regents, emperors and governments throughout history. Bastiat described this conundrum so eloquently back in 1848 when he stated, “The public has two hopes, and government makes two promises – many benefits and no taxes. Hopes and promises, which being contradictory, can never be realized.”

Debt has inevitably been the ‘solution’ for bringing the riches of the future into the hands of people today. In times of inelastic currencies, it was more of a serious commitment with the lender very much in control, as when the bankers of Genoa laid claim to most of the Spanish regent’s gold and silver from their American adventure. However, once such cumbersome barriers could be negated with temporary suspension of specie payments and eventually fiat paper currencies, relatively unlimited credit expansion could take root for better and for worse.

Finally, politicians could promise more benefits and less taxes and deliver by issuing debt and paying it back in depreciating fiat – at least for as long as the all-mighty bond market played along. To overcome the cumbersome market forces of this group of pesky bond vigilantes, we have since added an old wrinkle to bring this full circle. The good people at our central banks can now meld their efforts with those of our governments and cut out ‘Mr. Market’ completely…or at least lobotomize him with a constant drip of powerful stimuli and reoccurring shock treatment when needed.

By most measures, we are now into absolute dream-land (or nightmare-land if you are a saver) with the world awash in trillions and trillions of debt and declining currencies in real terms combined with real threats to the viability of the much promised ‘benefits’ such as pensions and healthcare along with creeping taxation, outright or by stealth via inflation.

Significant and competing currency devaluations around the world have been part of the ‘solution’ since the GFC. In places it has been overnight drops off a cliff, in others we are deploying more stealthy and measured tools, obfuscated by wonky terminology and complicated ‘scientific’ white papers plus a roaring chorus exalting the new market highs. Recently I came across this old clipping that I have kept in a folder with some of my initial observations and scraps of information, back when we first commenced with the great QE experiment.

The Sorcerer’s Apprentice – The spirits that I called

The Sorcerer’s Apprentice by Goethe (1797) is a classic German poem that begins when a powerful sorcerer retires from his workshop, tasking his young apprentice to fill a large vat with water to complete his chores. The lazy apprentice, tired of fetching water with a bucket, uses his master’s magic and enchants a broom to complete the task for him. When the broom comes alive and begins fetching the water, the apprentice is delighted! Alas the boy is not fully trained in the magic he is attempting and the broom will not cease filling the vat with water even after it is full. Before long, the workshop is flooded and the apprentice is unable to control the spell he has cast. In desperation, he takes an axe and splits the broom in two, but this only makes things worse. Now the two pieces of the broom come alive and begin fetching water anew at twice the speed. The workshop is now overflowing and the apprentice has no choice but to call his master for help. When all seems lost, the Sorcerer reappears, calls off the magic spell, and the broom falls lifeless to the floor. The Sorcerer’s final warning to the boy is that those untrained in the art of magic risk great danger by calling upon spirits they are not capable of controlling.

Have we called upon spirits we are not capable of controlling? Who do we call to deal with the resulting mess? Are we doomed to repeat the experiences of generations past for not heeding the lessons of history or is it somehow different this time?

Reinhart & Rogoff provides the following perspectives: “The essence of the this-time-is-different syndrome is simple. It is rooted in the firmly held belief that financial crises are things that happen to other people in other countries at other times; crises do not happen to us, here and now. We are doing things better, we are smarter, we have learned from past mistakes. The old rules of valuations no longer apply. Unfortunately, a highly leveraged economy can unwittingly be sitting with its back to the edge of a financial cliff for many years before chance and circumstance provoke a crisis of confidence that pushes it off."

Perhaps more than anything else, failure to recognize the precariousness and fickleness of confidence – especially in cases in which large short-term debts need to be rolled over continuously – is the key factor that gives rise to the this-time-is-different syndrome.

Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang confidence collapses, lenders disappear, and a crisis hits. Economic theory tells us that it’s precisely this fickle nature of confidence, including its dependence on the public’s expectation of future events, which makes it so difficult to predict the timing of debt crises.

Economists do not have a terribly good idea of what kinds of events shift confidence and of how to concretely assess confidence vulnerability. What one does see, again and again, in the history of financial crises is that when an accident is waiting to happen, it eventually does. When countries become too deeply indebted, they are headed for trouble. When debt-fuelled asset price explosions seem too good to be true, they probably are.

It could be different this time. Even if not, assessing the difference between that which is inevitable and that which is imminent is always a challenge. There are few facts about the future, but things tend to move in cycles in the affairs of man; this has certainly proven to be the case in all matters pertaining to money and government. Investors should take note.

The four horsemen of the wealth apocalypse have left the stable…

Over the long arch of history, the four ‘horsemen of the wealth apocalypse’ are war, revolution, taxation, and inflation. Once they have left the stable, the best you can hope for is that it is the latter two who arrive at your doorstep, as they can be somewhat managed with proper planning. On the path ahead you best be prepared either way. What has been, will no longer be. At least not for another turning of the ‘flat circle’ of time.

To protect that which is rightfully yours, you will need to think outside the paradigm of the last 4 decades and assess if you have the foundation of a sandcastle, or something longer lasting.

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