Demographics

In many Western industrialized nations, debt has overwhelmed or is about to overwhelm the economy's debt-servicing capacity. In the run-up to a debt crisis, bad debt tends to move to the next higher level and may ultimately accumulate in the central bank's balance sheet, provided the economy has its own currency. Many observers assume that, once bad debt is purchased by the central bank, the debt crisis is solved for good; that central banks have unlimited wealth at their disposal, or can print unlimited wealth into existence.

However, central banks can only create liquidity, not wealth. If printing money were equivalent to creating wealth, then mankind would not have to get up early on Monday morning. Only a solvent central bank can halt hyperinflation. The longer governments run large deficits, the longer central banks continue to monetize them, and the longer their balance sheets grow, the higher the potential for enormous losses and thus hyperinflation.

Necessary preconditions for hyperinflation are a quasi-bankrupt government whose debt is monetized by a central bank with insufficient assets. One way or another, owning physical gold is the safest and most effective way of insuring against hyperinflation.

In the last few days we have seen reports suggesting Brazilian household debt and service payments are weighing on growth, that Southeast Asia’s commercial credit is approaching its pre-1997 financial crisis peak of 75% GDP, and that South Korea’s household debt has reached 164% of disposable income compared with 138% in the US at the start of the housing crisis. Chinese debt rose 15% in excess of GDP last year from 191% to 206%. Its corporate cash flow is around 50% of profitability whilst loan growth is way in excess of the banks’ return on equity meaning the growth is dependent on a continual supply of new capital to the banks. Over the last few years whilst the developed economies have struggled to reduce their debt relative to GDP – (the most successful of the major economies has probably been the US which has taken non-financial sector debt down from a high of 253.15% GDP to 248.18% GDP) – the developing economies have taken advantage of cheap funding to inflate their debt levels dramatically, leaving the global debt position worse than in 2007.. Some of the emerging market debt is relatively small and the necessary rebalancing of the economy should be relatively easy to achieve, but even if it is only a cyclical limit as oppose to the structural limits of the developed economies, it is coinciding at the same time and will add to the global problem. As data on world GDP growth would suggest, it is not just Brazil where the numbers show “the exhaustion of a growth model based on consumption”.

... And this time it is a true parabola.

Two and a half years ago, George Soros' former partner Stanley Druckenmiller closed shop when he shut down his iconic Duquesne Management, after generating 30% average annual returns since 1986. Some time later he raised many red flags by being one of the first "establishment" types to expose the Fed's take over of the market when he said in a rare May 2011 interview that "It's not a free market. It's not a clean market.... The market isn't saying anything about the future. It's saying there's a phony buyer of $19 billion of Treasurys a week." This was in the context of the constantly declining interest rates on an ever exploding US debt load. And while back then total debt was a "manageable" $14.3 trillion, as of today it is some $2.3 trillion higher moments ago printing at a fresh record high of $16.6 trillion, not surprisingly the phony buyer is still here only now he is buying not $19 billion by over $20 billion in total debt each week. But just like it was the relentless rise in the US debt that forced him out of his privacy in the public scene back then, so it was also the US debt that was also the topic of his rare CNBC appearance today (where he fiercely poked at all those other TV chatterbox pundits when he said "money managers should manage money and not go on shows like this") in the aftermath of his recent WSJ Op-Ed. There, he once again said what everyone knows but is scared to admit: "we have an entitlement problem."

The Federal Reserve's policy of targeting unemployment is based on a curious faith that low interest rates and lots of liquidity sloshing around the bank system with magically lead employers to hire more workers. I say this is a curious faith because it makes no sense. In effect, the Fed policy is based on the implicit assumption that the only thing holding entrepreneurs and employers back from hiring is the cost and availability of credit. But as anyone in the actual position of hiring more staff knows, it is not a lack of cheap credit that makes adding workers unattractive, it is the lack of opportunities to increase profit margins by adding more workers. If the economic boom of the mid-1980s proves anything, it is that the cost of credit can be very high but that in itself does not restrain real growth. What restrains growth is not interest rates, it is opportunities to profitably expand operations.

Following today's dismal GDP print, the massive ongoing borrowing being undertaken by our government, and the Bernankian policies which appear inescapable (and entirely ineffective for anything but the market), we thought Ken Rogoff's recent op-ed from the FT was extremely appropriate. Many foreign observers look at the US budget shenanigans with confusion and dismay, wondering how a country that seems to have it all can manage its fiscal affairs so chaotically. The root problem is not just a hugely elevated level of public debt, or a patently unsustainable trajectory for old age entitlements. It is an electorate deeply divided over the direction of government, with differences compounded by changing demographics and sustained sluggish growth. It is hard to escape the notion that today’s budget battles are but a skirmish in a much longer-term war that won’t be settled soon. The idea that one should just ignore all these problems and apply crude Keynesian stimulus is a dangerous one. It matters a great deal how the government taxes and spends, not just how much. The US debt level is a constraint.

The global economy is ill, and everyone who is not mired in denial or a paid shill knows it. Saying it's healthy doesn't make it so. Is is possible to usefully generalize the illness and outline a cure in a few points? Maybe not, but let's try anyway.

Most governments are heavily in debt, they are ultimately going to be forced to cut back spending through austerity programs.

The recent landslide victory of the Liberal Democratic Party (LDP) on a platform that promised positive change for the long-struggling Japanese economy has thrust a somewhat forgotten Japan back into the headlines. Indeed, as Goldman notes, asset markets have already responded aggressively to the prospective changes with Japanese equity markets climbing to multi-year highs and the Yen declining to multi-year lows against the US dollar and the EUR. But, as Kyle Bass has recently explained, very real questions remain about the ability of the LDP and new Prime Minister (PM) Shinzo Abe to deliver on promises and break the damaging cycle of low growth and deflation that has become well-entrenched in the Japanese economy over the last five-plus years. These doubts are reinforced by concerns about the health of the domestic banking sector and of Japan Inc. in general. "Abe-nomics 'appears' positive, but for how long?" Goldman asks and Hamada's recent concerns over 'going too far' are very real - though in general Goldman's positive 'take' is a useful counter-point to Bass' somewhat more realistic apocalyptic endgame thesis.

It is hard to find a policymaker who hasn’t actively tried to talk his currency down. The few who don’t talk, act as if they were intent on driving their currency lower.  Citi's Steven Englander argues below that the ‘currency wars’ impact is collective monetary/liquidity easing. Collective easing is not neutral for currencies, the USD and JPY tend to fall when risk appetite grows while other currencies appreciate. Moreover, despite the rhetoric on intervention, we think that direct or indirect intervention is credible only in countries where domestic asset prices are undervalued and CPI/asset price inflation are not issues. In other countries, intervention can boost domestic asset prices and borrowing and create more medium-term economic and asset price risk than conventional currency overvaluation would. So the MoF/BoJ may be credible in their intervention, but countries whose economies and asset markets are performing more favorably have much more to lose from losing control of asset markets. So JPY and, eventually CHF, are likely to fall, but if the RBA or BoC were to engage in active intervention they may find themselves quickly facing unfavorable domestic asset market dynamics.

They say "be careful what you wish for", and they are right. Because, in the neverending story of the American "recovery" which, sadly, never comes (although in its place we keep getting now semiannual iterations of Quantitative Easing), the one recurring theme we hear over and over and over is to wait for the great rotation out of bonds and into stocks. Well, fine. Let it come. The question is what then and what happens to the US economy when rates do, finally and so overdue (for all those sellside analysts and media who have been a broken record on the topic for the past 3 years), go up. To answer just that question, which in a country that is currently at 103% debt/GDP and which will be at 109% by the end of 2013, we have decided to ignore the CBO's farcical models and come up with our own... To answer just that question, which in a country that is currently at 103% debt/GDP and which will be at 109% by the end of 2013, we have decided to ignore the CBO's farcical models and come up with our own. The bottom line: going from just 2% to 3% interest, will result in total 2022 debt rising from $31.4 trillion to $34.1 trillion; while jumping from 2% to just the long term historical average of 5%, would push total 2022 debt to increase by a whopping $9 trillion over the 2% interest rate base case to over $40 trillion in total debt!

To understand this endgame, we need to start with the financial and political basics of wealth and power in the U.S. Put these nine structural dynamics together and the endgame becomes clearly visible: Politically, a Tyranny of the Majority comprised of those who draw direct transfers/benefits from the Federal government, is ruled by the top half-of-1% financial aristocracy who own the majority of income-generating assets.  The minority, who pay most of the taxes (the 24.5% between the majority and aristocracy), will see their taxes rise as the aristocracy buys loopholes and exclusions while the bottom 50% pay no income tax. Financially, the Federal government’s spending has outrun the tax revenues being collected.  Structurally, Federal expenditures for entitlements (Medicare, Medicaid, Social Security, Veterans Administration, etc.) will rise as Baby Boomers retire en masse over the next 15 years, while tax revenues will stagnate along with earned income. There is no way to square these circles. What few dare admit, much less state publicly, is that the Constitutional limits on the financial Aristocracy and the Tyranny of the Majority have failed.

The developed world’s Ponzi scheme is caused by record-high levels of public and private debt. As Boston Consulting Group notes, it is exacerbated by huge unfunded liabilities that will be impossible to pay off owing to long-term changes in developed-world demographics. Addressing these challenges at any time would be difficult. To make matters even worse, however, BCG points out that they come at a moment when the developed world’s traditional model of economic growth appears to be broken. This is partly a consequence of the Ponzi scheme itself. The underlying issues cannot be ignored any longer. The developed world faces a day of reckoning. It is time to act. In this excellent layman's guide to the the real world, not only does BCG explain the Ponzi, but they lay out ten critical steps that developed economies must take to definitively end the era of Ponzi finance. Some are sacrifices required of various stakeholders. Others are new social investments, both public and private, that are needed in order to return to a sustainable growth path.

Presenting Dave Collum's now ubiquitous and all-encompassing annual review of markets and much, much more. From Baptists, Bankers, and Bootleggers to Capitalism, Corporate Debt, Government Corruption, and the Constitution, Dave provides a one-stop-shop summary of everything relevant this year (and how it will affect next year and beyond).

Facing reality is positive. That's the upside to the fiscal cliff. The last decade's fantasy that we could borrow our way to prosperity while lowering taxes on upper-income earners (because it's so cheap to borrow trillions at near-zero interest rates) is finally running into reality-based resistance.