Submitted by Paul Brodsky of Macro Allocation
According to the Fed, there is about $60 trillion of US Dollar credit (claims for US dollars):
Also according to the Fed, there are about $12 trillion US dollars:
So, the data show plainly there are five times as many claims for US dollars as US dollars in existence. Does this matter to investors?
Well, yes, it matters a lot. Not only is there not enough money to repay outstanding debt; the widening gap between credit and money is making it more difficult to service the debt and more difficult for nominal US GDP to grow through further credit extension and debt assumption. Remember, only a dollar can service and repay dollar-denominated debt. Principal and interest payments cannot be made with widgets or labor, only dollars.
This means that future demand and output growth generated through more credit issuance and debt assumption is self-defeating. In fact, it adds to the problem. Credit-generated growth is not growth in real (inflation-adjusted) terms because rising GDP, which engenders an increase in money, is also accompanied by a larger increase in claims on that money. Why larger? Because debt comes with interest.
By definition then, debt compounds while real growth does not. In fact, economies naturally economize because innovation and competition tend to drive prices lower. This natural deflation works against debt service and repayment that needs perpetual inflation.
As we know, for thirty years beginning in the early 1980s the Fed helped the US and global economies grow consistently more or less by reducing interest rates, which gave consumers of goods, services and assets incentive to take on more debt. Following the inevitable debt crisis in 2008, the Fed had to reduce the overnight interest rate it targets to zero percent.
As we also know, to keep the economy growing from there, the Fed then had to begin creating money, which it did through quantitative easing (QE). It bought assets directly from the money center banks it deals with (primary dealers), and paid for them with the newly created money. At the same time, the Fed paid these banks – and continues to pay them - interest on the money they created for them (Interest on Excess Reserves). This provides a disincentive for banks to lend to the public, which is how the Fed is trying to control US growth and inflation today.
The long and the short of this discussion is that either the Fed and other central banks overseeing highly leveraged economies must inflate their money stocks and get the new money into the hands of debtors, or inflate their money stocks and get the new money to creditors. The former would make systemic debt service and repayment easier. The latter would keep creditors solvent when debtors inevitably default. The economic impact of getting new money in the hands of debtors would be significant inflation. The economic impact of creating more bank reserves would be significant economic austerity (a full-blown depression). Why? Because debtors would be increasingly starved of the ability to service and repay debt.
Impact on Assets
Investors might ask themselves how two pools of dollar-denominated assets can be valued collectively at $38 trillion ($19 trillion each for US Treasuries and US equities), when there is only $12 trillion in existence? Not only does this gross imbalance not include the market value of other assets, like other bonds and real estate; it also does not include the value of the US private capital stock, such as inventory, resources, enterprises, and collectibles. (Economists might want to think about this too.)
In short, the value of dollar-denominated assets is not supported by the money with which it is ostensibly valued. This has not been a problem historically because the proportion of un-reserved credit has been low relative to asset values and cash flow. As we are seeing today, however, it is becoming a significant problem because balance sheets are already highly levered and zero-bound interest rates chokes off the incentive to refinance asset prices higher.
If the total value of US denominated assets is, say, $100 trillion, and the US dollar money stock is somewhere around $12 trillion, then the inescapable implication is that the market’s expects either: a) $88 trillion more US dollars will be created in the future to fund the purchase of the gross asset pool at current valuations; b) there has to be a decline in the nominal value of aggregate assets, or; c) both.
Obviously there never has to be a full exchange of assets for money because there will always be asset holders wishing to keep their assets. But that is not the point. The issue is that there is a significant rate of inflation embedded in the currency (clearly higher than 2% targeted by the Fed), and/or a significant rate of deflation embedded in assets.
What forces the issue? Production, or the lack thereof. If/when the value of asset prices exceed the value of production by an amount that disincentives production, GDP will contract.
Warren Buffet is famous for considering the total market capitalization of US equities against GDP. While this Market Cap-to-GDP ratio provides a clue as to how easy or difficult it may be at any point in time for public companies to generate higher revenues and earnings relative to past equity markets, it does not consider the dynamic driving demand for goods and services in the broader economy.
In other words, it does not consider what actually drives GDP. The presumption is that nominal GDP will always grow. This is not necessarily a bad assumption (in fact it is a reasonable one for reasons we will discuss next week), but it does not consider how the pursuit of nominal growth in today’s macro environment will actually reduce real growth and real ROI.
It is that easy. We think there will continue to be an inflationary deleveraging in the US and across the world, and ultimately significant widespread inflation. More on this next week.
Mr. Buffet and most investors have not had to be concerned during the secular leveraging phase with output contraction in real terms, and so they have not had to be concerned with negative real ROIs. Looking forward, we think it is becoming increasingly obvious that wealth and alpha will be created by allocating capital to assets in which price and real value are closely aligned.
Un-levered assets should outperform levered assets. Businesses that sell to less levered consumers should outperform businesses that sell to levered consumers; and so on.