I’d like us to look at a couple charts I’ve pulled together and then we’ll try to break down what they mean and why they’re important.
So what are we looking at and why do we care? Starting from the top and heading down we see the annual federal surplus/deficit levels which are simply how much the government spends versus what it takes in as revenue. A key point of interest there, which we will discuss later is that deficits start to take hold around 1971. The second chart shows us the CBO’s surplus/deficit projections (you can see there are no projected surpluses going forward). The third chart shows total debt as a percentage of GDP providing both historical and forward projections based on historical trend modelling (total debt includes both intragovernmental and public debt). The final chart shows money velocity (M2) which tells us how efficiently we are putting our money to use creating GDP (income).
Ok so that’s what we are looking at but why do we care? The key is that there is a fundamental relationship between these charts. Now follow me on this….. As we continue to run deficits we are required to find additional money to cover the deficit. We can do that by raiding our government trusts such as social security but we’ve pretty much depleted those trusts and so now we must ask the Fed to print money or foreigners to lend and give it to us in exchange for debt (today debt/GDP is more than 100%). Now debt in and of itself is not a bad thing. In fact, quite the contrary in many cases. Debt can and often does lead to better returns and higher income through a mechanism called leverage. However, in order for leverage to work for us and not against us those borrowed funds must be deployed efficiently. Meaning they must be put to use or allocated in such a way as to create income sufficiently above and beyond the debt itself (principal and interest). This takes us to the last chart. Quite clearly we see that our money velocity has been plummeting since the late 1990’s to its current all time low of around 1.5. This tells us that for every dollar we now borrow we are generating about $1.5 of GDP. In the late 1990’s we were getting around $2.2 of GDP for each dollar borrowed. Although we are still generating more than we borrow the trend is ugly. If theoretically we get to a point where money velocity is less than 1 we could no longer stave off the calls of insolvency. That is because for each dollar borrowed we are generating less than a dollar of income and thus would be losing money on every dollar.
So what is the answer? Another stellar problem to think about, but wouldn’t a solution be better serving?? Solutions are great but merely identifying the problems will not take us there. We need to understand the problems. So let’s go over those we identified above and look to understand them. Making our way back to the charts we see they are visual representations of the problems. Since 1971 we’ve been fairly consistently running deficits each year. We also seem to be in a state of perpetual deficits going forward according to the second chart. As we run these deficits we are being forced to take on more and more debt and to employ a strategy of leverage. As discussed above such a strategy could work, however, the last chart shows us we are not using the leverage effectively and so the leverage strategy has a high probability of working against us. Those are the problems. Now on to understanding.
In 1971 Richard Nixon took us off Bretton/Woods (quasi gold standard). He had very few other options at that point as the US could no longer fulfill its obligations to swap USD notes for gold at the fixed rate of $35/oz of gold. The USD then became a fiat currency which has much more flexibility than does a currency pegged to a commodity. By flexible I mean we can be much less fiscally responsible under a fiat currency as there is nothing holding us back so to speak. Think of it this way, if I know that all USD notes in circulation can be exchanged to me for a fixed amount of gold then knowing I only have a certain amount of gold from which to exchange against dollars traded in I must limit the amount of dollars I put into circulation. This leads to fiscal responsibility because I cannot run a deficit if I cannot print money to cover it so it drives a balanced budget. However, once USD notes can no longer be exchanged for gold (or anything else) I can now put as many dollars into circulation as I choose and thus to run deficits. Quite clearly coming off Bretton/Woods led to deficit behaviour as depicted in the first chart above. So the problem is irresponsible spending. It’s a behavioural problem in government. That is to say, as soon as we no longer had to be fiscally responsible we chose not to be. So one solution is choosing responsible fiscal behaviour or spending within our means. Pretty simple stuff right? Well the second chart shows us that the government study from the CBO indicates we are not going to choose that solution. Deficit spending and thus irresponsible behaviour is predicted to continue as far out as we can see. Ok, so now what?
Well so then we are choosing to lever up and take on more debt. As mentioned earlier leverage can be a good thing if implemented correctly. That means deploying the borrowed dollars in a way to maximize the amount of GDP (income) derived from each borrowed dollar. Looking at the last chart (money velocity) we see that this solution will not work either as we are actually deploying our dollars as inefficiently as we ever have. This actually puts a bit of a wrench in the Keynsian theory of fiscal stimulation. That is to say that fiscal spending is at all times highs but money velocity is at all time lows indicating fiscal stimulation, at least employed as we have done, is not an effective way to stimulate GDP growth. There is an additional problem in terms of money velocity. The private sector, although generating all time high profits is not reinvesting those profits back into the US economy in a way that drives growth. Specifically distribution of income is as concentrated as it’s ever been. This means that a few people have all that money to redeploy and as such, much less of it is being redeployed. If a society has $100 income but it all goes to one man he may spend $80 but will likely save $20. Alternatively, if one hundred men each make $1 so that total income is the same each man will spend the full $1 so that all $100 are spent. This is how income distribution drives money velocity. When income distribution narrows money velocity declines. So we have a government sector spending dollars inefficiently and we have income distribution tightening up both leading to an all time low money velocity.
So now we have the problems identified and the problems understood leading us to the logical solutions. However, all the data indicates we are not adopting the logical solutions. Spending is out of control and money is not being deployed effectively. At the same time debt continues to grow. The end result is that debt to GDP levels are becoming notably unsustainable. This phenomenon absolutely, and I want to be very clear about this point, with no uncertainty will lead to a collapse of USD which will likely begin with a repeal of USD as the world reserve currency. The collapse of the dollar will lead to an economic crash. The only uncertainty is how we as a society will pick up the pieces. Some nations have recovered quickly and other nations have disappeared altogether. The law of probabilities would suggest that we fall somewhere in between, however, given we are the world’s economic engine there could very well be a skew to a more difficult recovery. It seems to me there is an awful lot of systemic risk when the US falters in this ‘too big to fail’ world given America’s place amongst the globe. When it does all come crashing down we will finally see the extent of the house of cards built by the Fed and its affiliates. The stark reality is that no matter how well or poorly we recover there will be pain and there will be significant losses to people you know and love. Certainly there will be those that escape the losses and in fact some will benefit from the collapse (11% of Soros’ portfolio is now shorting US markets – far too large a position to be a hedge) but for the vast majority of us it will devastate. I trust you are starting to get the picture.