KEYNESIAN CREDIT CREATION MEETS ITS ARMAGEDDON / MACLEOD FINANCE

Keynesian credit creation meets its Armageddon

Or how runaway government debt threatens to collapse the entire credit system

MACLEODFINANCE

Few commentators are aware that the dynamics leading to an inevitable collapse of credit are increasing. 

When these dynamics begin to unfurl, there is bound to be a global rush out of fiat credit into gold. 

This is why prescient central banks have been accumulating bullion.

This week, the more observant among us will have detected a fork in the road of credit creation. 

Major nations are now officially in recession, suggesting that interest rates should be reduced according to the Keynesian playbook. 

But inflation is showing signs of rising again, mandating the opposite. 

These are a rerun of the conditions which discredited Keynesianism in the 1970s, leading to a common description of something that was to statist economists impossible: stagflation.

The only reason that the US is not in an official recession is the massive amounts of government spending in excess of tax revenue: in other words, it is printing its way out of recession. 

Inevitably, this will continually undermine the dollar’s purchasing power even further, an effect which feeds into the inflation pipeline. 

Any hopes of a sustainable reduction in interest rates can be dismissed on these grounds alone.

The US is not the only nation with this problem. 

Intractable budget deficits abound in the UK, Japan, and Europe as well. 

According to the Institute of International Finance, global government debt has increased from $33 trillion in 2008, to $71 trillion before the covid crisis three years ago, to $90 trillion today. 

With interest rates and borrowing costs having also risen inexorably, global government debt has gone parabolic.

The table below shows current estimates of some debt-to-GDPs and budget deficits by the same measure.

In inflation creation terms, the US and 9% budget deficit is the worst offender. 

That is likely to be the trigger destabilising the finances of the other nations on the list.

Now let us make some reasonable assumptions. 

Current forecasts are for a mild recession in most nations on the list in the table. 

They make no allowance for the likely depth of collapse in economic activity and the consequences for budget deficits. 

Furthermore, the general assumption in markets is that interest rates will decline now that consumer price inflation is “under control”. 

Consequently, interest rates and bond yields are expected to fall. 

But as this article’s opening comments points out, that is not how things are shaping up. 

Indeed, there is compelling evidence as to why interest rates will rise.

Put these two factors together, contracting economies and rising interest rates and we can see why the colossal mountain of global fiat credit estimated by the IIF to be $313 trillion is entering a crisis, driven at its core by indiscriminate government spending driving full tilt into inescapable debt traps. 

And when credit is in crisis, the only refuge for ordinary people is in physical gold which is true, legal money and has no counterparty risk. 

Owning gold is to opt out of a collapsing system.

Actors in the financial establishment are ill-prepared for such an event. 

They are learning the true understanding of risk the hard way, having had how to avoid it educated and regulated out of them. 

They think that cash dollars are the ultimate safety, when the issuer is a department of a government facing bankruptcy. 

And the risk-free investment is US Treasuries, the debt obligations of a bankrupt nation.

With this in mind, the establishment holds onto the erroneous belief that if interest rates are going to rise, then that’s bad for gold. 

And they think that a rising trade weighted index for the dollar is also bad for gold, when all the TWI does is compare pigs with pork. 

It is time for some re-education about debt traps, interest rates, credit, and gold.

Resolving debt traps

There is a simple solution to this problem. 

Eliminate the budget deficit by cutting public spending, not just to balance the books, but to reduce the tax burden on private sectors. 

But in common with their opposite numbers in other nations, US politicians are still asserting wasteful spending in this presidential election year with agreement from both sides of the house. 

As FX Hedge Newsletter points out (fxhedge@substack.com):

Conservatives in the House GOP, led by Jason Smith, quickly passed a bill with a wordier but equally deceitful title: the Tax Relief for American Families and Workers Act of 2024.

As if it came right from Orwell’s Ministry of Truth, 91.5% of the money claimed as tax relief for American families and workers will instead go to expanding welfare, primary for those who are barely working, if at all, while disincentivizing the formation of stable families.

That’s what we call conservative values.

Not only are the politicians trapped by the wrong mind-set when it comes to acting with fiscal responsibility, but they continually add to the problem. 

It seems that there is no one in America’s political class willing to seriously consider where their destructive fiscal policies are taking them. 

And with presidential favourite Donald Trump likely to prioritise tax cuts over cutting public spending if he is elected President, the deficit problem is likely to get even worse.

Nor can we ignore the mechanics of a debt trap. 

Interest payments in the first quarter of this fiscal year were running at an annualised rate of over a trillion dollars, making up nearly half the deficit — and rising. 

According to the Congressional Budget Office’s forecast, net interest on government debt held by the public will total $870 billion and average 3.1% this fiscal year. 

This must include debt being refinanced which with this year’s budget deficit is approaching one-third of the $34 trillion outstanding. 

Clearly, the CBO’s figures which were released earlier this month are already out of date.

So far, funding this profligacy has been easy. 

Cautious bankers have diverted balance sheet liquidity from private sector lending to buying T-bills, yielding over 5%. 

And money funds have also been winding down their lending to the Fed through reverse repos to buy T-bills as well. 

Since end-December 2022, RRPs outstanding have collapsed from $2.3 trillion to $532 billion. 

This represents a massive wave of credit debasement as it is spent into the US economy, unbacked by any increase in consumer savings. 

No wonder the GDP number is so buoyant.

Shortly, the US Treasury will have to secure term funding which means testing the appetite of investors rather than short-term credit providers. 

In recent months, there have been a few auctions with mixed results, perhaps reflecting demand for notes and bonds for regulatory purposes from pension funds and insurance companies, which is essentially limited. 

And with the major foreign holders in Japan and China having turned net sellers of Treasuries, term funding will almost certainly lead to higher bond coupons.

This is what a debt trap is all about: a realisation in the buyers’ minds that higher coupons are required, but that higher coupons increase the default risk. 

Investing in government bonds becomes like buying junk debt but from an issuer who doesn’t even pretend to deploy the debt productively.

For now, the US Treasury has $840 billion in its general account in the Fed system, suggesting that it has a few months’ liquidity in reserve. 

But that will run down and then the debt trap will be sprung against a deteriorating outlook for consumer price inflation.

Inflation is still in the pipeline

The Fed’s system of inflation management is like driving on the highway by observing the carnage created through the rear windscreen. 

Along with regulated markets, The Fed reacts to “hard data” (heavily manipulated) and extrapolates it rather than viewing the road ahead. 

But without any commercial nous, it is impossible for the Fed to make economic judgements successfully except accidently anyway.

In the absence of an increase in consumer saving, the massive and underestimated expansion of the budget deficit generates excess demand for goods and services in the economy, only offset by overseas aid and spending. 

From experience and an understanding of the Cantillon effect, we know that it takes time for the excess credit created by a budget deficit to impact prices. 

Therefore, we can say with a high degree of certainty that the current rapidly rising budget deficit will continue to reduce the dollar’s purchasing power at a higher rate than currently recorded by the consumer price index.

This leads to a Hobson’s choice for the Fed. 

Either it goes along with rising interest rates in managing treasury funding which must compensate buyers for their expectation of the dollar’s loss of purchasing power, or it must accept a decline in the dollar’s exchange rate as a consequence of interest rate suppression. 

This is because it is only through higher bond yields that the foreign and marginal price setting buyers can be expected to invest.

At a guess, the Fed will resist monetary policies leading to higher costs for government funding, the more so because this is an election year. 

That will require a return to QE to fill the gap left by the absence of foreign demand. 

In other words, the Fed will pay pension funds and insurance funds to accumulate new government debt. 

But instead of doing so against a background of extremely low interest rates, it will be against a rising interest rate trend driven by a weakening dollar which is considerably more dangerous.

Furthermore, credit inflation at the Fed would find favour with the other central banks facing similar funding problems by taking pressure off from their own currencies. 

The sighs of relief at the Bank of Japan, which still clings onto negative deposit rates, will become audible.

Realistically, the only course open to the Fed is to sacrifice the dollar. 

If it doesn’t, it will not only create a funding crisis for the US Government deliberately, but for other major allied nations as well. 

Additionally, US businesses and their bankers facing bankruptcy will be pushing hard for lower, not higher interest rates.

The relationship between purchasing power and interest rates

To appreciate what drives the relationship between a currency’s value and interest rates, we must look at it from a foreign dealer’s point of view. 

He will consider the following:

·      compensation for not possessing credit for immediate spending; this is referred to as time preference.

·      Counterparty credit risk.

·      Prospective changes in purchasing power for the currency of his investment.

There are other factors. 

For instance, there is the prospective change in purchasing power of the currency being exchanged, and in the dollar’s case, its role as the global reserve currency. 

But clearly, if a foreign buyer thinks that the dollar’s purchasing power will decline over a period of time, then compensation for it together with time preference and credit risk must be given, otherwise the currency will not be bought and is likely to be sold.

This is surely simple to understand. 

But this is why it is an error to think of higher interest rates as being bad for gold because gold is simply the refuge from credit risk of all sorts, including that presented by fiat currencies. 

It is only when the value of gold measured in a fiat currency rises, that the foreign exchange markets force interest rate rises on the currency. 

Interest rate setters at central banks will always attempt to keep them too low, only raising them as a last resort, under pressure from a rising gold price.

Consequently, interest rates and the gold price correlate, as is clear from the chart below, of the relationship in the 1970s.

The correlation is remarkably tight, and only changes when a central bank anticipates further rises in the gold price by raising interest rates sufficiently high to deter gold ownership. 

This is what Paul Volcker did in 1980—81, which together with the subsequent expansion of derivative supply and manipulation of inflation calculations artificially suppressed gold in the decades that followed.

Those times ended with zero interest rates and covid. 

We have now entered an economically destructive period characterised by government debt traps, widespread malinvestments to be unwound in the private sector, and excessive consumer borrowing — all caught unawares by price inflation and rising interest rates. 

In short, for those of us that remember them the conditions of the 1970s are back with a vengeance.

Whatever the Fed tries to do to lessen the funding pain for the US Treasury, soaring budget deficits ensure that there is yet more price inflation in the pipeline. 

Medium and long dated Government debt will have higher and higher coupons. 

The spiralling debt trap will collapse the value of credit relative to gold. 

The one thing it will not do is suppress the gold price.

The entire financial system is wholly unprepared for these conditions. 

It is estimated that globally there are $150 trillion in financial investments (excluding derivatives), of which less than one per cent is in gold and investment substitutes. 

As a measure of the scale of demand in a credit crisis, a one per cent increase in bullion holdings is the equivalent of buying over 23,000 tonnes.

The looming full-scale government debt crisis described in this article could collapse fiat currency values extremely quickly, measured in legal money without counterparty risk, which is only gold. 

When the public shakes off the Keynesian propaganda about pet rocks there is bound to be a rush out of credit through the golden exit.