THE DEBT BUBBLE BURSTS / MACLEOD FINANCE

The debt bubble bursts

When increasing debt becomes unsustainable, the credit bubble bursts threatening bonds, equities, and the entire credit system. The fiat dollar itself becomes a bad debt.

ALASDAIR MACLEOD 

Introduction

Very few economists and investors realise that after 54 years of post-Bretton Woods fiat-currency expansion, freed from the constraints of gold standards we have never experienced such a large debt-cum-credit bubble. 

At the centre of it all is the US federal dollar, which has acted as the international trade pricing and settlement medium in place of gold.

By way of precedent, in financial history there have been other periods of excessive credit expansion, eventually failing to be sustained and undermined by bad debts being exposed. 

Tulipomania in 1636—37, Mississippi, and South Sea bubbles both in 1720 were noteworthy. 

And the Roaring Twenties leading to the Wall Street Crash in 1929—32 was the last such event, though there have been times, such as the lead up to the dot-com bubble of 2000 and the crisis of 2008—09 which threatened similar financial devastation.

In common with 1929, today we have a combination of a credit bubble and new trade tariffs. 

In 1930 it was the Smoot-Hawley Tarif Act, which lifted US tariffs by about 20% on average. 

This time the bubble is far larger; and the consequences of the Trump administration’s tariffs are likely to be considerably more destructive to a more international global economy with extensive supply chains, and to the US economy as well.

When this bubble blows, a process which may have already started, the consequences are likely to be at least as far-reaching as the Wall Street Crash which led to the 1930s slump and failure of 9,000 US banks. 

Behind every credit bubble implosion are bad debt problems which lead to a domino effect of cascading failures, even taking out otherwise healthy businesses.

Defining today’s debt problem

With global debt at the highest levels ever, much of it is bad hidden within the estimated $324 trillion total. 

And much of the estimated one-third of it issued by governments is unsustainable. 

Of the $110 trillion of government debt, one third of that is owed to creditors in US dollars by the US government alone. 

Its rate of expansion is accelerating due to a combination of continuing budget deficits, the compounding accumulation of debt interest, and persistently high interest rates.

However, so far the trend for budget deficits and debt accumulation towards unsustainability has broadly tracked the trend for gold priced in dollars, shown in the chart below:

The budget deficit is the engine which propels both debt accumulation and monetary debasement. 

And the fact that together with the accumulation of debt it is keeping broadly in line with the gold price tells us that despite gold’s 91-times dollar-price increase since Bretton Woods was abandoned, gold is not overvalued. 

This will not surprise monetarists who follow quantity theories. 

But quantitative relationships are not the only influence when it comes to the value of a fiat currency measured by what it buys. 

Foreign faith in it is more important.

Without a gold standard, ultimately a fiat currency depends on the subjective value placed on it predominantly by foreigners. 

This differs from its value to domestic users in their daily transactions. 

In transactions for goods and services, a fiat currency has the objective or constant value, with value variations subjectively being confined to the items being exchanged. 

It is in exchange for gold and other currencies that a currency’s subjectivity of value arises.

This is why domestic users of their currency in their lived experience are generally unaware of its changes in purchasing power. 

They overwhelmingly believe that changes in the general level of prices are due to variations in goods prices and not in the currency, which they see as a constant factor. 

They view inflation as a price problem and not a currency one.

But if you look at a fiat currency from a foreign perspective, then it is your own currency which you will tend to view objectively and the foreign currency as subjective. 

Thus, a British businessman accounting in pounds will look at the dollar exchange rate as the dollar varying against the pound, rather than the pound varying against the dollar.

This much should be clear. 

And when we note that of all the foreign owned currencies the dollar is the most widely held to the tune of some $40 trillion, there is a very large amount of dollars in the hands of individuals, businesses, and governments who view it differently from the American citizens who use it for their daily sales and purchases.

That $40 trillion is invested in bank deposits, other short-term instruments, bonds, and equities. 

For a foreigner accounting in his own currency all dollar-values are subjective, which means that his belief as to what their future values might be is his most important consideration.

Foreign faith in a currency’s future can be fickle. 

The question posed by foreign creditors is how secure are dollar-denominated debts, and if not, what is the risk of non-repayment?

An independent assessment of any government’s finances must focus on the sustainability of its debt. 

In simplest terms, debt is only sustainable so long as the income is available to pay the interest. 

But the US government never pays interest, rolling it up into future debt. 

Therefore, tax revenues must increase at least as fast as the debt mountain increases for the debts to be regarded as sustainable by foreign actors.

This is not the outlook. 

US tariff policies are inflicting untold damage on global economic prospects with negative consequences for US GDP growth. 

The US tax base, which is proportional to the private sector’s GDP, is already contracting when the distortion of the government budget deficit to GDP at about 6.5% is subtracted from the GDP total. 

It leaves the tax-paying private sector already shrinking. 

Therefore, the US government is in a debt trap: a trap of debt increasing faster than the means to fund it.

This has been the situation from Trump’s first presidency. 

The reason the debt trap has gone unnoticed is that foreigners have not yet fully appreciated the precarious condition of US finances. 

By his actions President Trump is now changing that perception.

Therefore, a wider realisation is beginning to gain ground, that there is increasing credit risk for foreign holders of federal dollars and US government debt. 

Compensation for this risk is now being priced into currency and bond markets, requiring higher not lower interest rates and bond yields. 

Of course, domestic actors viewing their dollars objectively do not yet understand it, believing that any signs of economic growth faltering can be countered by the Fed reducing interest rates.

This is why according to US analysts the interest rate outlook is for further cuts over time, a view shared by domestic actors in other jurisdictions. 

But the reality is that if rates do not rise to compensate for increasing credit risk, foreigners will simply refuse to finance further debt expansion; and at the margin they will reduce their dollar exposure undermining the dollar in the foreign exchanges against other currencies and gold.

Putting it another way, foreign faith in the fiat dollar is eroding — this is why in the absence of a credible gold standard, its value ultimately depends on its credibility to foreign holders.

In defiance of today’s lower interest rate expectations, rising bond yields are already reflecting the unsustainability of debt in longer maturity yields. 

And that in a nutshell is the current problem, reflected in a deteriorating outlook for the dollar, while long bond yields rise. 

This is evident in my next chart:

Following President Trump’s “Liberation Day” of 2 April (marked by the pecked line) when he announced increased tariffs on all foreign trading nations, the dollar’s trade-weighted index fell sharply while the long bond yield rose. 

Normally, they share direction in approximate synchrony. 

Clearly, this was due to foreign holders of dollars bailing out of both bonds and dollars.

Indeed, the dollar’s technical position looks dire, as the chart of the trade-weighted index shows. 

A technical analyst would pencil in a further decline to 90 at least:

For now, the majority of foreign holders are not yet aware of the severity of the US debt situation. Otherwise, there would be a widespread panic which has hardly started on foreign exchanges and bond markets.

The sellers of dollars and dollar debt so far have been the ultimate insiders — foreign central banks and perhaps some sovereign wealth funds. 

But undoubtedly, the negative sentiment among foreign governments, international businesses, and wealthy Asians is still in early days.

This brings us back to gold. 

The first chart in this article demonstrates that so far it has only tracked the dollar’s debasement and does not reflect any loss of faith in the dollar. 

All the signs are that this will shortly change, given the growing realisation of the unsustainability of dollar debt. 

And as the dollar sinks and long bond yields rise further, the entire dollar-based post-Bretton Woods fiat currency system will fail, triggered by loss of faith in the dollar and paving a way for gold to eventually return as the safe alternative to dollars and all fiat currencies.

How long this failure will take is impossible to answer: forecasts of that type are purely speculative. 

But we will become increasingly aware that the combination of the largest debt-cum-credit implosion in economic history coupled with tariff protectionism will collapse the dollar’s value as a currency. 

The dollar itself is already a bad debt.