DEBT AND GOLD / MACLEOD FINANCE

Debt and gold

It’s 5 years since central banks suppressed interest rates at the zero bound, or even below it. It is the origin of many debt zombies which now face refinancing at far higher rates.

ALASDAIR MACLEOD

There is little doubt that the suppression of interest rates by central banks ahead of, during, and following covid lockdowns led to an explosion of unproductive debt. 

Businesses had to finance shutdowns and supply chain disruptions, and governments had to fund support plans and the loss of tax revenue.

The surprise for many was the consequences for the inflation rate, which led to higher interest rates as central banks struggled to contain it. 

And it wasn’t until late last year that the interest rate shock softened. 

Interest rate policies since covid are illustrated in the Fed Funds Rate, below.

What now?

There is little doubt that so long as a 4% Fed Funds Rate exists there will continue to be debt refinancing problems. 

Pressure on central banks to reduce rates persists, particularly for the Fed and Bank of England. 

But the spectacular increase in gold prices points to lower rates being inflationary, better described as undermining fiat currencies’ purchasing powers.

Not that macroeconomists, who reject classical economic theories and gold standards take gold’s signal seriously enough — they are inclined to view its rise as speculative excess. 

But it indicates instability in the outlook for fiat currencies, and particularly the dollar. 

After all, they are only credit, whose values depend on faith.

The problem is in the quantity of debt, with government debt increasing from $23.2 trillion before covid to over $38 trillion today — that’s a 64% increase and an enormous acceleration in debt creation inflating GDP. 

It should be noted that credit is the other side of debt, and when government increases it, it is unproductive. 

Over the same timeframe, total credit to the non-financial sector has hardly grown:

While there has been volatility, total credit to non-financials is up by only $500 billion in five years, just a fraction of overall credit creation.

We know or should know that nominal GDP is no more than the total credit deployed in the non-financial economy. 

This is because GDP measures transaction payments, not what they are actually for. 

Statistically, it has grown. But that growth is substantially due to the government deficit, the contribution from the non-financial economy swinging wildly since covid but only being up a net 5% to today.

Admittedly, there has been some recovery since mid-2022, but we have to ask ourselves whether it reflects genuine recovery in business conditions, or credit being deployed unproductively. 

Given the increase in interest rates at that time which is reflected in the first chart, we can reasonably assume that much of the credit expansion has been to pay interest.

Yet bank credit increased significantly more — about $4.8 billion. 

But some of this funded short-term government debt through T-bills, and the rest expanded financial activities other than the smaller figure for non-financial activities. 

Of this financial lending, stock market leveraging has been of growing importance, as our next chart shows:

In these days of huge numbers, a trillion dollars is commonplace. 

But it gives leverage to three times that. 

Above all else, this explains why the non-financial economy stagnates, while stocks are hitting record levels. 

Stocks are soaring on the back of credit expansion instead of earnings.

Let’s take a moment to reflect on current stock market conditions. 

While Main Street stagnates, Wall Street booms. 

It replicates the roaring twenties which similarly were fuelled by credit aimed at stock speculation. 

Additionally, in 1929 which was the peak of that credit bubble, the Smoot-Hawley Tariff Act of 1930 was being considered by Congress, finally signed into law the following year by President Hoover.

Today’s credit bubble is magnitudes greater, permitted by the dollar’s detachment from gold and giving free rein to credit expansion. 

Additionally, President Trump is replicating the trade disaster that was Smoot Hawley. 

Furthermore, the US economy is more dependent on foreign trade inputs today than in 1929.

Put more brutally, stock markets are in the grip of extraordinary popular delusions, where value is disregarded in favour of outright speculation.

As with all credit bubbles, this bubble will end. 

And when it does risks of default over the whole US economy and the rest of the interconnected G7 will soar, not just as leveraged bets go sour but as collapsing stock markets reveal all the weaknesses hitherto ignored. 

And as default risk replaces other considerations, bond yield are bound to increase.

The order of events is open to question, whether the bubble pops first or bond yields rise to expose the dichotomy between markets and economic reality. 

But as sure as the sun rises every morning it will happen, because it always does.

Our final chart confirms the disparity between the sober valuation metric of the long bond yield relative to that of equities. 

It is constructed to show how the long bond yield is normally inversely tracked by the S&P 500 Index and illustrates that deviations from trend are valuation signals not to be ignored.

Note how the negative correlation between the bond yield and the S&P 500 index is normally pretty tight. 

And if it deviates it always reverts to trend. 

The disparity today is three times as great as at the time of the dotcom bubble (both arrowed) and given the size of the debt-cum-credit bubble, which is almost certainly the most extreme in financial history, the correction for overvalued equity markets will be on a nuclear scale.

The implications for the dollar’s value

So far, we have described the accumulation of debt, and how it has increasingly been to support speculation in financial assets. 

We have also shown both by a priori analysis and historical evidence that markets are in the last stages of a credit-fuelled mania, unsupported by deteriorating conditions for the large majority of non-financial businesses.

When the bubble pops, the political mandate will be to take measures to protect the banking system and their more important customers from bankruptcy. 

Already, we are seeing the Fed reducing interest rates as credit risk increases. 

But as credit risk increases, lending rates are bound to reflect it, with banks refusing to support zombie corporations. 

They are already doing so, as the slow growth in bank lending to Main Street proves.

Now, the Fed’s Beige Book which informs monetary policy is producing growing evidence of an economic downturn. 

It is bound to confirm expectations of lower funds rates from 4 ¼% at the next two FOMC meetings. 

In other words, the inflation target is being abandoned to one which is designed to stop unemployment rising.

No wonder the gold price took off in August, when it became increasing clear to markets that the inflation target was being downgraded in importance. 

There can be little doubt that this trend will continue and likely accelerate, better described as the outlook for the dollar being one of deteriorating purchasing power.

The flight out of credit into real legal money without counterparty risk is bound to continue.