…but it is what it is

The Albatross Of Debt: The Stock Market’s $67 Trillion Nightmare, Part 2

By David Stockman

In Part 1 we postulated that the chart below embodies nothing less than the nightmare that will be coming to Wall Street right soon. It means, in effect, that you can climb the financial tiger’s back for an extended time, but when you reach the mane its generally impossible to get off alive.

Needless to say, we have reached the mane. What drove the US economy for the past three decades was debt expansion—-private and public— at rates far faster than GDP growth. But that entailed a steady ratcheting up of the national leverage ratio until we hit what amounts to the top of the tiger’s back—that is, Peak Debt at 3.5X national income.

As we also showed yesterday, the fulcrum event was Nixon’s abandonment of the dollar’s anchor to a fixed weight of gold at Camp David in August 1971. That unleashed the Fed to expand it balance sheet at will, thereby injecting fiat credit into the financial system at relentlessly accelerating rates; and it also paved the way for takeover of the FOMC by Keynesian academics and apparatchiks in lieu of the conservative bankers and money men who had run the Fed prior to 1970.

At length, the Fed’s balance sheet grew by 82X over the 48 years since June 1970, erupting from $55 billion to $4.5 trillion at the recent QE3 peak. The effect was drastic and enduring financial repression that drove bond yields far below what would have prevailed on the free market based on the supply of domestic real money savings.

Stated differently, as the so-called “reserve currency issuer” the Fed’s massive balance sheet eruption forced money-printing reciprocity among all the central banks of the world owing to the fear of rising exchange rates—a syndrome which afflicts politicians and policy-makers everywhere. So the convoy of modest central bank balance sheets that collectively stood at perhaps $80 billion in June 1970 totals more than $22 trillion today.

That is, herded-on by the rogue central bank unleashed at Camp David, the convoy of global central banks evolved into a gigantic yield-insensitive bond buyer. For all practical purposes, they collectively operated the monetary equivalent of roach motels: The bonds went in but never came out.

This massive sequestering of real debt funded by fiat credits, which central banks conjured from thin air, had the obvious first order effect of suppressing yields well below honest market clearing levels. That’s just the law of supply and demand 101.

But the second order effect—-front running by private carry-trade speculators—-drove bond prices even higher, thereby pushing yields even deeper into sub-economic levels (and bond prices higher). That, in turn, caused the carry cost of debt relative to income to steadily fall, incentivizing the public and private sectors alike to ratchet up their leverage ratios to levels that were unheard of prior to 1970.

At length, cheap debt got built into the warp and woof of public and private sectors alike. So doing, rising leverage ratio caused future economic activity to be pulled forward in time—-meaning that domestic and world GDP are far higher than they would otherwise be had growth been funded by real savings extracted from current production, not debt enabled, financed and stimulated by central banks.

For example, fixed asset spending financed on the margin through central bank bond purchases—directly or indirectly through arbitrage displacement—added to GDP faster than savings-based investments would have otherwise .Even then, however, the eruption of global central bank balance sheets proceeded apace at rates dramatically faster than even the growth of debt-bloated GDP.

Thus, global GDP has expanded from about $3 trillion to $80 trillion since 1970 or by 26X. By contrast, the balance sheets of central banks has exploded by around 275X.

Yet, as economist Herb Stein once famously observed, things which are unsustainable tend to stop. And foremost among them at the present juncture is the central bank driven explosion of total debt.

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