Buttonwood

Investors call the end of the government-bond bull market (again)

It is the corporate-bond market they should worry about



FOR the umpteenth time in the past decade, a great turning-point has been declared in the government-bond market. Bond yields have risen across the world, including in China, where the yield on the ten-year bond has come close to 4% for the first time since 2014. The ten-year Treasury-bond yield, the most important benchmark, has risen from 2.05% in early September to 2.37%, though that is still below its level of early March (see chart).

Investors have been expecting bond yields to rise for a while. A survey by JPMorgan Chase found that a record 70% of its clients with speculative accounts had “short” positions in Treasury bonds—ie, betting that prices would fall and that yields would rise. Meanwhile a poll of global fund managers by Bank of America Merrill Lynch (BAML) in October found that a net 85% thought bonds overvalued. In addition, 82% of the managers expected short-term interest rates to rise over the next 12 months—something that tends to push bond yields higher.

In part, this reflects greater optimism about the global economy. For the first time since 2014, America has managed two consecutive quarters of annualised growth of 3% or more. Forecasts for European growth have also been revised higher. Commodity prices, including oil, have been rising since June, which may be a sign of improving demand.

The BAML survey found that, for the first time in six years, more managers believe in a “Goldilocks” economy (in which growth is strong and inflation is low) than in a “secular stagnation” outlook (in which both growth and inflation are below trend). If those views turn out to be correct, then it might be expected that bond yields would move a bit closer to more “normal” levels. Until the crisis of 2008, the ten-year Treasury-bond yield had been above 5% for most of the previous four decades.

Investors also expect that, eventually, some kind of fiscal stimulus will be passed in Washington, DC. Of the fund managers polled by BAML, 61% expect tax cuts in the first quarter of next year. Such a package may increase the deficit and induce more economic growth; both factors would push bond yields higher.

Another factor behind the upturn in yields is a shift in central-bank policy. The Federal Reserve has started to wind down its balance-sheet, by not reinvesting the proceeds when bonds mature. The European Central Bank will soon cut the amount of bonds it buys every month by half, to €30bn ($35bn). The private sector will have to absorb the bonds that central banks are no longer purchasing.

Whether this will trigger the long-prophesied collapse of the bull market in bonds is another matter. Globally, there are no signs of a sustained surge in inflation (see previous article).
PIMCO, a fund-management group, thinks that global economic conditions may now be “as good as it gets”. The momentum of growth may already have reached its peak.

Central banks also know that higher bond yields can act as a brake on economic growth. In G20 advanced economies, the combined debt of households, governments and the non-financial corporate sector has been rising steadily and stands at 260% of GDP. Every debt is also a creditor’s asset, but higher borrowing costs can create awkward adjustments; in America, for example, 30-year mortgage rates are around half a percentage point higher than they were a year ago. So the pace of tightening will be very slow. And if the economy shows any sign of wobbling, central banks will probably relent.

Perhaps the real area of worry should be the corporate-bond market. Low government-bond yields have pushed investors in search of a higher income into taking more risk. American mutual funds now own 30% of the high-yield bond market, up from less than 20% in 2008. The spread (extra interest rate over government bonds) on these riskier securities is close to its lowest level since before the financial crisis. BlackRock, another fund-management group, says there is “a more favourable environment for issuers at the expense of lenders”, especially as the quality of the covenants protecting lenders has been deteriorating.

With the rate of bond defaults falling, and the global economy doing well, investors probably feel there is little to worry about. But there is a problem: the corporate-bond market is less liquid than it was before 2007, as banks have pulled back from their market-making roles.

Investors have found it easy to get into the market in search of higher yields. When the time comes, they will find it much more difficult to get out.


China’s central bank injects $47bn into financial system

Largest intervention in almost a year sends bond yields down from 3-year high

Don Weinland in Hong Kong and Yuan Yang in Beijing


China’s central bank injected $47bn into its financial system, its largest intervention in nearly a year, in an effort to calm investor fears that Beijing’s crackdown on debt-fuelled growth would put a brake on the country’s rapid expansion.

Yields on China’s benchmark 10-year sovereign bond had risen above 4 per cent this week, a level not seen since 2014, following a sell-off that began following last month’s Communist party Congress, where the outgoing People’s Bank of China chief warned of the risks from excessive debt and speculative investment.

Although Thursday’s Rmb310bn injection saw the yield eased to 3.98 per cent from an intraday day peak of 4.015 per cent, analysts warned the PBoC had no clear target and that yields could rise beyond 4 per cent again without further easing.

“They don’t want the market to panic but I don’t think they have a set target,” said Zhou Hao, senior emerging markets economist at Commerzbank in Singapore.

Emerging markets have been suffering a rough patch as investors have retrenched following Venezuela’s recent bond default, Saudi Arabia’s threatening war against Iran and continued political turbulence in Turkey. The jitters have also resulted in price swings for commodities such as metals and oil.

But China has come under particular scrutiny after recent remarks by policymakers that they are determined to crack down on easy credit, which many analysts believe has created bubbles and oversupply throughout the economy.

Loose monetary policy in China has helped keep bond yields artificially low as central bank liquidity — often in the form of stimulus intended to support the economy — has flowed into financial markets.

But policymakers are concerned the easy credit has masked concerns over the build-up of bad debt and a slowdown in China’s economy. The PBoC’s recent decision to hold off on adding liquidity to the system has led to a correction in Chinese markets as those fears are priced in.

“There should be a credit-risk premium but yields have been distorted by all the liquidity,” said Kevin Lai, chief economist for Asia ex-Japan at Daiwa Capital Markets in Hong Kong. “This year they have stopped the liquidity and the bond market is only now catching up with reality.”

Yields remained steady during the party congress in October as banks, mutual funds and other state-backed institutions — often referred to as the “national team” for their role in stabilising the market — continued to buy sovereign debt.

But the buying has recently slowed amid signs the government planned to rein in credit growth.

“Investors, in particular mutual funds which have become the second-largest buyer of China’s government bonds, had previously bought sovereign debt because they had assumed the government would loosen [credit] in the fourth quarter in order to achieve the GDP growth target,” said Jonas Short, Beijing head of Sun Kai Hung Financial, an investment bank. “But the realisation that in fact there will be no loosening whatsoever has triggered the sell-off.”


Industrial commodities hitch a ride on global growth hopes

Metals are rising sharply, but this is not a repeat of the commodity ‘supercycle’

by David Sheppard and Neil Hume in London
.

© Bloomberg


Industrial commodities are on a tear. Oil, copper and niche metals such as cobalt all shot to multiyear highs in recent weeks, buoyed partly by the strongest and most widespread global growth since the financial crisis.

The move, which has seen Brent crude top $60 for the first time in two years and copper pass $7,000 last month, has been accompanied by renewed interest from investors and hedge funds who had largely abandoned the sector during a brutal slump over the past three years.

Now, with growth picking up and commodity markets tightening due to under-investment and producers’ attempts to rein in output, some industry executives and analysts say funds are again treating commodities as the go-to assets to profit from global growth.

They caution, however, that while the commodity cycle appears to be turning, this is not a repeat of the so-called “supercycles” that propelled oil and metals to record highs last decade, as China’s rapid industrialisation caught the industry napping.

“We are in the upswing of a classic commodity cycle but this time — while demand is strong — it is being driven by supply constraints rather than a sudden surge in consumption that the industry just wasn’t ready for,” said Julian Kettle, vice-chairman of metals and mining at Wood Mackenzie.

“The last five years there has been under-investment in metals and to a certain degree energy and, while supplies are relatively comfortable, investors are starting to see that producers are risking storing up problems for the future.”




The issue, analysts say, is that miners and oil producers were so badly burnt by the commodity crash that they have pulled investment from new projects during the downturn.

While demand is not soaring at the rate it was last decade, it is now expanding quickly enough to provoke concerns about future supplies, drawing in investors who want to tap into global growth and to have a possible hedge against rising inflation.

“The herd-like behaviour from investors is certainly reminiscent of what we saw a decade ago,” said Caroline Bain, chief commodities economist at Capital Economics in London.

“But a lot of this optimism we’re seeing is about future demand. The crash in prices has caused much lower investment.”

Take oil, for example. Swiss commodity house Trafigura was one of the first to sound the alarm in September when it warned demand could exceed supply by as much as 4m barrels a day by the end of this decade, after energy companies halted $1tn of spending on new production during the oil crash.

While the market is currently being propped up by Opec supply cuts, doubts are growing that the US shale industry will be able to meet future demand growth wholly on its own, which is forecast to keep expanding even as electric cars become a bigger part of the market.

Hedge funds have amassed a near-record bet on higher Brent crude oil prices in recent weeks.




In metals, the industry has been awash with projections that the same growth in electric cars will transform corners of the market, with nickel — long a laggard on the base metals complex — set to see demand soar as battery use grows, while copper is also seen benefiting due to its use in charging points.

Cobalt, essential to modern battery technology, has also become the industry’s new darling, with supply dominated by challenging jurisdictions such as the Democratic Republic of Congo, where 50 per cent of the metal is mined. The price has soared by 200 per cent over the past 18 months.

Ivan Arriagada, chief executive of Chile-focused copper producer Antofagasta, said this week that the talk around electric vehicles meant that investors were looking at metals and mining with different eyes.

“We have generally been seen as an industry at the periphery of the modern economy and all this [the electric vehicle narrative] is showing that metals are very important,” Mr Arriagada said.

Ian Roper, general manager of Chinese metals data company SMM, highlighted, however, that it is still supply issues rather than demand that has provided the main impetus for the recovery in industrial metals. China has prioritised cutting pollution, leading it to place restrictions on mines and smelters for many key metals and minerals, including steel and coal.

“Given we’ve seen all the clampdowns from the supply side and the lack of investment in new mines globally that could put commodities on a very firm footing on the next three to five year cycle,” Mr Roper said.

Not all commodities are benefiting, however. Agricultural commodities, from grains to pulses, remain weighed down by bumper crops. Gold, which tends to act as a hedge against weak economic growth, is likely to face headwinds.

Paul Horsnell, head of commodities research at Standard Chartered, said the key message was investors still need to pick and choose commodities and the companies that produce them carefully.

“This probably isn’t a rising tide that is going to raise all ships,” Mr Horsnell said.

“Each of the commodities that has rallied has its own unique story and fundamentals, so investors need to be cautious. In a lot of them we’re going up simply because prices have been too low.”


Additional reporting by Henry Sanderson


The Trouble With Spanish Nationalism


Summary

Spain is at once very young and very old. For most historians, modern Spain was born in 1469, though some argue that something resembling Spain existed as far back as fifth century B.C. Yet the political structure that governs Spain today has been in place for just 40 years.

Spain is, moreover, at once very strong and very weak. Few countries in the world have governed empires as vast as Spain’s was in the 16th and 17th centuries. The Spanish language attests to its legacy: The only language in the world with more native speakers than Spanish is Mandarin. Yet in the past 200 years, few countries in the Western world have had as turbulent and violent a history as Spain.

In the 1960s, Spain was a backwater, politically isolated from much of the world and economically stunted compared with its European neighbors. By 1981, its fortunes had changed, and it has been making up for lost time. Spain is now the fourth-largest economy in the European Union and the 13th-largest economy in the world, with a gross domestic product of roughly $1.2 trillion. It is also the fifth-most populous country in the eurozone, accounting for just under 10 percent of its total population.

Now Spain’s political foundations are shaking once more. Catalonia, a wealthy autonomous region in the northeast, has declared independence, as it has been inclined to do in the past. But the prospect of a new nation-state is not in question. Catalonia will not secede from Spain. The government in Madrid will not allow itself to preside over the dissolution of the country. But Catalonia’s independence referendum raises a difficult question: What happens when two peoples claim the same land for different nations?

Spain’s peculiar history explains how Madrid and Catalonia have come to ask themselves this very question again in 2017. Theirs is a story shared by nearly every nation-state – and every would-be nation-state – in the world. And though the outcome is all but certain, a better understanding of why this is so can teach us much about the geopolitics of nations.

Lower Stakes

Geography affects the development of all nations in profound ways, but rarely has it done so more strikingly than in Spain. Today the country is renowned for its beaches, but its defining geographic feature is its mountains. On the European Peninsula only Switzerland boasts a higher mean altitude. It is the existence – and more important, the location – of these mountains that has fostered the distinct, regional communities that make Spain so difficult to govern.

The Iberian Mountains have peaks as high as 7,500 feet (2,300 meters) and have always isolated northeastern Spain from the center of the country. In the northwest are the valleys and low mountains of Basque Country, another of Spain’s autonomous communities and, aside from Catalonia, the one with the most well-defined national consciousness. Farther west, the Cantabrian Mountains separate the coast of northwestern Spain from the interior of the country. The region of Galicia in the northwest corner of Spain has had serious independence desires of its own at various points in Spanish history.


South of the Cantabrian Mountains is the Northern Meseta, or the northern plateau. The central mountains border the Northern Meseta to the south and separate it from the Southern Meseta, which is home to the capital, Madrid. Together, the Northern and Southern Mesetas account for almost 40 percent of the land of the entire Iberian Peninsula, yet they are sequestered by mountain ranges. South of the Southern Meseta are yet more mountains – the Sierra Morena – which separate the Southern Meseta from the Guadalquivir River Valley. This valley is bordered to the east by the Baetic Mountains and the Sierra Nevada range, with snow-capped peaks that reach almost 12,000 feet.

Last and most important are the Pyrenees, in northeast Spain, which separate France from the Iberian Peninsula. The region was named by the Greeks, and later the Romans stayed close to this moniker, calling it “Hiberia” after the Iber River, known now as the Ebro River.

It’s hard to overstate the geopolitical significance of the Ebro in the ancient world. The area between the Ebro and the Pyrenees was the de facto “demilitarized zone” between ancient Carthage and Rome. When Hannibal crossed the Ebro, he started the Second Punic War, a war that determined that it was to be Rome, and not Carthage, that would rule the Mediterranean.

The stakes are not nearly as high today, but the Ebro River Valley is where Spain’s current crisis is unfolding. Sandwiched between the Pyrenees and the Iberian Mountains, the Ebro River Valley flows through Aragon and Catalonia. It is the lifeblood of these regions.

Though mountains are Spain’s most conspicuous geographic feature, they are not the only one to impede government efforts to unify the country. The weather patterns in Spain differ profoundly from region to region. Northwestern Spain gets a great deal of rain each year – sometimes as much as 80 inches a year. Compare that to the Southern Meseta, which sometimes sees as little as 10 inches of rain per year. Central and southern Spain are much dryer, though the Guadalquivir River Valley is a notable exception. Northeastern Spain has comparatively less rainfall too, but Catalonia has the Ebro River (and Valencia the Turia River) for irrigation.

None of Spain’s major rivers, though, connect to one other. This is true of most European states, but it is especially pronounced in Spain because of the way the mountains and the climate serve to define the country’s regions. A unified Spain, where a strong central government can execute its authority, requires the expensive work of building the infrastructure necessary to stitch the country together. Spain’s geography challenges central rule because it creates resilient national and linguistic identities.

Geography has confounded every ruler from Isabella I to Mariano Rajoy. But it’s not that simple. If geography alone defined political power, Spain would never have unified as a country, let alone become one of the richest and most powerful empires in the modern world. Spain has never lost the legacy of its diversity, but in modern times it has always tried, and mostly succeeded, to consolidate that diversity under the idea of the Spanish nation. When Catalonia declared its independence, Spanish Prime Minister Mariano Rajoy said, “Spain is a serious country and a great nation.” He wasn’t wrong. Spain is a serious nation-state, and it is serious not because of its geography but despite it.

Most history books teach that modern Spain was the result of the marriage of Isabella I of Castile and Ferdinand II of Aragon. There is, of course, a slight problem with ascribing the birth of the Spanish nation to Isabella and Ferdinand’s nuptials – neither of them was, or became, “of Spain.” Both were rulers of separate kingdoms, and when Isabella passed away before Ferdinand, he simply returned to Aragon. The dynasties that ruled Spain in the centuries after Isabella and Ferdinand were family dynasties – first the Hapsburgs, then the Bourbons. Isabella and Ferdinand gained more power than any of their predecessors, but they did so by maintaining the laws and local constitutions of the various lands under their dominion.

Still, two important things happened during the reign of Isabella and Ferdinand: the Reconquista and the discovery of the New World. The Reconquista was the result of centuries of conflict. Muslim forces invaded the Iberian Peninsula in 711, and by 717 they had reached the Pyrenees. Muslim rule of the Iberian Peninsula would ebb and flow for almost 800 years. Sometimes the Muslims occupied nearly the entire peninsula, but mostly they controlled the southern half of what we now call Spain. They named this territory al-Andalus.

Medieval Spain, then, was diverse not just because of Spain’s geography. The Muslim invasion of Spain created a religious diversity that is present nowhere else in Europe except perhaps in the Balkans, where the Ottoman Empire exerted control for many centuries. There was also a large and influential Jewish population in medieval Spain.

This diversity was a source of intellectual creativity – and of cultural provocation. Christian rulers in northern Spain never accepted the legitimacy of the Muslim invaders, and for centuries they pushed the Muslims farther and farther south. Their efforts culminated under Ferdinand and Isabella, who drove the last Moorish kingdom of Grenada off the peninsula in 1492. That same year, the Spanish Inquisition, which had begun in 1478, decreed that all Jews and Muslims remaining in the Iberian Peninsula should convert or leave.

Most of Europe was staunchly religious, but no Western European country remained as religious for as long as Spain. Spain’s national identity grew partly from the idea that it was where the Muslim invasion of Europe had been stopped. Spain may well have needed religion to hold its society together, since it could not depend fully on the peoples’ identification with a unified and indivisible Spanish nation. Being monarchs was not enough for Ferdinand and Isabella to receive support, but being the Christian vanguard in the fight against Islam substantiated their claims. Their tactic has been used throughout modern Spanish history. Francisco Franco, who helmed a military dictatorship in Spain for 39 years in the 20th century, was a devout Catholic who did not shy from using his faith to legitimize his rule and bring the country together under a common banner.

The second thing that happened under Ferdinand and Isabella was the discovery of the New World. Christopher Columbus was born in Genoa, but it was Ferdinand and Isabella who agreed to fund his expedition in 1492. Columbus was not expecting to discover the Western Hemisphere, of course, and Ferdinand and Isabella were not expecting him to discover it either. Columbus was looking for a shorter way to get to Asia. But Columbus did discover parts of the New World, and he claimed those discoveries for the Crown of Castile. By 1503, Isabella and Ferdinand were dispatching bureaucrats to their new holdings and organizing what would become the Spanish Empire. By 1545, the new Spanish Empire had struck gold (and silver). The political union that had been made possible by Ferdinand and Isabella’s marriage suddenly came with a dowry of immense wealth. Wealth conferred on Spain the power to challenge the rest of Europe itself.


 
Powerful though it may have been, Spain was still a hodgepodge of variegated peoples. The Spanish nation still did not exist. Money helped its rulers forget these differences, but the system that was built around it was difficult to sustain. By the 17th century, that system was beginning to come apart. A great example can be found in the Catalan Revolt of 1640. The crown had to finance its various military conflicts, and so it levied more taxes on the Catalans, lest Castile continue to foot a disproportionate amount of the bill. Catalonia, like other Spanish regions, viewed itself as part of the Spanish Empire but separate from Spain when it came down to culture, language and the rule of law. It revolted accordingly.

Centuries later, when nationalists of the 1800s sought to forge a Spanish nation, they harkened back to the reign of Ferdinand and Isabella and their two great marks on history. It was the perfect grist of a national myth, one compelling enough to bind together Spain’s disparate regions.

With Independence Came Chaos

Europe changed irrecoverably in the 19th century. Nationalism was in the air, and the emergence of new nation-states began to change the balance of power, with frightful consequences to come in the 20th century. For Spain, the watershed event was the Peninsula War of 1807-1814, one of the Napoleonic Wars. Spain and France allied together to invade Portugal, but France betrayed Spain and occupied it. In 1808, an insurrection against the French began in Madrid but soon spread to other regions. In the past these regions had squabbled among themselves, but France gave them a common enemy. Thus began the Spanish War for Independence.

Spain would win its independence, aided as it was by the United Kingdom, but with independence came chaos. The country had, in fact, already begun to destabilize – the Spanish Empire had been in decline for more than a century, and its alliance with Napoleon was a last-ditch effort to reverse the decline. The French occupation was merely the final straw. Now autonomous, Spain had the daunting task of building a system of governance capable of maintaining order in a rapidly changing yet already diverse country. The 19th century would not be a peaceful one. By the end of the century, Spain had tried its hand at nine different constitutions and two different forms of government. It was constantly changing democratic political structures and restoring the monarchs from different families.

Spain’s most famous civil war was fought after the turn of the century, from 1936 to 1939, but it was at war with itself well before then. The preceding conflicts are known as the Carlist Wars. The Carlist Wars had at least three chapters in the 19th century, but in the Third Carlist War (1872-1876) a new king was to be installed, one who meant to restore the local constitutions of Catalonia, Valencia and Aragon. During this time there was even a short-lived state in the Basque Country. The Spanish government managed to crush this rebellion, but the appetite for regional autonomy could not be suppressed. Increasingly a haven for labor movements, communists and even anarchists, Catalonia would revolt again in 1909, only to be put down by King Alfonso XIII. Jose Ortega y Gasset, one of Spain’s most famous philosophers, would write in 1922 that Spain had become an “invertebrate,” a people ruled by a government that hadn’t the slightest idea how to best respond to their needs.

Ortega y Gasset was right. Spain had not yet coalesced into a nation, and its leaders had not yet been able to respond to the needs of all the people. In 1931, yet another constitution was ratified, and for a few years, Spain’s Second Republic tried to bring order to the country. It failed. The new government was actually a friend to Spanish regions, but more traditional elements in the country, such as the military and the clergy, believed regional autonomy threatened the soul of Spain. They believed the electoral process unfairly brought certain groups to power – indeed, the Popular Front won the 1936 elections with less than 50 percent of the vote – and they were unable to fully assert their control.

Yet another military coup ensued. Its leader, Francisco Franco, would rule Spain as a dictator for almost 40 years. He was supported by the likes of Hitler and Mussolini, who saw in him a shared sense of nostalgia for “better” times. (Spain was “better” in the time of Ferdinand and Isabella, Germany was better in the time of Teutonic knights, and Italy was better in the time of ancient Rome. Such was the cultural currency of fascism.) On the primacy of Spanish nationalism, Franco would not compromise. The nation was all encompassing and all important. More than 500,000 people would die fighting over what it meant to be Spain before Franco emerged victorious in 1939.

Franco was an authoritarian, if not quite a totalitarian in the vein of Hitler. His rule was absolute. His military dictatorship crushed regional autonomy and political dissent throughout the country. And yet for all the regime’s sins, Franco’s government gave Spain its first extended period of political stability in more than a century. By the time he left office, Spain had become an important Cold War ally of the United States, and economic reforms had been made that significantly improved the Spanish economy and primed it for the success Spain would enjoy after it joined the European Union.

His “success,” such as it was, raises an uncomfortable question: Did Spain need a heavy-handed regime to define what it meant to be Spanish? The Spanish people eventually rejected Franco’s vision, of course, but Franco’s desire to unify Spain was nothing if not ambitious, something that all Spanish leaders before him had also desired to accomplish but never quite succeeded. Tellingly, the widespread dissatisfaction with Franco may have brought the Spanish people closer together, much as the contempt for the French occupation had more than a century earlier.

In any event, in 1978, Spain adopted a new constitution, one that recognized the Spanish nation as well as the legitimacy and rights of its autonomous regions. It was unclear whether the constitution would hold, but it did. Spanish King Juan Carlos put down a military coup in 1981 to protect it. It has defined Spanish politics to this day.

Demons

Most countries become countries violently. The United States did not become a nation until more than 600,000 soldiers and countless civilians died in its Civil War. Modern China did not become a nation until millions – and perhaps tens of millions – died in China’s Civil War. Birth is bloody and messy and painful, even if the end result is joyous.

All nation-states have demons to face. Even the most homogeneous of peoples are not completely homogeneous. Nationalism is a powerful ideology, one that is based on something very real: the desire of a people with shared language, or culture, or values, to live in community and freedom with and for each other.

But its power cuts both ways. A large portion of the Catalan population wants to be independent, and if history teaches us anything, it teaches us that a large portion of the Catalan population has always wanted to be independent. Not all Catalans do, though, for Catalonia is no more monolithic than is Spain. It doesn’t seem as though there is a critical mass of Catalans willing to pledge their lives, fortunes and sacred honor to prevent the central government from reasserting its control. Until Catalonia has the will and power to make itself independent, the desires of its secessionists will remain stillborn.

For Spain, Catalonia’s independence declaration – even if it represents the will of only some 38 percent of the Catalan population – leads to a dark place. The Spanish Constitution was designed in part to remove Spain from its past, to pave a democratic way forward for a country that could be as proud of its internal diversity as of the unity of the Spanish nation. But wishing something does not make it so, and writing it down in a constitution does not necessarily make it real for the people. In crushing Catalonia’s desires, the government in Madrid is doing the same thing previous Spanish governments have been forced to do when facing revolts in the periphery. Letting Catalonia go would mean the Spanish nation is more myth than reality. Forcing Catalonia to stay at gunpoint means present-day Spain is not exceptional – it is like all previous Spanish regimes.


 
This is an issue faced by nation-states around the world. For a time, the ideologies that moved the world were based on ideas, not on personal relationships. Communism tried to universalize the proletariat, wherever he was and whatever language he spoke. Western liberalism, with its emphasis on individual rights, said governments derived legitimacy by protecting the rights of individuals, wherever they lived and whatever personal beliefs they held. But a son does not choose his mother based on ideological preference, and a worker does not choose his or her language and culture.

And so the world, after a move toward larger and larger political bodies, is self-segregating, rallying around familiarity and self-reliance and national loyalty. It is Spain’s turn now. But it won’t stop in Spain. What Spain does will not affect the world – but the demons Spain is facing are not Spain’s alone.


The US Plutocracy’s War on Sustainable Development

JEFFREY D. SACHS

Inmates in the USA

NEW YORK – The US plutocracy has declared war on sustainable development. Billionaires such as Charles and David Koch (oil and gas), Robert Mercer (finance), and Sheldon Adelson (casinos) play their politics for personal financial gain. They fund Republican politicians who promise to cut their taxes, deregulate their industries, and ignore the warnings of environmental science, especially climate science.

When it comes to progress toward achieving the United Nations Sustainable Development Goals, the US placed 42nd out of 157 countries in a recent ranking of the SDG Index that I help to lead, far below almost all other high-income countries. Danish author Bjørn Lomborg was puzzled. How could such a rich country score so low? “America-bashing is popular and easy,” he surmised.

Yet this is not about America-bashing. The SDG Index is built on internationally comparable data relevant to the 17 Sustainable Development Goals for 157 countries. The real point is this: sustainable development is about social inclusion and environmental sustainability, not just wealth.

The US ranks far behind other high-income countries because America's plutocracy has for many years turned its back on social justice and environmental sustainability.

The US is indeed a rich country, but Lord Acton’s famous aphorism applies to nations as well as to individuals: power corrupts, and absolute power corrupts absolutely. The US plutocracy has wielded so much power for so long that it acts with impunity vis-à-vis the weak and the natural environment.

Four powerful lobbies have long held sway: Big Oil, private health care, the military-industrial complex, and Wall Street. These special interests feel especially empowered now by Donald Trump’s administration, which is filled with corporate lobbyists, not to mention several right-wing billionaires in the cabinet.

While the Sustainable Development Goals call for mitigating climate change through decarbonization (SDG 7, SDG 13), US fossil-fuel companies are strenuously resisting. Under the sway of Big Oil and Big Coal, Trump announced his intention to withdraw the US from the Paris climate agreement.

America’s annual energy-related per capita CO2 emissions, at 16.4 tons, are the highest in the world for a large economy. The comparable figure for Germany, for example, is 9.2 tons. The US Environmental Protection Agency, now in the hands of lobbyists from the fossil-fuel sector, dismantles environmental regulations every week (though many of these actions are being challenged in court).

The SDGs also call for reduced income inequality (SDG 10). America’s income inequality has soared in the past 30 years, with the Gini coefficient at 41.1, the second highest among high-income economies, just behind Israel (at 42.8). Republican proposals for tax cuts would increase inequality further. The US rate of relative poverty (households at less than half of median income), at 17.5%, is also the second highest in the OECD (again just behind Israel).

Likewise, while the SDGs target decent jobs for all (SDG 8), American workers are nearly the only ones in the OECD that lack guaranteed paid sick leave, family leave, and vacation days. The result is that more and more Americans work in miserable conditions without job protections. Around nine million American workers are stuck below the poverty line.

The US also suffers from an epidemic of malnutrition at the hands of the powerful US fast-food industry, which has essentially poisoned the public with diets loaded with saturated fats, sugar, and unhealthy processing and chemical additives. The result is an obesity rate of 33.7%, the highest by far in the OECD, with enormous adverse consequences for non-communicable diseases. America’s “healthy life expectancy” (morbidity-free years) is only 69.1 years, compared to 74.9 years in Japan and 73.1 years in Switzerland.

While the Sustainable Development Goals emphasize peace (SDG 16), America’s military-industrial complex pursues open-ended wars (Afghanistan, Iraq, Syria, Yemen, Libya, to name some of America’s current engagements) and large-scale arms sales. On his recent visit to Saudi Arabia, Trump signed a deal to sell over $100 billion in weapons to the country, boasting that it would mean “jobs, jobs, jobs” in America’s defense sector.

America’s plutocracy contributes to homegrown violence as well. The US homicide rate, 3.9 per 100,000, is the highest of any OECD country, and several times higher than in Europe (Germany’s rate is 0.9 per 100,000). Month after month, there are mass shootings in the US, such as the massacre in Las Vegas. Yet the political power of the gun lobby, which opposes limits even on assault weapons, has blocked the adoption of measures that would boost public safety.

Another kind of violence is mass incarceration. With 716 inmates per 100,000 people, America has the world’s highest incarceration rate, roughly ten times that of Norway (71 per 100,000).

Remarkably, America has partly privatized its prisons, creating an industry with an overriding interest in maximizing the number of prisoners. Former President Barack Obama issued a directive to phase out private federal prisons, but the Trump administration reversed it.

Lomborg also wonders why the US gets a low score on global “Partnership for the Goals,” even though the US gave around $33.6 billion in official development assistance (ODA) in 2016. The answer is easy: relative to gross national income of almost $19 trillion, ODA spending by the US amounted to just 0.18% of GNI – roughly a quarter of the global target of 0.7% of GDP.

America’s low ranking in the SDG Index is not America-bashing. Rather, it is a sad and troubling reflection of the wealth and power of lobbies relative to ordinary citizens in US politics. I recently helped to launch an effort to refocus state-level US politics around sustainable development, through a set of America’s Goals that candidates for state legislatures are beginning to adopt. I am confident that a post-Trump America will recommit itself to the values of the common good, both within America and as a global partner for sustainable development.


Jeffrey D. Sachs, Professor of Sustainable Development and Professor of Health Policy and Management at Columbia University, is Director of Columbia’s Center for Sustainable Development and of the UN Sustainable Development Solutions Network. His books include The End of Poverty, Common Wealth, The Age of Sustainable Development, and, most recently, Building the New American Economy.


Buttonwood

Criticism of index-tracking funds is ill-directed

Theories of their malignance run ahead of reality



INDEX funds were devised in the 1970s as a way of giving investors cheap, diversified portfolios.

But they have only become very popular in the past decade. Last year more money flowed into “passive” funds (those tracking a benchmark like the S&P 500) than into “active” funds that try to pick the best stocks.

In any other industry, this would be universally welcomed as a sign that innovation was coming up with cheaper products to the benefit of ordinary citizens. But the rise of index funds has provoked some fierce criticism.

Two stand out. One argues that passive investing is, in the phrase of analysts at Sanford C. Bernstein, “worse than Marxism”. A key role of the financial markets is to allocate capital to the most efficient companies. But index funds do not do this: they simply buy all the stocks that qualify for inclusion in a benchmark. Nor can index funds sell their stocks if they dislike the actions of the management. The long-term result will be bad for capitalism, opponents argue.

A second argument is that index funds pose a threat to competition. The asset-management industry used to be remarkably diverse. It was hard for any active manager to keep gaining market share; eventually, their performance took a hit. But passive managers benefit from economies of scale. The more funds they manage, the lower their fees can become, and the more attractive the product.

Since passive managers like BlackRock and Vanguard own the shares of every company in an industry, the fear is that they might play a role reminiscent of the monopoly “trusts” of the late 19th century. Studies have argued that the concentrated ownership of shares is associated with higher fares in the airline industry and fees in the banking sector.

These criticisms cannot surely both be true. They require index funds simultaneously to be uncritical sheep-like investors and ruthless top-hatted capitalists devoted to gouging consumers. Furthermore, passive investors, in the form of mutual funds and exchange-traded funds, own only 12.4% of the American equity market. It seems remarkable that they can have such a big impact on the corporate sector with such a small stake.

It is worth examining the criticisms in detail. The Marxist criticism implicitly assumes that the investment community is divided into two—passive investors and active managers devoted to combating corporate excess and ferreting out exciting new bets. But a lot of “active” investors run portfolios that cling closely to a benchmark index for fear of getting fired if they underperform. So they, too, own shares in the biggest firms. A few “activist” investors do try to change corporate strategy but most fund managers don’t have the time to campaign. They may be active but they are not activist.

When it comes to voting at annual general meetings, moreover, passive managers can and do get involved. In one 12-month period, BlackRock says it voted in support of proposals from activists 39% of the time, compared with 33% of occasions where it backed existing management.

As for the studies that found evidence of anti-competitiveness caused by passive money, they have been challenged. A recent academic paper* found “no relationship between common ownership and prices in the airline industry”; another** from the Federal Reserve on the banking industry found some results that were consistent with an anti-competitive effect but “the sign of the effect is not robust, and implied magnitudes of the effects that are found are small.”

Even if you concede the potential for a small group of fund managers to exert baleful influence on a few sectors through their cross-holdings, passive managers are surely the least likely participants in such a conspiracy. The point of their existence is that they hold the market weight in every industry; they have no reason to favour the success of one over any other. If a conspiracy were to occur, it would surely be driven by active managers buying very large stakes in a particular industry, and hoping to benefit accordingly.

There is an element of reductio ad absurdum about the anti-passive arguments. Yes, if the market was 100% owned by index funds, that would be a problem. And if there were no crime, policemen would be out of work. But we are nowhere near that point. Stop worrying and enjoy the low fees.


* “Common ownership does not have anti-competitive effects in the airline industry” by Patrick Dennis, Kristopher Gerardi and Carola Schenone

** “Testing for competitive effects of common ownership” by Jacob Gramlich and Serafin Grundl


The Federal Reserve Has Never Printed 'Money': The End Game

by: Eric Basmajian


- The first three parts to this series covered the mechanisms of Federal Reserve operations, the unintended consequences of too much debt and the resulting issues from the increase in bad debt.

- Critics say that the US will not be able to repay its debt obligations and that hyperinflation will result in a collapse of the US dollar; this is likely inaccurate.

- Currencies are valued on a relative basis and our major trading partners are far more indebted, meaning that their currency must depreciate before the dollar.

- The only way all currencies can fall together (since they are relative) is to devalue against gold or some other hard asset commodity - an unlikely scenario.


Overview
 
This is the final segment to this four part series on the Federal Reserve, 'money printing,' the unintended consequences of Federal Reserve policy such as debt accumulation, the impacts to the economy and finally the end game.
 
The first part to this four-part series covered the mechanisms in which the Federal Reserve conducts open market operations and how the Fed has never actually printed money in its truest sense of the word but rather increased the monetary base through crediting reserve balances of primary dealers.
 
Reserves are not considered money and are not part of M1 or M2 but rather are part of the Monetary Base. The Federal Reserve had hoped to increase inflation by having the banks loan out their newfound reserves, which would thereby strongly increase the growth in the money supply and cause inflation.
 
This did not occur as the rate of bank lending never exceed the historical average and was lower than average in most cases, resulting in a growth of the money supply that was consistent with past decades. Because money supply growth was more or less constant and the velocity of money has been in decline, two factors that contribute to aggregate demand, the rate of inflation has been continuing to fall and has not exceeded the 2% Federal Reserve target with any degree of consistency, much to the surprise of popular market opinion.

The first part covers this process in great detail, and I strongly encourage you to read that part if you have not done so already. You can find the article by clicking here.
 
The second part to this series covered the unintended consequences of Quantitative Easing (QE) and zero interest rate policy (ZIRP) as well as the structural and secular issues of over-indebtedness, which have been exacerbated by these aforementioned polices.
 
The overload of debt that has accumulated recklessly over the past few decades, compounded by misguided Federal Reserve policy, has brought the economy to a point where we have mortgaged all our future growth for current (past) consumption. The anemic rates of growth over the past decade are a result of a massive debt increase in the four critical non-financial sectors of the economy (Federal, State & Local, Corporate, Household).
 
Total economic debt for the United States (public and private) has surpassed $70 trillion and now stands over 370% of Gross Domestic Product [GDP].
 
 
Total Public & Private Debt As A % Of GDP (Excluding "Off-Balance Sheet" Items):
Source: Federal Reserve, Bank For International Settlements, US Treasury
 
 
Total Public & Private Debt (Trillions) (Excluding "Off-Balance Sheet" Items):
Source: Federal Reserve, Bank For International Settlements, US Treasury
 
 
Part II of this series outlines the debt problem across all the economic sectors in more detail as well as how the increase in debt will mathematically guarantee lower rates of growth in the future without some positive shock to the economy. You can find the article by clicking here.

The penultimate part to this series on the Federal Reserve detailed the consequences and symptoms of an over-indebted economy.
 
Increases in debt raise the cost to service that debt, which lowers the saving rate, lowers the velocity of money, lowers long-term interest rates and causes companies to forego growth-generating projects in exchange for financial engineering.
 
These dynamics further decrease the productivity of the labor market, which cause a secular decline in wage growth, amplifying the problem and making it more difficult to pay down debt.
 
The Federal Reserve, through ever-tightening monetary policy, is taking steps to further decrease the growth in the money supply (M2), which multiplied with falling velocity, will stand to reduce the growth rate of the economy at an accelerating pace.
 
This final part will cover why the end game to this problem of over-indebtedness will not end in hyperinflation as many suggest but more likely will end with one of crushing deflation, similar to the results of the 1930s and 2008, two massive economic issues brought about by a systemic issue of over-indebtedness.
 
As I stated in part III, my current forecast is that the Federal Reserve is going to reverse the course of monetary policy before the end of 2018 due to severe disinflation and anemic or even recessionary levels of growth brought on by excessive debt, and that the equity market (SPY) will experience a much choppier ride due to these factors. The Federal Reserve is likely to cut interest rates by the end of 2018 due to falling long-term rates (TLT) that will cause a very flat or inverted yield curve (IEF), hurting the banking sector (XLF) and changing investor sentiment to one of more caution and fear of a pending economic slowdown.
 
Before moving on to the end game, and ultimately how we may choose to exit such a problem that we have created, it is important to take a look at past instances of over-indebtedness, the issues that led to such levels of debt, the consequences of that debt build-up and finally, the end game or the solution to the problem.
While these occurrences of debt-induced crashes happen at irregular intervals, which is one of the challenges in forecasting the next panic year, the build-up of debt, the actions during the build-up phase and the end game/solution have all followed similar paths.
 
We currently sit in the fifth major occurrence of debt accumulation in the United States since the 1800s and the current build-up of obligations dwarfs the past four debt peaks which led to panics and crashes that had lasting consequences.
 
It comes as no surprise that the level of economic growth that we face today, with the largest build-up of debt relative to GDP in the country's history, is at its lowest point and the polices that have been implemented to fix the problem are not only unhelpful in finding a solution but are actually magnifying the same consequences that have been associated with each past instance debt accumulation.
 
Long-Term Annualized Rate Of Economic Growth Deteriorating:
Source: BEA
 
 
With debt to GDP over 370% (~$70 Trillion), nominal economic growth - that is growth and inflation - of less than 3% on a long-term trending basis is a massive problem.
 
You cannot grow out of debt when it is debt that is the problem causing the slow growth.
 
When debt reaches the levels of today, you cannot grow out of debt, you cannot inflate your way out of debt and you certainly cannot increase debt to solve the problem. You cannot fix debt with more debt. Unfortunately, the later seems to be the path we are choosing to take and have no signs of changing course.
 
The only solution, which I will discuss at length, is austerity. Before that discussion, let's take a look at past debt-induced panic years in the United States to spot the similarities and provide context for the magnitude of today's problem.

Brief History Of Debt Problems In The United States

There have been four major debt episodes since the 1800s, not including today's, that have all followed similar paths.
 
I want to preface the discussion on the past four instances of debt accumulation and the resulting panic year by saying that each of these episodes can take on a lengthy discussion, but for the sake of this paper, I will only briefly summarize each period. Invariably there will be events that contributed to each occurrence that are not mentioned but the general theme, which is what I will cover, shows consistency across time. At the risk of being overly reductionist, I will first cover the similar phases that these manifestations of debt undergo.
 
The process of bad debt accumulation begins with artificially created incentives. These incentives are most often created by the government, not in all cases but most commonly. The poor incentives create a desire to speculate on those manufactured incentives typically done by accumulating debt in order to fuel the speculation. The debt is used to "gamble" on these assets, most often stocks, real estate, commodities and other low cash-flow generating goods.
 
The cash flow that is generated from these speculative assets are not enough to repay the principal and interest of the debt that has been taken on in order to facilitate the speculation and thus the buyer has no steam of income and must rely on higher prices (greater fool theory) in order to pay down the debt. This phenomenon causes a large boom in the asset of the time. (Tulips, housing, stocks, commodities etc.)
 
A minority of the population sees the problems that can arise from the build of non-productive and non-cash flow producing debt in order to speculate on assets and choose to pay down their debt and exit the situation, saving themselves money and hardship in the long run in exchange for 'watching the game go on' for a period of time while others get rich, on paper, only to have it all vanish in the panic year.

After a minority of the investors' exit and additional credit (debt) becomes less available to increase further speculation, the asset prices begin to flat-line, not even decline just cease their acceleration in price growth. Due to the fact that the accumulation of debt had no cash flow and the only way to pay it back was to have a rise in the asset, a halt in the rise of the price is enough to cause another wave of investors to cut their losses and sell their speculative assets.
 
Once this occurs, the rest "smell the smoke at the same time" and all try and exit at once. This results in the panic year.
 
This process can be simplified to an issue of artificially created incentives that drive debt-financed speculation in non-cash-flow-producing assets (Ponzi-Finance), which require higher assets prices in order to repay principal and interest; a reduction in the price of the asset that has been speculated on makes the debt unpayable since the investor is now underwater and does not have a stream of cash from the asset causing a wave of selling to cut losses and a resulting crash/panic in the asset class that was primarily speculated on.
 
This has occurred four major times in the United States since the 1800's and is likely to happen again today due to the level of debt that has been accumulated again, for unproductive uses (stocks, real estate, bitcoin, share buybacks etc.).
 
Again, these summaries are overly reductionist, but the trend described above can be seen clearly in each example.
 
 
History Of Debt Accumulation:
Source: BEA, Federal Reserve, Hoisington, Census Bureau
 
 
The first episode occurred in the 1830s in which there was a massive build-up of debt in order to build the steamships, canals and other infrastructure. While this was not the worst use of debt, the issue came from speculation in real estate along the canals as well as poorly thought out factories and other investments that did not have an immediate cash flow but rather were built as a way to "flip" for an increase in price. Investors took on debt to build homes near the major ports that caused a boom in home prices. Cotton, a non-cash-flow-producing commodity, was also speculated on using debt which caused the price to soar. The bank of England saw the easy money flowing out, their reserves declining and decided to raise interest rates, and reduce the amount of money loaned. Once the availability of credit contracted and that made its way to the United States, home prices stop rising at the same rate, factories and other projects failed, cotton prices fell and the money that was borrowed was not able to be repaid since the assets purchased did not produce the cash-flow needed to repay the money. Home values fell, a portion of the debt was defaulted on, and 1837 was the panic year.

The panic of 1837 lasted until the 1860s in which another round of debt was accumulated in order to build the railroads of the United States. This was financed primarily by the government. Again, this created the incentive to speculate on real estate and other infrastructure along the rails, all fueled by an increase in household debt. Once the government sponsored railroads failed, all the assets that were driven up artificially by debt-financed speculation crashed and 1873 was the panic year.
 
The third episode of debt-induced panic led to the great depression. In the 1920s, shortly after the creation of the Federal Reserve, easy money policy (similar to today) was enacted and this flooded the market with liquidity and caused massive speculation in stocks, real estate and commodities. The stock market reached levels it had never seen before and multiplies exploded to their highest level the markets had seen. There were also other assets that were speculated on, incentives that were created by low interest rates and easy money, including wheat, steel and cars (non-cash flow producing commodities). When interest rates began to rise, credit availability contracted and debt was unable to expand in order to continue the rise in asset prices, a minority began to sell their assets and this caused an initial decline in asset prices.
 
By the time the rest of the population began to "smell the smoke," the panic year was upon them and the assets declined dramatically and the debt that was accumulated in order to speculate was not able to be repaid.
 
Again, I fully understand that all of these episodes are complex matters that have much more detail, but the processes that each period went through have similarities that are consistent with debt-fueled speculation.
 
In 1933, debt to GDP was nearly 300%. Over 100 points higher than any past crash which is why the great depression was so much more severe than the past panic years.
 
It took over 70 years for the United States economy to reach a level of indebtedness that surpassed the 1930's.
In 2008, the economy had a level of debt over 350% of GDP. Low interest rate policy as well as other government-created incentives fueled debt-financed speculation, primarily in residential real estate, a non-cash flow producing asset. When the bubble in home prices was clear, the Fed began to raise interest rates, banks contracted lending, and the rise in home prices began to accelerate as a slower pace, declining in some instances. When the rise in the price of homes ended, the debt that was taken on by households in order to speculate on the value of homes was underwater, unable to be repaid, and a crash in home prices and a panic year ensued.
 
Another complex economic time, but it truly can be boiled down to artificially created incentives that caused a debt-fueled speculative bubble with the only path to repay debt was through a rise in price (greater fool theory) rather than through a stream of cash great enough to cover principal and interest. A contraction in the availability of debt in order to speculate stops the rise in that asset and causes the model of Ponzi-finance to collapse.
 
For those who claim the bubble was not clear, easy to spot, or not fueled by low interest rates, I humbly submit that you simply were willingly blind.
 
Below are three charts including home price growth in Las Vegas, Arizona, and nationally. You can see home prices growing over 50% year over year in the peak of the bubble. How this was missed is hard to imagine. Not only was the run-up clear, the decline in home prices also occurred prior to the recession as it followed the same three to four phases I outlined above.
 
 
Home Price Growth Las Vegas:
Source: S&P, Dow Jones
 
Home Price Growth Arizona:
Source: S&P, Dow Jones
 
Home Price Growth National Level:
Source: S&P, Dow Jones
 
 
There was a commensurate rise in home-building stocks such as Lennar (LEN), KB Home (KBH), Toll Brothers (TOL), Home Depot (HD) and D. R. Horton (DHI), which peaked in 2005, not 2007, when the meteoric rise in home price growth peaked.
 
 
Stock Price Growth of Major Housing Stocks:
Source: YCharts
 
 
The panic year of 2008 was arguably the worst in the United States history, and had it not been for unprecedented government bailouts, the economy would have been in a depression that lasted longer than the 1930s. (Some argue we have been in a depression for the bottom 90% of income earners.)
 
While the stock market and the financial assets that were speculated on were saved, after they crashed when debt was unavailable, the issue was not solved. In the past three crises that I mentioned, the debt was wiped out and the economy was able to reset with a clean balance sheet. After the 1930s crash, debt to GDP fell from 300% all the way down to a healthy level of just 120%. It took over 70 years to reach the same level of indebtedness that caused the great depression, and unsurprisingly, the same level of debt caused an equal-sized crash.

It took just a few years this time to surpass the level of debt that caused the 2008 crisis as we now sit with debt over 370% of GDP. It can only be assumed that since the higher the debt, the worse the crash, that the following panic year will be worse than the four preceding it.
 
While these occurrences of debt-induced crashes happen at irregular intervals, which is one of the challenges in forecasting the next panic year, the build-up of debt, the actions during the build-up phase and the end game/solution have all followed similar paths.
 
The pattern this time around is exactly similar to the past four.
 
Government-created incentives have fueled a debt-driven speculative rise in asset prices. The assets that have been speculated on, again, are non-cash flow generative and like the past, as long as the assets being speculated on continue to rise, all is well as the debt can be repaid with higher prices. Once the prices stop rising, and there are not higher prices nor cash flow to repay the debt that was used to gamble on the assets, the panic year will ensue - and this time, with levels of debt that are higher than any panic year in history.
 
Debt Is Higher Than Any Point In History
 
Total Public & Private Debt As A % Of GDP (Excluding "Off-Balance Sheet" Items):
Source: Federal Reserve, Bank For International Settlements, US Treasury
 
 
Total Public & Private Debt (Trillions) (Excluding "Off-Balance Sheet" Items):
Source: Federal Reserve, Bank For International Settlements, US Treasury
 
Below are a few examples of the assets that have been driven to record highs fueled by debt-driven speculation.
 
 
Stock Prices:
Source: YCharts
 
Real Estate Prices:
Source: S&P, Dow Jones
 
Bitcoin:
Source: YCharts
 
 
As history shows, once bank lending contracts and the ability to expand credit (debt) further in order to drive higher asset prices (multiple expansion, not fundamentally higher economics) the greater fool theory falls flat.
 
Of course it is impossible to predict when this occurs, but in fact, bank lending has already begun to contract in growth quite substantially as well as the growth in the money supply which indicates that credit availability is more scarce and the bang point may be closer than most people believe.
 
 
Bank Lending Growth Contracting:
Source: Federal Reserve:
 
 
Money Supply Growth Contracting:
Source: Federal Reserve
 
 
Prior to 2008, the three episodes of debt-fueled panic were followed by periods of economic prosperity for many years. The difference after 2008 was that aside from the rise in asset prices, economic growth did not rise to new highs but in fact, was slower than the last cycle.
 
The reason we continue to have slower rates of growth is because we have not solved the problem of debt like we did in past episodes.
 
After the 1930s there were 70 years of prosperity in which incomes rose, economic growth was robust and the standard of living rose.
 
Austerity was the cause for a resulting period of prosperity. The debt level fell almost 200% as a percentage of GDP and the country was able to move forward with a clean balance sheet.
 
After 2008, there was no such austerity, we chose to add more debt to solve the existing debt and the result was more of the same. Slow growth, reduction in velocity, more booms and busts in asset prices driven by easy money speculation.
 
The best evidence today suggests that each increase in debt creates 3-5 quarters of transitory gains that give the illusion of growth. After the gains dissipate, the economy is more indebted and worse off as incomes did not rise and the standard of living did not rise but debt levels did.
 
We continue to choose to increase the debt after each transitory spurt in growth subsides.
 
Debt mutes the business cycle.
 
All seems well today as the asset prices have not fallen but if/when they do, there will be no cash flow to repay the record high levels of debt that have been accumulated.
 
When debt reaches the levels of today, you cannot grow out of debt, you cannot inflate your way out of debt and you certainly cannot increase debt to solve the problem. You cannot fix debt with more debt. Unfortunately, the latter seems to be the path we are choosing to take, with no signs of changing course.
You cannot grow your way out of the problem because debt is the reason growth is so slow to begin with. Tax cuts or any other fiscal or monetary policy may induce transitory gains but the issue of debt will actually be amplified by increased budget deficits which will add to the debt, reduce velocity of money, and create slower growth and in the end, higher levels of debt that are even more difficult to repay.
 
You cannot inflate your way out of debt because as inflation rises, which it will likely not do because debt is the reason inflation is so low (velocity is too weak), interest rates rise in proportion to the rise in inflation.
 
Interest on the debt is already in the top three most expense categories of the budget. For those who believe that inflation is a way out, if inflation rose to 20%, interest rates would rise accordingly and the debt that rolls over will now incur an interest rate of 20% and the interest payments will take up over 100% of tax receipts and there will be no money left to repay the existing debt.
 
The notion that you can inflate your way out of debt ignores the fact that the interest expense will rise in proportion to the rise in inflation and make the problem worse, not better.
 
Defaulting on the debt denies futures borrowing so that option is very poor as well.
 
Since you cannot grow your way out of a debt problem and you cannot inflate your way out of a debt problem, the only long-term solution to the debt burden is austerity, a solution that no one wants to hear.
 
Austerity is the end game.
 
End Game To A Debt Problem
 
In order to move on to a long-term period of prosperity in which incomes rise, the standard of living rises and the economy grows at a reasonable rate, you need to clean the countries balance sheet by reducing the debt burden. This is the only way to increase the velocity of money and create long-term high economic growth. To pay down the debt, you need a period of pain or austerity which most economists define as a long-term rise in the savings rate.

Sometimes this period of austerity is imposed for you, other times it is the collective decision of the country but in either case, history shows there has never been a major developed economy that has solved a debt problem without a period of austerity.
 
For example, many assume the United States got out of the great depression due to World War II. This is a superficial analysis and not completely true.
 
The real reason the US was able repair the economy was due to austerity imposed by the government.
 
The war had begun and our trading partners were in need of war time supplies from the United States.
 
Our industries boomed to fill this newfound demand and this created income and a trade surplus for the country.
 
You need to go one step further to understand how this created prosperity.
 
While it is true the war created a boom in exports, the US government imposed mandatory rationing, which meant that households were not allowed to spend the rise in incomes they were receiving. This caused the savings rate to soar (austerity defined as a long-term rise in the savings rate) up to 25% (currently at 3% today), and this rise in the savings rate allowed the country to pay down the debt of the 1920s and 1930s.
 
 
Savings Rate Rose Due To Imposed Austerity:
Source: BEA
 
 
The ratio of debt to GDP did not trough until the savings rate rose in the 1940s. The imposed austerity and reduction in the debt down to 120% of GDP from 300% is what cleaned the balance sheet of the country and allowed us to prosper for almost 70 years.
 
A reduction in debt and a clean balance sheet is what is needed again today although with debt levels way higher than the 1930s, the austerity will be even more painful which is why we seem to not have the political will to solve the problem.
 
Why Austerity Is Essential To Fix The Economy & What Investments Will Benefit
 
I want to focus on the United States economy, but in order to do that, I have to address our major trading partners, Europe, Japan and China who are more indebted than the United States and face bigger challenges than the United States. This is both a blessing and a curve for the United States for reasons I will outline.
 
Many critics of the United States' debt burden claim that a collapse of the US dollar (UUP) is inevitable and that our debts will be repaid with worthless dollars. This is a very poor analysis of the situation as it does not take into account the global situation.
 
The first point to make is that currencies are valued on a relative basis. The euro and the dollar cannot both go down against each other at the same time.
 
The only way that all currencies can depreciate simultaneously is if they are devalued against gold (GLD), silver (SLV) or some other commodity (USO). More on this later.
 
Operating under the assumption that all currencies will not depreciate relative to gold for a minute, that leaves one currency to be the "winner" or the strongest relative to the others. I am referring to a long-term multi-year trends in the currencies, not monthly or yearly moves.
 
The relative indebtedness of Europe, China and Japan are significantly worse than the United States.
 
The United States stands at debt 370% of GDP, China at nearly 400%, Europe around 475% and Japan at almost 600%.
 
 
Country Debt To GDP Level:
Source: Hoisington, Bank of Japan, Cabinet Office, Statistics Canada, Federal Reserve, BEA, Statistical Office of the European Communities, Bank of Australia, Haver Analytics
 
 
If the United States cannot repay its obligations then surely countries who are more indebted cannot repay them either and will default faster should that be the case.

If the other three largest countries will by definition have to default faster than the United States, due to higher levels of debt, that serves to put a long-term bid under the US dollar.
 
How can Japan not default prior to the United States if they have a level of debt almost two times as great. If Japan defaults prior to the dollar, then the yen (FXY) will fall dramatically and cause a massive upward pressure on the exchange rate between the dollar and the yen.
 
Unless you believe that the US, the relatively least-indebted country, will default with less debt than other countries with more debt AND slower economic growth, then the long-run trend in the dollar must be higher.
 
This does not refer to small moves in the dollar caused by knee-jerk reactions to Federal Reserve policy but rather large multi-year trending moves in the exchange rate of the dollar against other currencies.
 
 
Long-Term Trend In The Dollar:
Source: Federal Reserve
 
 
The long-term trend is the dollar is higher relative to other currencies. If countries that are significantly more indebted than the United States default first or continue on the path to higher levels of debt relative to the United States, there must be a long-term bid under the dollar keeping its value relative to other currencies.
 
Higher levels of debt cause the velocity of money to decline, which is why the countries that I mentioned which have higher levels of debt also have lower levels of velocity, which causes lower long-term interest rates.
 
 
Velocity of Money Across Countries:
Source: Hoisington, Bank of Japan, Cabinet Office, Statistics Canada, Federal Reserve, BEA, Statistical Office of the European Communities, Bank of Australia, Haver Analytics
 
The United States, having the highest relative long-term interest rates, low on a nominal level but high relatively, since currencies trade on a relative basis, will also serve as a factor keeping a long-term bid under the dollar as foreign money will demand our higher interest rates.
 
 
Interest Rate Comparison:
Source: YCharts
 
 
The factors above, higher interest rates and low relative levels of debt, will serve to keep the value of the dollar relative to other currencies.
 
This, as I mentioned, is a blessing, as the risk of default for the United States essentially cannot come prior to other countries, but also a curse as higher levels of the US dollar relative to other currencies is a deflationary pressure that serves to lower economic growth and make the debt harder to repay.
 
I mentioned briefly the possibility of all currencies falling relative to gold or some other commodity.
 
This is a low probability, but it is worth mentioning.
 
I believe that the long-run trend will be upward for the US dollar for the reasons mentioned.
 
There is the possibility that no country can repay their debts and all fiat money loses its value.
 
In this scenario, gold will reprice to multiples of the current level (estimates are roughly $10,000 per oz) in this instance.
 
The value of stocks, bonds, and other assets would be worthless in this case, so the discussion around inflation hurting bonds but not stocks is an irrelevant point. The only protection against this scenario is hard assets.
 
In the portfolio I run in my Marketplace service, EPB Macro Research, I always have a certain allocation to gold as a protection against this scenario (very unlikely in the near future); the exact allocation changes based on market conditions, of course, is exclusive to my subscribers.

That being said, the analysis that suggests that there is a collapse of the dollar on the horizon does not take into consideration the debt of other countries that by definition, almost have to default prior to the United States and therefore keep long-term severe upward pressure on the US dollar.
 
A small allocation to gold protects against a total fiat currency collapse which is very unlikely, but serves as an insurance policy that is worth holding on to. I do like a small portion of gold as a long-term investment and believe it should be part of everyone's portfolio.
 
Austerity
 
Now that the probability of hyperinflation has been thoroughly reduced, the situation returns to the United States and to one of deflation as ever-increasing levels of debt will make our economic situation mirror that of our trading partners who are several years ahead of us in terms of debt, velocity, low growth, low inflation and low interest rates.
 
Unless we, as a country, stop the increase in debt, which we seem to have no intention of doing, the velocity of money will continue lower towards the figures seen in Europe and Japan. Lower rates of nominal growth will be the result and similar interest rates will follow. 2.4% interest rates will be a distant memory once the velocity of money in the United States falls below 1, as will 2% economic growth.
 
The economy is too indebted for interest rates to rise and stay up.
 
Monetary policy has been proven to be ineffective as the last 7 years of experiments from the Fed have raised stock prices, but have resulted in the lowest level of economic growth in decades.
 
Fiscal policy, in the form of tax cuts, will also have an immaterial effect.

Many will scream to look at the Reagan tax cuts as a proxy for how the new potential tax cuts will benefit the economy, but a major hole in that logic is that Reagan had a debt to GDP ratio of around 40% at the Federal level, not 107%.
 
Also, Reagan had the benefit of the best demographic mix the country has ever seen. Today, the demographic situation is materially worse as population growth has been declining as well as fertility rates.

That leaves austerity.
 
The problem is too large to be solved by spending alone or tax increases alone. There needs to be compromise on all sides for reasons I will outline.
 
Currently, the Federal Budget is roughly 20% of GDP.
 
 
Federal Budget to GDP:
Source: BEA
 
 
Without any changes to policy, due to obligations that we have promised including debt repayment, social security and Medicare the unfunded liabilities are near $100 trillion and will cause the federal budget to rise to 40% of GDP in 20 years, according to the IMF.
 
This does not take into account future borrowing that we are likely to incur so it is the most optimistic and conservative forecast.
 
In 20 years, if the nominal rate of growth averages 2% (3% currently) that means in GDP will be roughly $30 trillion.
 
If the budget increases from 22% to 40% of GDP, that is an 18% transfer from working households to retired households that we have promised. 18% of a $30 trillion economy is a $5.4 trillion per year increase in spending that needs to come out of the economy. Again, that is per year.
 
The only way to find an additional $5.4 trillion per year, is to borrow it, further adding to the debt problem and raising the interest payment expense or to tax it. That is on top of the current taxes.
 
Taxes collected are only about $3.5 trillion today.
 
 
Total Taxes Collected:
Source: BEA, IRS
 
 
This implies that over the next 20 years, without any additional debt (nearly impossible) that the taxes need to rise to $9 trillion in order just to keep the level of debt to GDP ratio the same at 370%, not to mention trying to reduce it.

Increasing the level of taxes over 100% is essentially impossible and would certainly grind the economy to a halt.
 
The only solution has to come from a combination of spending cuts, tax increases and a long-term rise in the savings rate.
 
The issue is that the best analysis suggests that a $1 increase in the marginal tax rate reduces economic growth by $2-3, a negative multiplier.
 
Reducing loopholes, of which there are currently over 3,000, does not have the same negative multiplier and is more effective.
 
Therefore, a reduction in spending, an increase in taxes by reducing loopholes but NOT by raising the marginal rate (in fact you can cut the marginal rate to spur growth if the loopholes are closed and the tax base rises), and a long-term rise in the savings rate are the only hope to get the economy back on track. On top of this, there would likely need to be a consumption tax. Ironically, a consumption tax and no income tax is the best way to run a prosperous economy but the days of that being the only solution are long gone; the problem is too great.
 
Thomas Hobbes said "income is what you give to society, consumption is what you take from society."
 
By taxing income, we are punishing contributions and encouraging consumption (lack of savings). A consumption tax leads to high rates of saving, a vital component to a long-term healthy economy.
 
There needs to be structural reform to social security and Medicare because even with the above prescription, which would be enormously painful in the short run, it is not enough to meet the obligations and debts that we have assumed.
 
If we do follow the above plan, short-term pain for long-term gain, we are looking at a multi-year decline in GDP.
 
We do not seem to have the political will to go down that path and we instead are choosing a path of increased debt on top of old debt.
 
By following the same path, we are going to get the same result. Students of history will understand that we have been down this road four times before and will make investments accordingly.

Long-term interest rates will fall due to increased debt, reduced velocity and lower growth/inflation will make long-term bonds (TLT) (IEF) a strong long-term investment for the capital appreciation that will come when interest rates fall to the level of Europe and Japan over the next 10 years. Of course this should be hedged with gold for the reasons outlined in the above sections.
 
The gain on a long-term bond from 2.5% down 1% or lower is enormous. Anyone who bought a Japanese JGB at 2% is in good shape with rates now at 0%. They are getting 2%, and have a massive appreciation on the bond.
 
Since we know the path that Europe and Japan took, and we have no political will to follow the above prescription but rather are following in their footsteps, we will get the same result.
 
The path to lower nominal growth and therefore lower interest rates is set in stone due to the increases in debt.
 
If we continue on the path towards the indebtedness of Europe and Japan, our economy will mirror those results. Velocity will crash which will make any fiscal or monetary policy ineffective because the increase in money supply will not circulate fast enough to spur the required growth.
 
The lows in long-term interest rates are nowhere near the current levels. If we continue on the path of Japan we could see 10-year yields at the same level, sub 1%.
 
That is likely more than 10 years away, so the current forecast, outlined in the introduction, is that the Federal Reserve is going to reverse the course of monetary policy before the end of 2018 due to severe disinflation and anemic or even recessionary levels of growth brought on by excessive debt, and that the equity market (DIA) will experience a much choppier ride due to these factors.
 
The Federal Reserve is likely to cut interest rates by the end of 2018 due to falling long-term rates that will cause a very flat or inverted yield curve (BND), hurting the banking sector - JPMorgan (JPM), Bank of America (BAC), Goldman Sachs (GS) - and changing investor sentiment to one of more caution and fear of a pending economic slowdown.

The result of Federal Reserve policy that created a horrible incentive of too much debt will be one of deflation, not inflation, and create lower growth, lower interest rates and a structurally weaker economy unless we are willing to address the problem. Another panic year will occur and we then have the choice to go in the opposite direction of our trading partners and get a different result or take the same path of more debt and achieve the same result. Until then, long-term bonds, hedged with a small amount of gold is, in my opinion, the best long-term investment out there today. If rates go the way of Japan over the next 10 years, that will be a tremendously profitable investment.