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What's the Debt Super Cycle? |
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Macroeconomics has observed the existence of economic cycles for hundreds of years. Different schools of economic thought have attributed cycles to various causes -- from generational habits, to cognitive biases, to bourgeoisie greed, to bank credit, to government interventions -- depending on their political presuppositions. The supercycle theory comes from work spanning diverse sources in different schools all arriving at one basic observation: the main driver of cycles and supercycles is a miscommunication of information across the economy with regard to supply & demand of money, credit, and other inputs resulting in miscalculation of value and risk. The sources of miscommunication can be any of the above or some other cause.
The general structure of a "business cycle" is a boom or bubble driven by the perception of increased money, credit, or demand for goods and services, followed by a bust, correction, or contraction during which malinvestments and bad debts are liquidated. On the surface, it would seem that such cycles are always a net negative. However, there are political and financial interests which promote business cycles in order to profit from the boom and to use the crisis of the bust to acquire assets at fire sale prices and to consolidate power. But whether such interests actually cause the business cycle or simply capitalize on it is debatable.
But individual business cycles are not secular phenomena in and of themselves, but also constitute a larger cycle called the "supercycle" in which entire financial and monetary systems grow and then collapse as a result of ever-increasing amounts of distortions, misallocations, dysvaluations, biases, and myths which eventually collide with undeniable facts and must reset to conform with the actual state of the system. It's conceivable that business cycles could theoretically be self-contained if the bust was allowed to fully liquidate and unwind the excesses of the boom, but government and central bank interference always try to minimize the pain during the crash, and this ensures that the imbalances are not resolved from one cycle to the next, thus creating the supercycle. The violent realignment of the economic model with actual reality at the resolution of the supercycle often completely destroys the financial and monetary system underlying the mythical construction.
Throughout the supercycle, each intermediate bust evokes fears that the ultimate crash is imminent, but people are wont to believe that reflation via central bank easing and Keynesian stimulus is sufficient to right the ship, and for a long time they end up being right. But the confidence game cannot last forever. Each new cycle adds ever more leverage and distortion and malinvestment until the entire construct is completely untenable. First those distortions are transferred from small, diverse, private companies and banks to larger, public ones receiving special privileges and bailouts. Then they are transferred to the central bank and government. The central bank balance sheet explodes and the sovereign debt grows without bounds. This sets the stage for a monetary crisis on the one hand and a sovereign debt crisis on the other. Ultimately, the government will either have to declare bankruptcy and repudiate the debt (preventing any further borrowing and spending, which governments hate), or the central bank has to monetize the debt and deficit and other economic distortions, eventually shaking confidence in the value of the currency. Because the monetary method is less transparent and less obvious to the masses, and thus allows the can to be kicked just a little farther down the road, that is almost always the path chosen.
But monetary profligacy cannot be ignored forever. The first rumbling of a crisis usually starts with foreign exchange reserves and other foreign buyers of sovereign debt. Capital flight from sovereign debt drives interest rates up, which is a tightening of monetary policy, which the central bank must respond to with the printing of currency. But when it becomes clear that the major source of liquidity in the market for that sovereign debt is the country's own central bank, then loss of confidence becomes a self-reinforcing feedback loop. Likewise, when government spending of freshly minted cash drives up consumer prices (more money chasing after the same or fewer goods), then people spend their money sooner before prices rise again, increasing the velocity of money, which sends consumer prices even higher. This increases the cost of government, which must print even more currency to maintain services. This produces a self-reinforcing feedback loop. We call this process hyperinflation because the monetary base grows hyperbolically until commerce and trade simply cannot continue.
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Is This Just Theory, or Has It Actually Happened Before? |
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Debt supercycles collapsing into hyperinflation are a fairly common occurrence. With fiat currencies, it is the rule that eventually this will happen. The mediating factors include the strength of the underlying economy, the savings of the people, the trade position of the country, the military might of the government, the level and frequency of government and central bank interventions, war and other destabilizing situations, et cetera. Some supercycles take a very long time, measured in decades, others just a matter of a few years. Hyperinflation is often defined as a period starting when there is a month in which the price level increases by at least 50% and ending when it has been under 50% for at least a year. Of course hyperinflation is actually a monetary phenomenon, not a retail price phenomenon, but this is how it is most evident. In a monetary sense, hyperinflation occurs when a central bank must print money at an exponential rate in order for the government to keep providing services and paying interest on its debt. But since governments in such a condition rarely advertise their fiscal and monetary problems, economists must use the general price levels to estimate when hyperinflations are occurring. Here are a few dozen examples from just the past century...
It's probable that Venezuela and Argentina are currently in the early stages of hyperinflation. |
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But This Time It's Different, Right? |
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Well, yes and no. There is no fundamental difference in the current debt supercycle which would prevent it from collapsing. What is different this time is that the nexus of the problem is the U.S. Dollar, which is the reserve currency of the world, which underpins almost all global transactions. So what's different this time is the scale of the collapse. In the past, when a country completed a debt supercycle and hyperinflated their currency, they would eventually stabilize the situation by adopting a more stable currency, usually of a neighbor, or in many cases the United States. For example, when Zimbabwe hyperinflated during the past decade, they adopted both the U.S. Dollar and South African Rand to bring economic conditions back to normal. But this time there will be no safe haven because the entire global economy is involved. You will not be able to escape to a better place nor import a stable foreign currency (besides physical gold and silver). The entire world is concluding an ill-founded experiment of floating fiat currencies, none of which are backed by anything of real value. So we can extrapolate on events we can expect to transpire based on single-country collapses, but cannot fully predict the depth and extent of destruction about to occur. |
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The Ill-founded Experiment of Floating Fiat Currencies |
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Following World War II, when the United States was the only first-world nation not seriously devastated by war, and sitting on the majority of the world's gold thanks to financing the allies' war machines, the Bretton Woods agreement of 1944 established the gold-backed U.S. Dollar as the reserve currency of the world to which all other currencies would be pegged (along with creating the International Monetary Fund and World Bank). A peg is maintained by buying and selling currencies and debt securities such that a constant market exchange rate is achieved. The U.S. backed the Dollar by gold at a rate of 1/35th oz of gold per dollar (i.e. $35/oz). Thus, the world returned to something approximating a gold standard after most of their currencies were massively depreciated during the war. As a consequence, most foreign reserves held in the central banks of the world were denominated in the U.S. Dollar and most international trade transactions were likewise denominated in the U.S. Dollar. However, at the time, the U.S. maintained massive trade surpluses since everyone was buying U.S. exports. This presented the problem of a shortage of dollars around the world. The U.S. had to reverse this flow and run a trade deficit in order to export enough dollars for international trade and foreign reserves. The primary method of achieving this was the Marshall Plan for large-scale financial and economic aid for rebuilding Europe and Japan, creating a huge balance of payments deficit which provided the world with tens of billions in Dollar liquidity. This was followed by promotion of European and Japanese trade competitiveness so that America could import foreign goods and export dollars. Furthermore, the U.S. established a policy of foreign aid to any pro-U.S. regime in the third world, particularly to oppose communism. So long as the U.S. ran balance of payments deficits, the global economic system remained liquid and relatively stable. The flip side of this construct was that the U.S. capital account, i.e. net ownership in national assets, would be in serious surplus, with foreign investment in U.S. assets, primarily Treasury bonds. The U.S. government used this public debt to finance the Vietnam War and Great Society programs.
In 1960, Robert Triffin observed that eventually this system must collapse (called Triffin's Paradox) because eventually a massive balance of payments deficit and growing national debt would erode confidence in the Dollar as the reserve currency and create global instability. Indeed, by 1959, the amount of U.S. dollars in global circulation exceeded the amount of gold backing them up. The London price rose to $40/oz despite the U.S. official rate of $35/oz. I.e. the Dollar was over-valued relative to its quantity printed. The U.S. Federal Reserve and seven European central banks colluded in the "London Gold Pool" to manipulate the market price of gold so as to defend the Bretton Woods fix of $35/oz. This worked until 1968 when runs on gold, the Dollar, Pound, and other pegged currencies overwhelmed the official exchange rates and France withdrew from the pool. Gold redemptions continued at $35/oz (while the open market rate was higher) until 1971 when U.S. President Richard Nixon was forced to cancel direct convertibility of the U.S. Dollar to gold. Despite the "Nixon Shock", which also included price and wage freezes and capital controls, the Bretton Woods system of international financial exchange endured for the most part. And when reforms meant to return to gold convertibility failed, in 1973, the world moved to entirely freely floating fiat currencies with the Dollar still the reserve currency, albeit no longer backed by gold. While the global economy didn't collapse or hyperinflate at this point, it did bring on nearly a decade of stagflation -- recession, unemployment, high inflation, price controls, rationing. And it created a monetary experiment of epic proportions like never seen before in the history of the world. The entire basis of global trade and finance would now be a fiat currency. For thousands of years, it was gold and silver.
To maintain the vital position of the U.S. Dollar in international trade, the U.S. struck a deal with Saudi Arabia -- the principle exporter of global oil supply -- such that in exchange for U.S. military weapons and protection of their oil fields, Saudi oil would be exclusively denominated in the U.S. Dollar. This meant that any country seeking to purchase Saudi oil must first exchange their own national currency for U.S. dollars. This was a defacto backing of the Dollar by oil instead of gold. By 1975, all OPEC nations were backing the Petrodollar Standard in exchange for weapons and military protection. This created a double advantage for the United States -- unlike gold, oil demand and supply would expand with global growth, allowing Dollar liquidity to expand without devaluing the currency, and because OPEC countries did not have sufficient industrial and infrastructure demand for the dollars domestically, they would be recycled back into U.S. Treasury bonds, allowing the U.S. military adventurism and social welfare to continue as it had under Bretton Woods. So for the time being, Triffin's Paradox was deferred. But not indefinitely. By the 1990s, several countries started to question the wisdom of accepting constantly depreciating paper dollars for their oil and propping up American living standards and interventionism. These countries were labeled the "axis of evil" by the U.S. and were targeted for regime change by the U.S. military. While collapse of the Petrodollar Standard was delayed, it was at the cost of trillions of dollars of warfare, and it ultimately made the oil exporters even more wary of the ill-fated relationship.
The 1997 Asian financial crisis helped to set up a new paradigm to extend the Dollar hegemony a bit longer. Like many countries, most of East Asia, including Thailand, Indonesia, South Korea, and others were pegged to the U.S. Dollar. A number of factors undermined a credit bubble (called the Asian economic miracle) in those countries which resulted in a collapse that forced the de-pegging of their currencies. Unlike Japan, which could defend its currency with massive foreign exchange reserves, most Asian central banks had little in the way of reserves. Market interventions to prevent flight of capital were therefore not very sustainable and very high interest rate policies to try to retain capital resulted in more economic damage, worsening the crisis. But when the currencies were allowed to float and depreciate, this exacerbated foreign-currency liabilities and the crisis ballooned even further. In the aftermath of the crash, these countries and other emerging markets (EM) adopted the Japanese model of creating a current account surplus and building huge foreign currency reserves -- primarily U.S. Dollar denominated -- as capital insurance buffers. This construct harks back to Bretton Woods, with now the emerging markets taking the place of the first-world countries in that model. As such, the period from the early 2000s to 2015 is referred to as Bretton Woods II, even though no formal agreement was written. During this period, emerging economies primarily in Asia and lead largely by China accumulated north of $6 trillion in U.S. Treasuries as the U.S. national debt exploded to fund expensive wars in Iraq and Afghanistan and to provide fiscal stimulus at home.
In late 2014, petrodollar recycling came to an unceremonious close as net flows of dollars reversed back to oil producers. Around the same time, and especially into summer 2015, Bretton Woods II also reversed, as China unloaded about half a trillion dollars of reserves and de-pegged its Yuan from the Dollar. Former Treasury Secretary Larry Summers once referred to this as "mutually assured financial destruction" in that dumping Treasuries will devalue China's own foreign currency reserves and cause global depression. But since China is already suffering a major economic crash and cannot sustain the peg, there's really no alternative. As Nouriel Roubini noted in his 2005 article on "balance of financial terror", Bretton Woods II payment imbalances persisting would merely "postpone the eventual hard landing in time; it does not prevent it, it... will make the hard landing nastier when it does occur... and be assured that hard landing would eventually occur."
Well, in 2015/16, mutually assured financial destruction has arrived. Prepare accordingly. The emerging markets hold some $6 trillion in U.S. debt and are on the verge of dumping it en masse following China's already substantial lead. The Federal Reserve has another $2.5 trillion and has committed to clearing its balance sheet by 2020. The Social Security Trust Fund has almost $3 trillion, and must liquidate it to make good on payments to retiring Baby Boomers. Likewise with the nearly $2 trillion owned by government and military retirement funds and Medicare. Mutual funds and pension funds will also be liquidating. And the Treasury itself must sell at least $500 billion in fresh debt annually, plus roll over maturing debt. Who on Earth is going to buy over $18 trillion of debt? There's nobody left to absorb even a fraction of it. The U.S. government must either default, raise its rates to unpayable levels to attract market interest, or else instruct the Federal Reserve to monetize it. And we all know where debt supercycles end up.
This will be the first ever global hyperinflation. Nothing like this has ever occurred. The best case scenario would be a rapid realization of what's going on by global governments and a simple default and repudiation of debt followed by a balancing of fiscal budgets. But there is probably little hope of that. In 1997, William Strauss and Neil Howe described the following in their book called "The Fourth Turning", which details the end of a generational cycle:
Imagine some national (and probably global) volcanic eruption, initially flowing along channels of distress that were created during the Unraveling era and further widened by the catalyst. Trying to foresee where the eruption will go once it bursts free of the channels is like trying to predict the exact fault line of an earthquake. All you know in advance is something about the molten ingredients of the climax, which could include the following:
- Economic distress, with public debt in default, entitlement trust funds in bankruptcy, mounting poverty and unemployment, trade wars, collapsing financial markets, and hyperinflation (or deflation)
- Social distress, with violence fueled by class, race, nativism, or religion and abetted by armed gangs, underground militias, and mercenaries hired by walled communities
- Cultural distress, with the media plunging into a dizzying decay, and a decency backlash in favor of state censorship
- Technological distress, with cryptoanarchy, high-tech oligarchy, and biogenetic chaos
- Ecological distress, with atmospheric damage, energy or water shortages, and new diseases
- Political distress, with institutional collapse, open tax revolts, one-party hegemony, major constitutional change, secessionism, authoritarianism, and altered national borders
- Military distress, with war against terrorists or foreign regimes equipped with weapons of mass destruction
We can no doubt count on a fair amount of all of the above. Keep tuned to the homepage of this site for regular updates indicating how the collapse is playing out.
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