Debtor's Prison

Greetings fellow inmates!

A very, very long time has gone by since we last convened in these hallowed halls of fiber-optic imprisonment.   We are extremely apologetic to you dear readers and fellow inmates for our recent silence and greatly appreciate all your letters of support and encouragement.   Much to our own dismay, your friendly DP staff took leave for these past three months for personal reasons, but DP will now be fully operational once again.   As always, your contributions in terms of time, energy, information and prose are infinitely valuable.     Needless to say, as all of you are aware, much has happened in the past three months.   Our own absence has at least allowed us to get some perspective on the financial issues at hand, echoing a maxim that we’ve held from the beginning:  time is slow.  More precisely, some of the larger economic questions, imbalances and unknowns have not changed significantly, if at all. Since we love thinking about debt, especially in solitary confinement, we will look at a broad picture of it today.   As you know, we love definitions and simply counting the numbers, which often reveals interesting insights and mind-bending paradoxes.   For that reason, this post will be of the “forest through the trees” variety; many of the details will be discussed in later instalments.

We all know that governments around the world have undertaken huge bailout packages to support their economies and financial systems.    To do so, they have all needed to borrow heavily.    Fiscal and monetary packages alike have resulted in a greatly increased need to finance them, leading to an extremely high level of public debt issuance.   In effect, to support the crumbling financial and economic infrastructure, the world has reacted by borrowing more from itself.   In the reckless panic and devious manipulation, we have been sold the idea that to save ourselves from the impending cataclysmic destruction of our economic system we must drain our future and our childrens’ with reckless abandon.    There are many shades of this mechanism and many different types of debt, which we will deal with more detail in due course.   For now, however, we will look at public debt as a cross-section of this market which is becoming even more systemically risky.

Let’s take a medium term look at the estimates for public debt growth and make some rational deductions.   The economist newsmagazine, a subsidiary of the Economist Group, predicts that gross public debt for the G20 countries will grow to 106% of GDP in 2010 and 114% in 2014, up from 74% in 2007, representing an increase of $9 trillion dollars.   Of course, we must bear in mind that these projections are in today dollars rather than the greatly devalued dollars likely to exist in the next five years.  But that is a topic in and of itself to be covered in a future post.    Below is a table with more detail on 7 of these members of the G20, the subset group of the G7, covering from 2008-2012.   The data comes from the IMF and Numbers from 2009 onwards represent estimates.  As always, we advise you to take data at face value and consider the source.   The IMF is after all, a big part of The System and thus the problem.  We present these 7 countries as they will be the major debtors over the next five years.

Several interesting things pop out.   For starters, in every single case within the G7, the average nominal GDP through 2012 will be less than average CPI.   Therefore, in these 7 most important economies we'll see real economic contraction from now until 2012. This, in and of itself, should rationally depress the value of existing debt, not to mention that we can’t expect all this new debt issuance to be paid for by real economic growth.    We can also notice from the table that 5 of the 7 countries (minus Japan and Germany) will have current account deficits until 2012 and much thereafter.   This means that they will continue to spend more than they make, forcing them to borrow more.   As the 7 most important economies, the heaviest borrowers and the core issuers of the total global foreign exchange reserves, it is mind-boggling that these countries can continue to borrow such enormous amounts with absolutely no indication of where the money to pay for it will come from.   Of course, this is the age-old problem that we habitually and blindly relegate to the future.   The future is now folks.    The System is not linearly infinite, it has breaking points, and the scale of what we are approaching warrants all attention.   The explosion of debt that has spread to the foundations of the economic and financial system not only thwarts all magnitudes ever before seen, but it is crossing paradigms that had yet to be crossed.    From 2008-2012, gross government debt as percentage of GDP will grow from 63% to 75% in Canada, 67% to 90% in France and Germany, from 105% to 126% in Italy, from 197% to 237% in Japan, from 52% to 94% in England and from 70% to 101% in the US.     These are astounding numbers; the world, at its largest scale, is saturating with debt.   

The next natural step is to ask who will be the likely holders of this expected debt issuance over the next five years?  Of course China, oil exporters, and many other net creditor nations are potential candidates, as they have seemed content for the moment to keep buying US bonds (though shortening their maturities).   Most of the debt governments buy is stored as Foreign Exchange Reserves.  The current total amount of Foreign Exchange Reserves is $6tr which was built up over decades.   So, it is unreasonable to believe that nations will fund even the majority of this additional $9tr of debt in an environment where global industrial production is expected to be mediocre at best.   In a future post, we will delve into more detailed projections on this matter, but at the moment we do not have any reliable estimates for the proportion of this expected $9tr of debt nations could be expected to pick up.  

Perhaps consumers worldwide will become large net creditors in the next five years.   This seems unlikely given the long periodicity of their own credit cycles as they finish undergoing the massive wave of deleveraging currently in process.   The availability of credit will trickle down (or up) from the monetary base expansion.    In other words, do we expect the downtrodden consumer, struggling to make debt payments and with lower real wage prospects to save up enough money to absorb this gargantuan amount of debt?  Nope!  Definitely not companies.   Insurance companies? Nope!   Mutual funds?  Nunca!  Then who?   Well, ALL of us, slaves to the infamous Federal Reserve Note (FRN) and his fiat brothers worldwide.    

Let’s take a look at a rarely mentioned, but very simple fact, listed at the bottom of Uncle Benny’s H.1 Release.    There are currently $880,880,000,000 (about $881bln) physical dollars in circulation worldwide, which are collaterized by $11bln (1.2%) of gold, $5bln of SDRs (0.6%), and $864bln (98%) of US Treasury, Agency and mortgage-backed securities (MBS) debt.    Please, think about that for a second.   Everyone knows that FRNs are solely “legal tender” on the production of the US government, taken at faith.  But when you simply look at how it works and the numbers, it really paints a ridiculous picture.   MBS debt is NOT the production of the US government, but rather a reflection of US borrowers’ ability to make good on their mortgages, which should be backed by sound assets.   Neither of these conditions are met, and we have seen an absolute haemorrhage of MBS holdings over the past 18 months from nations and other investors worldwide.   Of course, Uncle Benny gracefully decided to buy $1.25tr of that toxic MBS debt, which now stands ready to be collaterized into the dollar.   Two more things are very troublesome.   First, the listed amount of collaterized debt corresponds to the face value of the debt, rather than the market price.    Of course, this is a huge risk, because in an environment of high gov bond yields, as we will experience in the next five years, the prices and value of the assets which are backing my FRNs will greatly decline.   But this doesn’t show up in the numbers.    The other troublesome aspect is that there is no clarity on what is the breakdown of those $864bln between Treasury, Agency and MBS debt.   Oh, and riddle me this, what is the breakdown in maturities, because I am sure as hell not touching the 30-year bond with a 77-foot pole.  Why dincha axe me Uncle Benny?   But nevermind that, all I want to do is calculate the exact value of my dollar when I go out to trade and barter.   You know how many times I’ve been shanked for giving one cigarette too few?   But perhaps this is a pipedream, of course, the fiat system was always meant to be, designed to remove that very ability from us poor monkey slaves.  But, here in prison, we have learnt to be practical and be very demanding with our few assets.   It only seems like a natural question to ask oneself what is the exact, or at least roundabout real value (and we don’t mean real in the bogus –CPI sense) of this thing I’m exchanging for other things.    But on this, like many of the most simple-minded monkey questions, there is a perplexing silence or outright misinformation in economics, policy and the world at large.  What upsets us in our solitary prison is that the system itself was designed to keep this apparent ignorance in perpetua, preventing us from even attempting to answer these simple questions.  We will leave this lengthier discussion for a later post, but for now let’s just focus on the fact that it is just debt securities, in large part private debt of US consumers on their homes, that backs the US Dollar.   

Ultimately, there currently stand an additional $1.64tr of Treasury, Agency and MBS debt ready to be collaterized into the US dollar if needed.   Remember, that these are the exact same debt assets that are in the Asset side of Uncle Benny’s FedBS.  We believe that this is a purpose of quant-easing: to increase the amount of securities eligible to be pledged to back the physical FRNs.   Uncle Benny has not really fired up the helicopter yet as the amount of reserves he’s increased on the liability side of the FedBS are mostly sitting in the digital Reserves of the banking system.    This is part of the monetary base, which is expected to result in higher lending by the banks to consumers and businesses.   If this intended cascade of credit does occur, and economies revive, there will be much greater demand for physical cash, which will of course, simply revolve around labelling more of Uncle Benny’s worthless debt assets “for collaterization”.    This swindle WILL end.   In the next five years, it will seem like the enormous avalanche of government debt will be sucked into a black hole.    Our major currencies are that black hole.  Of course, the question is how big is this black hole’s appetite and tolerance for government and toxic private debt?   Well, we don’t know yet, but it sure isn’t infinite. We are, after all, a cyclical beast and Numbers never lie.    Who or what will be to blame when the current fiat system blows up?   Well, debt of course.  

Even our court jester friend over at The economist is able to see that this state of affairs is unsustainable.   In an article posted by our long-time friend Discipulus in The Yard, the sir states that such a system – where a country heavily in debt (the US) with a growing government deficit is creating vast amounts of new debt/money at low interest rates – “must surely break down, bringing a new currency system into being, just as Bretton Woods emerged in the 1940s.”   Yes, this will bring a new currency system into being, but not before another crisis.   Perhaps the “crisis to end all crises”.   In the next few posts, we will once again be discussing in more detail this potential new currency system and try to dilucidate the nature of the crisis that will be the impetus and justification behind the implementation of a new system.   One thing is certain about this impending currency crisis though, and that is that its origins will be in debt.   This crisis has been in the making for decades and it’s coming to its fateful end.   As usual, we are not advocating an end-of-days, histrionic viewpoint like many of those other websites you frequent.   Instead, we hope to understand the relationship between debt/money so that we might better protect ourselves amidst the drastic transition our financial and monetary system will undergo. 

We have come full circle to our initial motivation for this post on debt.      We meant to provide you with very simple data, some thought-experiments and rational conjectures.  In addition to the topics already mentioned, in the next few posts we will also be taking more granular looks at different debt markets and current debt holders and their likely evolution; the apparent discrepancy between the expected recovery shapes implied by the bond markets and by the risk markets (equities, commodities, etc); and what implications this growing debt mountain might have for the world built on top of it.    We are extremely happy to be back, and greatly look forward to the many fruitful discussions that await us.   Over the next few weeks, we will be updating the site features which haven't changed in a while.   If there is anything you'd like to see please let us know by Contacting the Warden.   Thanks again for all your letters and suggestions during our absense, your DP staff greatly appreciated them.   Keep them coming, and let's all continue working toward our collective emancipation from this debt prison.

May your capital be safe and your investments prosperous!

MAAA