Written on 4/13/2020
Deleveraging the US Economy. Modern Monetary Theory in Action.
The “Economy” and How We Live In This Machine (can skip this section if you have a good grasp of macroeconomics, credit theory of money, and quantity theory of money)
Ever since the gold standard was abandoned during the Great Depression, we’ve had an economy controlled by a central government and a central bank, all guided by printing money to create credit to increase spending. We are married to this machine because there is 47 trillion of credit… and only 3 trillion in cash / money.
Spending is the driver of the US economy. My spending is your income, and you in turn use that income to spend which becomes someone else’s income. Imagine a world with a fixed amount of cash… the only way to get more income is increasing productivity (i.e. working harder or smarter). In our capitalistic society, one person / company’s gain is at the expense of someone else losing market share. So we play a game of innovation or “productivity” increase.
Now let’s add in the concept of credit. There are those who have a lot of money, so much they can’t spend it. So they lend excess money as credit. If you make 100K a year and have no debt and have collateral (i.e. assets), you are “creditworthy”, and you can borrow another 10K a year to spend. So now you spend 110K, which is 110K of income to someone else, and they too are even more creditworthy because now they have a higher income! So now they can borrow 10% more (11K) and therefore spend 121K. And on and on we go. Ideally we want rising income to function as a result of increased productivity but we’ve been increasing asset prices and spending with credit… increasing “income” to fuel this party.
Our human nature has us wanting more…so we borrow more than we should and spend money now. Eventually we’ll have to repay that debt in the future. Most of what people own is not really wealth, but credit. Like your mortgage / house, you don’t really own most of that. Ideally, we borrow to increase future income. However, we borrow to buy a car, use credit cards to buy TV’s and other things that really do very little to increase our future income.
As we borrow and spend… and the multiplier effect of my spending becoming your income, and your increased income that resulted from my increased spending (that happened through credit) … leads to inflation. Asset prices rise to reflect demand.
In a normal cycle the central bank would increase interest rates to decrease the available credit. Therefore, this interrupts the cycle of borrowing and spending. Because there is less credit, this results in less spending, which will lead to deflation and declining asset prices. Eventually the central bank will lower rates and the Economy will begin the cycle of borrowing and spending anew.
Each cycle ends with more debt though because it’s human nature to want more. It may not be on your balance sheet… but look at the larger corporations with ever increasing debt burdens (minus your Berkshires of the world). In the up cycles it makes sense for us to borrow at 3% to buy machinery (or software) so we can increase productivity to increase income. Our debt to income ratios maintains parity. The borrowing and spending party continues…even as we have more debt, we have more income and asset prices continue to climb and we feel good and remain creditworthy to “make moves” in the world.
Eventually the debt burden gets too large and we must pay the piper. This is what happened in the USA in the 1920’s, the “dot com” bubble, 2008 the financial crisis (via mortgage backed securities), and 1990’s Japan. We need to deleverage… basically pay off our debts.
I hope we enter an area of great prosperity after this current deleveraging cycle. But before that, let’s discuss what happens during a period of deleveraging:
1. People / companies cut spending (i.e. tighten belts to pay debt… good ole’ Suze Orman stuff)
2. However, when people cut spending, incomes fall because your spending is my income and visa-versa
3. With less income we all become less creditworthy, so credit dries up
4. With less credit there is even less spending because we take credit to spend it
5. This is all deflationary because less money going around means less money to buy things so prices must decrease… and asset prices drop.
6. Because borrowers have lower valued assets, they are less creditworthy. They can no longer “roll over” debts (this is a function that happens with companies more than with people) and they must sell assets to raise funds to service their existing debt because they cannot obtain new debt to pay off the old debt. This further depresses asset prices. For example, AirBnB just raised 1 billion dollars…at 11-12% interest!
7. There is a vicious circle… less spending -> less income -> less wealth (lower asset prices) -> less credit worthiness -> less borrowing -> less spending
In a recession, the central bank would lower rates to increase the amount of credit therefore igniting the spending engine. However, we are currently at zero percent interest. We’ve been here in the 1930’s, 2008-2009, and again here. We have not fixed anything with this system since 2008. In times of deleveraging, the entire economy is not creditworthy.
There are 4 things that will happen:
1. Cut spending (austerity)
2. Debts will be restructured or defaulted
3. Wealth must be re-distributed
4. Central bank will print money
These things happened in the 30’s USA, 30’s Germany, 50’s England, 90’s Japan, Sovereign debt crisis in Europe during the 2010’s.
The first thing will be cutting spending… no new debt is taken, and old debt is paid down. However, this will lead to falling incomes because my spending is your income. Therefore, with less income, the debt burden is still too much! This is painful deflation.
Next comes debt restructuring. Lenders will want some of something rather than all of nothing. So, debt will be reduced by cutting the interest rate or extending the loan repayment terms. Just like what is happening with “mortgage forbearance” right now. Now this sounds good, however because debt = assets for someone, asset prices have now fallen with means the that those folks are less creditworthy so that leads to less credit which leads to less spending which leads to less income… which balances out the lower debt payment, which is just more painful deflation. This takes a little time to play out, but it is the mechanics of it.
This then hits central governments which usually tax income. With less income as a function of 1 & 2 above, they need to fill the deficit. Governments must tax the rich or borrow money. This is the story of our times … but this leads to tension between the haves and have-nots…. Capitalism vs Socialism. The folks that won the game of capitalism are resentful and the folks who don’t have as much are equally resentful. This can also be seen as tension between governments… like Greece & Germany during Greece’s default. This was a key factor in Hitler’s rise to power…he did a sales job of agitating the issue then providing the solution.
Finally, the central bank will print money so they can lend it to the central government. This is the only vehicle left since interest rates are already at zero. The government must tax or borrow… and the borrowing comes from the central bank, and because these deflationary cycles are largely worldwide, the central bank is the only entity left to provide the money. The Central bank (i.e. The FED in the USA) will print money which it then uses to buy US treasuries giving money to the central government. The central government can then use that money to fill the spending gap that is the result of deleveraging. If a government or sovereign nation is not creditworthy… this is problematic (i.e. Greece, Spain, 1930’s Germany).
THIS TIME AROUND
Deleveraging this time will re-shape our social contracts. Wealth disparity is the current generational theme… the top 1% have more wealth (i.e. assets) than the bottom 90%! So, let’s have an equitable deleveraging this time. We want to avoid pain… but this business of propping up asset prices only leads to further wealth disparity because the bottom 50% of the population have very little or no assets. You are seeing the Central Bank buying all kinds of assets right now! They are buying high yield, investment grade, stock ETF’s…. just propping up asset prices. This is correct action, because function #2 of deleveraging (which is tied to asset prices) is painful over time. Losing value in your assets makes you less creditworthy and less credit is less spending and that is the vicious cycle that must be avoided.
BUT, this time around… the central government (i.e.Congress) is deploying that printed money to not only prop up asset prices for large corporations (i.e. mortgage assets) but also sending some of that printed cash to people. Yes like in 2009, the central bank prints money then buys treasury bonds to give that money to the federal government… but unlike 2008, the central government is DISTRIBUTING that printed money directly to people (NOT a lot, but more so than back then anyway).
Spending is the engine… so printing money to counteract the deflationary pressure from #1 & 2 above is correct. The problem is that the central bank can ONLY prevent #2 above… they can only prop up asset prices in order to provide liquidity so debt restructuring isn't painful. However, that props up the investor class… which has led to this wealth gap we exist in today. Each bubble and response leads to investors being bailed out more than people because the Fed is more effective that Congress but only has one note they can play... buying assets / provide liquidity. The function of credit in our system, and how the central bank & central government controls that function needs to be addressed.
Here’s how we use this current deleveraging to fix that. #3 above, wealth redistribution, is difficult and leads to social tension. But how about the central bank printing money… then sending it to the central government, and THEN the central government distributes it to the regular people… rather than using most of the money to prop up asset prices. The function of printing money, then sending it to people via unemployment, basic monthly income, small business loans, and increase social safety nets has the same effect as #3, the redistribution of wealth, without the sting of a direct tax… it’s a kinder, gentler, more humanitarian way to exist in this system which we live in and are married to. The money is being printed, we are deleveraging, where that printed money goes is important.
This is hopefully the reshaping of the machine we exist in…it’s not there yet. The FED has committed nearly 2-4 trillion dollars to propping up asset prices. They’re buying junk bond ETF’s while the central government fumbles around to distribute 2 trillion through the CARES act (which only some of is going to regular people). Some organized systemic failure is a good thing (Airlines, Auto Makers, etc)… as long as we have a STRONG social safety net through unemployment, basic monthly income, social services, etc… to allow people to survive. Those failures will hit the investor class, the 1% who have more than the bottom 90%.... in a very fair way, capitalism has ups and downs and bailing out equity shareholders shouldn’t be a priority. We'll see how this all plays out. However, note the prologue as the thing called credit / debt has so much power.
Stock buybacks are dumb… it’s not how any of us live. The logic of using business income to buy company shares to prop up the asset price so you can sell it isn’t how we live. It looks sexy… the S&P chart pre-1980 vs post 1980… wow… sexy! But pre-1980 companies gave dividends which lower the stock price by the income distributed. We should go back to that. The game of increasing company stock value to sell it later is a function of bad credit. If I like the company, why incentivize me to sell shares? Please distribute profits like how nearly all small businesses operate.
Elizabeth Warren’s wealth tax is probably a good idea and a logical necessity. It’s what needs to be done at some point… it’s a function of #3 (wealth redistribution) which is the hard part of re-wiring this machine we live in. But the current wealth gap, a time of deleveraging (deflationary), and the reality that consumption (not saving) drives the economy...taxation of extreme wealth is probably inevitable. In this context taxation can be viewed as essentially destroying that money to drive consumption. Taxing money / assets above 100 million is only a drag on investment returns, not consumption. Spending drives our economy so let’s get that money into action. Alternatively, the government could allow assets over 100 million to be loaned as credit via micro loans to small businesses and not tax those returns. This business of credit, income, and asset prices will result in bubbles and the reply will add to immense wealth disparity… so this machine we live in should be adjusted accordingly.
The Fed cannot drop interest rates, so it is up to dysfunctional central governments to figure all this out. Printing money is the only vehicle left for the Fed and it can last for how long? I don’t know…maybe another 75 years. But that needs to be done is a way I described above, or pitchforks occur as a function of #3 because the Fed can only prop up asset prices, which will only increase wealth gaps.
Japan has been battling deflation for decades. Propping up asset prices and printing money will not be enough. Japan has been printing money and people have been saving it, not spending it. Will the USA get back to spending or will we save? We need to get out there and spend! But we cannot because physical distancing will continue for at least a year.
What capitalism, democracy, and the economy looks like on the other end of this pandemic will be different. This is quite the experiment with Modern Monetary Theory right now! If we continue to print money, which I think becomes the new normal... it should not be used to prop up asset prices but rather get out there via a "New Deal" like program.
Prologue: However, the logical next step, might involve an increase in defense spending. The world trades "credit" like we do money. And the holders (i.e lenders) of this "credit" call them assets with prices. What happens when someone sells you something that was supposed to have value, but you later find out it has no value? And it's not a object, but a verbal promise to pay? Mighty armies serve a function because the first debt / credit was once called "tribute". But to avoid the same cycle of civil uprising and redistribution of land / wealth to great detriment like Mugabe & Zimbabwe.... or, when the lender nation has power, imposing austerity at the expense of the public health of people like the IMF & Mozambique... the idea of credit ought to be changed to consumption and the thought consumption is valued over assets for inflating assets sake, or something else. Every new theory of money is at root a discourse on power and morality, and the resulting machine we then live in for another 75-100 years. And because of that, "defense" spending is tied to these macroeconomic thoughts as it relates to power and morality.