The End Game

This year is a waiting game, but makes no mistake, we are coming close to the end game in almost drunken fashion. Over the next several months, we are going to start explore various aspects of the end game. Can this time be different?

In highly leveraged economies, particularly those in which continual rollover of short term debt is sustained only by confidence in relatively illiquid underlying assets, it seldom survives forever, particularly if leverage continues to grow unchecked.

The longer we try to put off the pain, the worse the total pain will be. The US is facing a long and difficult road as it attempts to correct the over-indebtedness and wasteful expenditures of the past two decades. At $3.70 of debt for every dollar of GDP, US debt is excessive. According to a book ‘This Time is Different – Eight Centuries of Financial Folly’ by Reinhart and Rogoff, the main standard in explaining more than 250 crises studies in whether debt is excessive relative to national income, even though idiosyncrasies apply in each case. They reiterate that this old rule continues to apply and this time is not different.

It has been more than a year since the Fed began a massive expansion of Fed Reserve Bank credit from $1 trillion to $2.2 trillion, flooding the banking system with reserves. According to the late Nobel prize winning economist Milton Friedman, an increase in M2 of such increase in reserves to M2 of such magnitude would have been highly inflationary. However, M2 did not explore instead in the past twelve months, this aggregate has risen only 3% and this is less than ½ of the average growth rate over the last fifty years. Essentially, debt overwhelms monetary policy.

Despite the concurrent developments of little money growth and declining loan growth, the fear nevertheless remains that an inflation surprise might be just around the corner. Today it is obvious that the US economy has plentiful excess resources, so any increase in demand will result in little price change. This will be the case until our unemployment rate of over 17% drops by a considerable amount and we begin to use factories well above current 68% utilization rate.

Deficit spending only provides a transitory boost to the economy. It initially raises GDp as it did in the second half of 2009 but then the effect dissipates and later is reversed as financial resources available to the private sector are reduced. At the height of Japan’s banking crisis in the 1990s, repaving the streets in Tokyo became a routine exercise. As a result, Japan’s gross government debt-to-GDP ratio is now nearly 200% and a drag on what once was a vibrant economy.