It’s All About Math

I am often asked why I think that central banks can’t prevent a collapse in the financial system. Surely they can keep the game going, most people think. Just keep interest rates low and print lots of money.

So, I would like to show you three basic facts that will demonstrate how impotent central banks really are when the sh*t hits the fan.

First, the market is more powerful than monetary policy. The proof is in the recent past. When the tech boom began to unravel in 2000, the Fed very aggressively cut interest rates from 6% to 1% but the NASDAQ fell 83% from top to bottom anyway. And in 2007, as the economy began to weaken, the Fed once again aggressively cut rates from 4.75% to zero and pushed trillions of dollars in short-term liquidity into the financial system. Nonetheless, the economy collapsed and the average stock fell 60%. Here’s the chart of the Fed Funds Rate. Aggressive monetary policy does not stop a market panic.

Second, every dollar of liability is someone else’s asset. In their efforts to revive economic growth, central banks have cut interest rates and provided excess liquidity to the banking system because they want consumers and businesses to borrow more and thereby stimulate the economy. But lower interest rates are a two-edged sword. It’s easier for borrowers but very much harder for savers and retirees. What is saved on the liability side of the ledger is lost on the asset side, often by the same people.

Your house mortgage is cheaper but your retirement fund may go bust. As we have been arguing, pensions are now emerging as a major financial risk and low interest rates are a key reason. How bad is the global funding gap? The World Economic Forum (WEF) recently set out to answer that question. Their response is that by 2050 the underfunding gap is estimated at about $400 trillion, give or take a couple trillion. The study concluded that public employee pensions in the U.S. alone are already underfunded by nearly $4 trillion and that taxpayers in Illinois, California and New Jersey should probably be looking to move before getting drowned in their state’s coming pension-induced tax hike tsunami.

Record lower interest rates have simply robbed Peter to pay Paul. They have not helped the economy to grow faster; in fact, the data seems to suggest that lower rates impede growth by lowering the return on investment, discouraging savings and investment and encouraging short-term speculation. To support a reasonable level of income in retirement, 10%-15% of the average annual salary needs to be saved. Today, individual savings rates are a fraction of this because interest rates are so low.

But accommodative monetary policy has certainly enabled the creation of record amounts of debt. This leads to my third point. Even if interest rates remain very low, can the debt be serviced? If not, we could see a massive increase in defaults. It ultimately all comes down to cash flow. You can spin a story if your earnings miss estimates but miss one debt payment and the game changes big time.

Here is the chart showing total US credit market debt as a percentage of GDP. After falling in the aftermath of the 2008 Financial Crisis, credit market debt has begun to rise again and is now more than 350% of GDP.

Now, here’s where the math becomes important. To service this debt at an average interest rate of 2% (I’m sure it’s much higher), takes nominal GDP growth of 7%. That’s 7% growth just to pay the interest! Nominal GDP growth is real growth plus inflation. Real growth is running at about 2% so that means we need to have 5% inflation just to cover the interest. But inflation is only around 2%. So, we need to generate much more growth (which has been a failure) or much more inflation (not successful so far) just to service the debt we have already incurred. What this means is that the US is officially a Ponzi economy as defined by the economist Hyman Minsky; money is being borrowed to pay interest on existing debt.

Now you know why the Fed is pro-inflation. The Fed needs to get inflation to pay for the debt or face an enormous wave of defaults. It’s one or the other. As a taxpayer, you should be cheering for inflation too.

So, here is my conclusion. Can the Fed keep the present system going?  You either believe in magic or you believe in math. If you believe in math buy gold.