The Debt Crisis
How the debt crisis in the West is a secular cycle manifestation
Financial writer John Mauldin’s recent report caught my eye. He and the financial experts at his recent Strategic Investment Conference (SIC) see a crisis for America:
I’ve long been predicting a global debt crisis that will lead to a giant, worldwide restructuring. I call this the Great Reset (a term the Davos people later appropriated). One of my top takeaways from the Strategic Investment Conference (SIC) was that this crisis isn’t just inevitable; it is necessary. It’s what will allow us to do the unthinkable. Excessive debt isn’t quite an extinction event but it’s still a giant problem. After SIC, I’m more confident we’ll find a solution. It will happen the same way we solve other problems: when we have no other choice.
I also see a crisis, in which the debt plays a role, but is not the whole problem. In this post I place the debt issue into the context of the larger American secular cycle crisis.
John quizzed economist William White on whether the debt crisis would be inflationary or deflationary, to which he responded:
The private sector is deeply indebted. In the US, the households have come back a bit, which is good, but looking at it sort of globally, private sector debt has risen enormously. When you look at government debt, it's almost exactly the same thing. It's risen enormously. And in a way, this is how I think of it anyway, if we have real problems on the private sector debt side, that's going to drive us more into the deflationary outcome. If we have problems more on the government debt sustainability side and it's the government that's got control of the printing presses, then you're going to have more likelihood of an inflationary outcome.
Next, he quotes asset manager Felix Zulauf:
…my expectation for the next 10 years is one of major change in geopolitics, in economics, in the way the world is run. I think Neil has laid the groundwork for that with his Fourth Turning. I used to think that we repeat the mistakes of our grandfathers, but it’s probably even our great-grandfathers. What I think is we cannot continue to run the world the way we have run it for the last 30 years. And human beings are lazy by nature, and they try to continue in a way it has worked in the past. And they will only change if they get forced to change. So, I think we will run into several brick walls that will stop the trends of the past and force us to change. And this has to do with fiscal policy, with monetary policy, with geopolitics, demographics changing, etc.
The Neil referred to here is Neil Howe, who, along with the late William Strauss wrote a 1991 book called Generations that proposed an 80–90-year cycle has been operating in American history since colonial times. This cycle was driven by the interplay between distinct generations which they identified and named. For example, they coined “millennial generation” to refer to people born in the eighties and nineties. For about 15 years I used this generational cycle as a framework for thinking about recent American history and where we might be going. One problem with this cycle was it lacked a causative mechanism. The one suggested by the authors did not work when I tried to apply it to reproduce the generations they had identified. I came up with a Mannheim-type generational imprinting model based on ideas I got from a paper on political cycles to forecast the Strauss and Howe generations. This model forecasted a Fourth Turning beginning shortly after the start of the century and ending in the mid-2020’s. None of the major structural issues that are supposed to be addressed in a Fourth Turning have been addressed so far, casting doubt on the concept. I came up with a handful of testable predictions of future events based on correlation between the generations and certain economic and political cycles. These predictions did not happen and by 2014, I concluded it was not valid. More details on this can be found in America in Crisis.
I began to investigate Peter Turchin’s secular cycle concept as a replacement. This cycle has better empirical support that what I was working with before and it has a mechanism that checked out when confronted with data. I published three papers in Cliodynamics Journal, the journal Turchin established to track research in the field, in order to obtain some peer review to validate in my understanding of this new framework.
In 2016 Turchin published his take on how the secular cycle concept applied to modern America. I now use it (with modifications) as the framework around which I structure my thinking about American politics and economy. His analysis was largely based on demographics and did not take economics into account. In a 2019 paper I proposed replacing the demographic mechanism for the American cycle with a mechanism based on cultural evolution whereby business culture shifts between shareholder primacy (SP) where the objective of Business is to maximize shareholder value and stakeholder capitalism (SC) where the objective is to grow the size of your business.
Turchin’s cycle calls for severe political instability in order to rectify the problem of excess elites competing for limited number of top positions in government. During the secular cycle crisis, political instability manifests first as rising polarization (which we have seen since the 1990s) and escalates into political conflict (which we have seen since Obama’s election). The crisis may be resolved through violent conflict, other political crisis such as a coup, or through a nonpolitical crisis. America has previously gone through three of these secular cycle crises. The first two (Revolution and Civil War) were resolved by internal war, where competing elite factions strove to eliminate each other, solving the excess elite problem, while the third was resolved by financial and economic collapse, followed by high-tax economic policy that forestalled the emergence of excess elites going forward. High tax policy was eliminated after 1980, after which a proliferation of economic elites proceeded, leading to the current secular cycle crisis.
A key finding from my work with secular cycles is that excessive debt is another kind of instability that is naturally produced in modern secular cycles. This is in addition to political crises expected from the standard model. The mechanism for debt crisis was proposed by American economist Hyman Minsky. Minsky identifies three distinct income-debt relations for economic units: hedge, speculative, and Ponzi. Hedge financing units are those which can fulfill all of their contractual payment obligations out of their cash flows. Speculative finance units can meet their interest payments from their cash flow, but cannot repay the principal and need to issue new debt to meet commitments on maturing debt. Ponzi units cannot even pay interest from their cash flows and must either sell assets or borrow to meet obligations. Thus, Ponzi units are fully viable only when asset prices are rising. Hedge financing is inherently safe, while Ponzi financing is vulnerable to downward shifts in asset prices.
Over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is larger weight to units engaged in riskier speculative and Ponzi finance. Such a rise in financial risk sometimes culminates in a Minsky moment: “when investors are forced to sell even their less-speculative positions to make good on their loans, markets spiral lower and create a severe demand for cash.” In a Minsky moment, Ponzi units become vulnerable to bankruptcy. Such bankruptcies can trigger a financial panic, for example the failure of Jay Cooke and Co. in 1873, Overender and Gurney in 1884, the Philadelphia and Reading Railroad in 1893, and Lehman Brothers in 2008 initiated crises in those years. All of these financial crises were followed by serious economic downturns. These ideas are explored in more detail in chapter 4 of America in Crisis.
To track the development of speculative and Ponzi finance, I use corporate and margin debt, respectively, as proxies. Figure1 shows trends in these kinds of debt along with what I call enterprise premium, defined as the difference between return on capital and financial return, defined as the greater of real interest rate or real S&P 500 index appreciation over the previous 28 years (i.e. one stock cycle). Figure 1 also shows a measure of stock market valuation on an arbitrary scale where –2 indicates the lowest valuation over the period shown (in 1932) and +4 the highest value (in 2021).
Figure 1. Trends in enterprise premium, corporate, and margin debt, and stock market valuation
Enterprise premium is an indicator of financialization, while market valuation indicates the likelihood of an asset bubble. Between 1940 and 1982 enterprise premium was always positive, meaning investing in growing the business (an SC culture objective) always gave a better return than buying financial assets. During this time levels of corporate debt were low, implying the absence of speculative finance units. Stock market valuation was low (average value of P/R was 0.60 compared to 0.85 afterward), which implies that margin debt was also low indicating an absence of Ponzi finance units. Note the very high levels of margin at the 1929 market valuation peak, consistent with the large amounts of Ponzi units that should have been present in 1929, according to the Minsky hypothesis.
The low levels of speculative and Ponzi finance during the four decades after 1940 implies most units practiced hedge finance meaning little risk of financial crisis according to Minsky. Indeed, no crisis, stock market crash, or any other indicator of excessive market risk occurred. The situation after 1982 was very different. Figure 1 shows the steady growth of corporate debt, and with the rise of high valuations in the late 1990’s, margin debt. The trend shows as SP culture rose in prevalence, the economy became increasingly focused on the financials, and the prevalence of speculative and Ponzi units rose, raising the likelihood of financial crisis as the new century began. First was the tech wreck, which saw valuations collapse and then the 2008 crisis which tanked the housing market and produced the Great Recession. By 2021 market valuation and corporate debt had reached all-time highs while margin debt was at a post-depression high. All the ducks are in a row for another Minski moment (see Fig 2 here for a graph showing measures of political and financial “stress” indicative of intensifying crisis).
Hence, Mauldin and the experts he gathered at the SIC correctly sense that a crisis is brewing. Furthermore, they believe it is necessary for America (and the rest of the West) to resolve the crisis we are in. This is my view as well, though I see debt has just one facet of the crisis. Of course, this was an investment conference so their focus is properly on the financial aspects of the crisis. Neil Howe summarizes their view:
In order to actually balance our budget or just make it sustain…we’re going to have to have huge reductions in both entitlement programs… where all the long-term growth is, by the way. It’s all in entitlements. We can’t cut defense really at this point, and we are going to have large increases in revenues. And probably on top of that, we’ll need at least some large one-term inflation hit to basically do what we did after World War II… getting rid of a lot of our debt simply by inflating our way out of a lot of it before people readjust their expectations. We’re going to have to do all three of those. And what I’m saying is politically, we are nowhere near that ever happening. Our country would right now break in two pieces rather than come to an agreement like that. We’re going to have to be scared into it. And I think this is why crises become actually useful, right? Because they motivate people.
After forty years of wage stagnation, end of defined-benefit pensions, and increasingly unaffordable health care, it seems very unlikely that the American public will accept huge reductions in entitlement programs in order to preserve financial gains by investors. They briefly allude to large increases in revenues, but don’t mention where these would come from, and then talk about inflation. The experience of the stock market crashes in 2008 and 2020 show that the government under SP culture will create money to prevent a deflationary financial collapse, leaving only the inflationary outcome for the debt crisis.
The rise of “Modern Monetary Theory” (MMT), which seems to me to be a rehash of centuries-old ideas about inflation, provides a way to cut through things like using bonds (or platinum coins) in government finance. MMT holds that government spending creates money, just a bank does when it issues a loan. This idea is incorporated into the money balance in my inflation model. This money creation is offset by tax revenues, debt repayment, money exported to fund trade deficits and net flows of money from the real into the financial economy. Some of the created money is converted into real capital, resulting in economic growth, which is handled implicitly by characterizing all flows relative to GDP. The idea is the net balance is directly related to the natural level of unemployment, also known as NAIRU. High values of balance (i.e., net money addition to the real economy relative to GDP) are associated with an inflationary economy requiring higher unemployment to prevent inflation. Low values of balance are associated with a less inflationary economy, allowing low unemployment to be achieved with low inflation.
The curious idea that in the process of operating the government and managing inflation the state should provide a subsidy to wealthy investors in the form of bond interest is a historical artifact dating from the days when European feudal monarchs would borrow money from Italian banks to fund their many wars with each other. The monarchs and their vassals were essentially private citizens, who would borrow money like any other private citizen today, on which they would pay interest, and would eventually have pay back the loan or go bankrupt. As time went on and true states arose in the West, the resulting governments inherited the position of the monarch. As long as the banks from whom the state borrowed were politically independent of the state (as had been the case in medieval times) the situation remained the same, the state was more or less just another customer of the bank. But when the bank is within the jurisdiction of the state, as is the case for the US, then the bank is subordinate to the state. The old loan mechanism continued either because of tradition, or perhaps because economists insisted it was necessary that the government use a monetary system involving the transfer of public money to financiers as a side effect.
The Fed introduction of QE has allowed people to see through this tradition. QE is when the Fed buys government debt from financiers with newly-created money. Over 2009-2012 the government issued about $4.1 trillion in bonds to address the 2008 crisis, while over 2020-21 the government issued about $4.3 trillion to address the pandemic for a total of $8.4 trillion. Over the same period the Fed bought $7.9 trillion of bonds. While the government was selling $8.4 trillion in bonds, the Fed was buying $7.9 trillion in bonds. Wouldn’t it have been simpler for the government to just sell the bonds to the Fed? This, more or less, is what MMT proponents are calling for. It seems to me a low-risk way to test these ideas would be to try it out during the next crisis. The Minsky hypothesis asserts that more crises will he coming given the levels of speculative and hedge finance at present.
Not addressed so far are the inflationary consequences of massive stimulus to address downturns, which only becomes an issue during recovery. For example, during the pandemic, consumer fear of disease and business shutdowns resulted in a peak unemployment of 14.7%. The government spent large amounts of money on economic support payments over this time, which resulted in the economy surging back as businesses reopened, resulting in unemployment recovering to its pre-pandemic low just 30 months after the peak. Compare this to the 91 months required to do the same during the Great Recession, for which too-little stimulus was employed.
The inflationary dynamics of stimulus can be described using the balance model. Figure 2 shows balance and the associated NAIRU for the recent pandemic. The Pandemic stimulus sent NAIRU way up, but the unemployment increase was even higher, keeping unemployment above NAIRU and preventing inflation. High unemployment served the same role as price controls did in WW II to keep inflation low during the crisis. But when unemployment fell below NAIRU in early 2021, inflation began to rise, just as it did after price controls were removed after WW II. Inflation got worse until balance fell back to low levels in 2022, causing NAIRU to drop back to levels similar to what had existed before the pandemic. Fed interest rate hikes (see ST rates in Figure 2) stopped the trend toward lower unemployment, reversing the trend in inflation, and preventing unemployment from falling below the new NAIRU level, which might ignite another round of inflation.
Figure 2. Inflationary dynamics around the recent pandemic
The pre-pandemic economy saw a low-balance, low unemployment economy because large-scale stock buybacks removed money from the real economy. Employing funds for increasing stock market capitalization as opposed to expanding the economy makes sense from an SP culture standpoint because the former will likely increase shareholder value more than the latter (i.e. enterprise premium is low or negative, see Figure 1). Doing this reduces investment into the real economy and thus slows economic growth and weakens national power. By investment I do not just mean investment in plant and equipment, R&D, and other things recorded by the BEA as investment. A more subtle type of investment (and what the economy under SC culture did that the SP economy does not) is cultural investment. This investment manifests as periods of rising real wages for entry-level workers, such as were seen before 1973.
I touched on this idea in my 2000 book on stock market cycles when I was introducing business resources (R), my measure for the amount of capital represented by the market index:
The underlying meaning of R is subtle. Some resources are physical assets…However, most of R resides in the technical and business knowhow of workers. A company in a declining industry provides an environment less conducive to profit generation than a company in a rising industry. The declining firm becomes less able to attract and retain high-caliber employees, and loses R as a result. Companies in rising industries gain increasing numbers of talented employees and gain R. In a way the new employees bring a little R with them when they join a company.
New employees…are an asset (they have some R) that produces a return. Now where did they get this R? They got it as part of the cultural transmission they received from the previous generation. The quality of this transmission is a function of the richness of the cultural milieu in which this worker was raised. The richer the milieu, the more R. As a result of the accumulation of past retained earnings, companies grow and pay increasing wages to workers, which makes society richer over time….
For example, today’s autoworkers and other old-economy workers have reared a generation of computer-savvy children that will be real assets for the companies of the information age. They were able to do this because they worked in an environment (created by decades of accumulated retained earnings in the auto industry) that provided a higher standard of living than their parents had growing up. This higher standard provided a richer cultural experience for their children than the experiences their parents were able to provide for them. Hence, retained earnings by the auto companies produce R, which shows up in the workers of the next generation. If the car business remains strong, they will continue to attract the savvy workers of the younger generation and will keep the R they created through retained earnings. If not, the young workers will go elsewhere and take the R with them.
So, R is not conserved within an individual company. Companies on the rise can pick up “free” R, (i.e. R created by the retained earnings of other companies) while those in declining industries will lose R. On a society-wide basis, as long as there is a rising tide of cultural transmission to new generations, R is conserved.
The R measure assumes that retained earnings are reinvested back into the economy, producing more R, which then leads to a more capable, R-rich, population. The phenomenon of rising average IQ over time (the Flynn effect) is possibly an example of this process of cultural accumulation (see chapter 7 of America in Crisis for more on this). Another word for this is economic development, and it is most effectively pursued under SC culture. In contrast, the SP economy we have today doesn’t do this. It is not designed to efficiently use labor resources, consigning millions to rot in decaying inner cities and industrial towns. This is expected because the objective of economic activity it to raise market capitalization rather than economic output. But in a world with rising hegemonic challenges, can the US afford to maintain an economy optimized to create higher market capitalization, rather than the production muscle needed to underpin national power?
If we wish to have something other than a system for building “ziggurats of finance” as I put in in America in Crisis, perhaps something more like a restoration of the national greatness we saw in the aftermath of WW II, then we need to retool our economy to achieve this. We need to shift back to SC culture, with its emphasis on output rather than financial value. This would entail investment in real economic growth rather than stock buybacks. But those stock buybacks are what drain excess dollars from the economy and the inflation they would otherwise engender, according to the balance model. To make this work requires than something replace these buybacks. This is taxes, levied primarily on the wealthy and affluent classes. Thus, in order to prevent post-crisis (or postwar) inflation under SC culture, high taxes on the wealthy are required. Curiously, high taxes on the wealthy are also required to evolve SC culture in the first place.
This is what happened during the last secular crisis resolution. Taxes were raised in 1932 in bipartisan fashion to address post-crisis inflation. Further tax increases were enacted to deal with wartime inflation. The sustained high tax rates had evolved a significant amount of SC culture by 1940, which under the massive stimulus for WW II, led to an SC postwar economy. As I showed previously, the inflation that would otherwise result from WW II stimulus was forestalled by wage and price controls for the duration of the conflict. After the war, inflation appeared and persisted until Balance dropped back to a level consistent with a NAIRU around the same level as current unemployment.
What this analysis suggests is policymakers have a way to deal with inflation following stimulus in response to financial crisis or a war in an SC economy. Not only that, but by making use of “internal finance” (selling bonds to finance stimulus to the Fed rather than the public followed by Fed QE) the public debt crisis feared by the SIC Conference can be forestalled. As for private debt, the only way to deal with that is a cultural shift to SC culture. Doing these things would require major tax increases.