Deficit Financing: A problem

 

Thoughts are blossoming in my mind about a connection between prior outcomes and likely future outcomes that find similarities between the housing market boom/excess, the central bank QE efforts to add liquidity and boost prices, and the emerging global initiatives by governments to take on additional debt for military and infrastructure projects.  History seems to indicate that there is an existing and growing level of risk in the system that is not reflected in the financial markets.

During the 2004 thru 2008 timeframe, securitization of debt obligations emerged in a way that was marketed to investors as containing minimized risk in obtaining outsized returns.  This fed liquidity and encouraged investment bank demand for greater supply to meet investor desires for higher returns with low levels of default risk.  The supply was provided by new mortgages to finance an ever-increasing amount of housing demand that was being driven by free/low cost financing of homes.  Many of the new buyers had insufficient incomes to purchase a home, but the need for more mortgages to meet investor demand for securitized mortgage packages caused the banks to lower the income requirements thereby bringing greater levels of buyers into the market.  The new buyers’ income levels could not support the home price without ever increasing access to debt to fill the gap of price to income.  The growth in mortgages fed the debt securitization machine, and was further exacerbated by the selling of “insurance” on debt defaults to buyers who had no risk of principal on the debt being insured.  All of this low-cost financing that mispriced risk ultimately turned out very badly for the world.

The parallel that appears to be taking place today scares me in that if it continues to expand in an unchecked manner we will find we have a larger problem then we had in 2008.

Central banks across the world have used monetary easing policies to avoid debt defaults and economic contraction.  These policies have resulted in the Central Banks becoming the buyers of the debt issued by the governments of the world.  Market pricing of risk is absent as there is in the market a committed buyer at any price with unlimited access to money through the ability to print paper currency (actually, digital currencies), and to use this printing to buy all of the debt the market chooses to not buy, holding interest rates down in short term maturities and creating demand in the market for longer term maturities at depressed rates.  The duration of debt, the life of the debt, being held by market participants at historically low rates of interest create price/principal risk to the owners that could be crushing if global interest rates rise.  Think about this in terms of the similarity in the explosion in U.S. mortgage debt outstanding in the mid 2000’s and the explosion in U.S. government debt post-2008.  In the United States, government debt over the past eight years has grown by approx. $10 trillion (a doubling of debt from 2008) similar to the U.S. Residential Mortgage debt that doubled between 2001 and 2007.  Add in the rest of the world’s issuance of ever increasing levels of government debt and we are awash in liabilities that are at a level that has never existed before, and this debt is being priced at low interest rates as if no or little risk exists, just like the housing market priced mortgages.

The post 2008 debt growth increased asset prices in stocks, bonds, and in many physical assets.  This is similar to the way in which housing prices rose in the mid 2000’s based on the low cost to finance and easy access to excess credit availability.  The current increase in asset prices has not occurred in an environment where incomes are expanding.  In effect, the debt purchases by the Central Banks are filling the void that income cannot fill in supporting price increases.  At some point, the level of debt will reach a critical and limiting point of excess unless incomes and GDP growth expand rapidly to justify the asset prices we have today.  The answer to the question of where that income expansion is going to come from is paramount to the avoidance of a price correction lower.  Absent a rational answer that indicates favorable odds exist of realizing sufficient income growth that will rebalance the fundamental relationship of earnings to price, there exists a much higher risk in buying assets at current prices than the market is anticipating.

The outlook for future debt expansion after an incredible growth in debt over the past decade is troublesome.  The only way the US can finance the level of infrastructure investment and military expansion that is being contemplated is to take on an ever-increasing level of debt.  The hope or plan is that by deficit spending we will drive economic expansion and income growth.  However, our starting point of existing debt is problematic to the efficacy of filling the current income price void with more debt in the hope of accelerating future income growth.  We are entering the Catch-22 phase and that is scary (need more debt to generate more income, with new income being consumed by the interest cost of the new and old debt vs new income enabling new investment to drive additional new income sources).

During the past eight years, we have increased annual Government transfer payment to the population of the US by $800 billion per year (now over $2 trillion annually), which has cumulatively added to our national debt during this period by an incremental $2.9 trillion.  That increase to our debt served to provide financial support to people in need versus investment in productive assets (no political point of view on this, just simply stating facts).  Going forward the $2 trillion in annual transfer payments will continue to add to our debt before any impact of additional deficit financing for new investments.  The continued growth in the gap of our spending to income is troublesome, and the more debt incurred without an acceleration of income poses higher systemic risk to our economy and a meaningful potential decline in the value of the dollar.

The risk to the value of the U.S. dollar is simply a story of supply and demand.  The additional supply of currency coming to the market that will be created by financing our existing obligations such as interest payments and transfer payments, plus the new infrastructure and military investments, will debase the U.S. dollar’s value in terms of purchasing power given the lack of income driven investment growth by the private sector that is needed to serve as an incremental demand factor for dollars.  This will ultimately stall the power of the economy and lead to stagflation and levels of government debt that are not serviceable from tax receipts given the lack of income growth.

We and the world have a problem, and the lack of global growth coupled with deficit financing and Central Bank buying of governmental debt will one day reach a point where default is the only available path.  It will be a very bumpy ride when we get there, and being prudent with investment decisions will one day be rewarded.

Author: Thomas Connolly

Tom possesses a rich and diverse background that includes deep investing experience, senior corporate executive positions, and roles as a Regional Managing Partner and Global Industry Leader within Ernst & Young. He has advised executives on some of the largest acquisitions and dispositions in the Media and Entertainment industry, including clients such as Comcast, Citibank, Sony, Dalian Wanda and Publicis. Tom is a Certified Public Accountant with a Masters Degree from Columbia University. His skills are further accompanied by a personal passion for the study of economic trends and evolving market dynamics.

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