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Debts, more debts and even more debts

by on 06/05/2020

It’s not obvious what economic impact Coronavirus will have on the global economy and the financial system. What seems already clear, the immediate economic policy will be an additional increase in the national debt as rate from GDP in all the major economies, US, EU, and China.

The global debt had grown in increasing scale in the last 10 years since 2008 and more than doubled itself as percentage of GDP. To make the economy run again, after the 2008 financial crisis, the governments were forced to reduce the interest rates to zero and sometimes even to negative values, while buying out the government bonds and securities. (To this act of central banks was given a nice name, Quantitative easing). This act means transfer of government debts from private entities ownership back to central banks and Federal reserve bank. It also means exchanging government bonds ownership of private entities to cash money, a more liquid form of financial instrument.

The table below represents debt in percentage of GDP as of year 2019 divided between public, households and corporate debts of major economies.

        Government  Households  Corporations

US   107         75             75

Euro     82         58           108

China     50         54           151

Japan   220         59           102

https://rodeneugen.com/2020/04/14/deficit-does-it-really-matter/

While in the Euro area the public debt rate to GDP since 2013 started to decrease, in the USA the public debt increased by 50% since 2008, and continued to grow.

The basic principle of debts is that it includes expectation of repayment. If this principle is invalidated, the lender-borrower relation may be fundamentally disrupted. Lenders who are also the savers, are legal entities, individuals or companies, with faith in preserving the promised future value on their savings,  

The savers can hold financial assets, as cash money, money deposited in financial institutions, (banks  insurance companies, etc.), corporate shares, bonds and other securities, etc.;

or alternatively real assets, as privately owned companies, real estate, rent generating intangible or tangible assets, brands, market shares, etc. The agent representing the value of the assets is cash money, that is financial asset in its most liquid form. Cash money is always the exchange value agent at the act of sale-purchase. The institution keeping the money as its trusty to the act of  transfer, are the commercial banks and other financial institutions. If they fail to fulfill their promise, they will cease to exist. If all these institutions stop to function, the whole system based on trust will collapse. 

The lender-borrower relations have two leads, one moral-political, and two economic. 

The moral concern is about fair relations between borrowers and lenders, that means, the money borrowed to any institution, be it government, financial institution, private company, or private individual, will be used in a way, to support fulfillment of contractual obligation to the lenders. The lenders are savers, many of them employees, their income is wages, whose savings are mostly in pension funds. Against them are standing the businesses, taking loans from banks, or raising money by issuing bonds. Yet, often wrong business decisions, or sudden unexpected change in economic circumstances may cause bankruptcies of borrowers. On the other hand, if the borrower is a big company, the borrower-lender relation, based on assumption, that debts must be repaid or huge personal price is to be paid by the owner of the business for defaulting on debt repayments, is many times violated. The bailout of big corporations issuing bonds that fail to fulfill their obligations, breaks the relationship between a business decision and its consequences. Such a development may break down the relationship between reward in form of money and productive labor, which could lead to collapse of the existing economic system and with it the political system too. It can also cause collapse of the existing socio-economic network. If these moral or economic  principles of lender-borrower relations are substantially disrupted, this may cause the end of the existing monetary system.

Will it happen? If yes, when will it happen? How will it happen? what will the alternative be? No one can predict.

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Increased government debt and commercial banks credit means increased volume of money in the economy. Debt of businesses to commercial banks, and accumulated government debts covered by treasury bonds and securities held by central banks, stand against money, accumulated in the monetary system as bank deposits, or cash money. It also means, when the central bank purchases on open market government bonds, it adds to the monetary system additional cash money.

By contrast, bonds issued by private company, transfer money from bank deposits of bond purchasers, to the bond issuing company, and it does not add new money to the monetary system. If the money borrowed by corporations is used not to increase the corporation’s production capacity and its economic vitality, to secure in the future bonds and loans repayments, but rather to buyback shares of their own company, or to pay bonuses to the executives and/or dividends to the company shareholders, it is transfer of resources at the expense of the savers and may create insolvency in the future. If many corporations are implementing such a policy, the whole system of corporate liabilities as debts or bonds is endangered. 

Private corporate bonds do not add money to the monetary system, they transfer it from one hand to the other, but once the federal reserve starts to buy out corporate bonds, to resque corporations from liquidity problems, it will increase the government deficit, translated to accumulated public debt. This also means additional money in the economy. 

The question is, should we be worried about this additional public debt and cash money in the economy. In the last 10 years, such a policy didn’t increase the prices of consumer basket. (It increased the prices of value holding assets, as shares and real estate.). Will it continue to be so?

If before the pandemic the US government debt was about 23 trillion US dollars, growing at an annual rate of more than 1 trillion US dollars, against US GDP of 21 trillion dollars. At the end of 2020, the GDP will probably drop below 20 trillion US dollars. This also means disappearance of the profit of the businesses. The huge rise of unemployment to levels of close to 20%, means decrease in wages. All this means decrease of national income, and with it decrease of government income from taxes. All this will happen at time of skyrocketing government spending. 

The US government declared an increase in its spending by more than 2 trillion US dollars and it is far from the end. To add to it the expected decrease in tax collection, the deficit for the year 2020 in the US will be probably more than 5 trillion dollars. To add to it the GDP decrease, and the US public debt at the end of 2020, will be well above 100% of the GDP, the limit the congress tried to apply during Obama’s presidency. The same trend, even if more moderate can be expected in Europe. China, where most of the debt before the pandemic was of private businesses and corporations, and since their production capacity will have to compete in shrinking markets in US and Europe, it will need help from the government to save them and with it the Chinese economy. the Chinese businesses’ debt will need to be bailed out by the government. This means swapping the Chinese businesses debts to government debts, as it already happened in the US and Europe, after the financial crisis of 2008. 

This process means, the deficit is accumulating as public debt, mostly in form of treasury bonds and securities. At times of recession to secure enough financial liquidity in economy, and to decrease the interest rates, the central banks are forced to repurchase these treasury bonds and securities in exchang for cash money, newly printed and flooding the monetary system. 

This is Japanisation of the debts in the major economies, meaning by the end of 2020 probably the public debt of the big economies will be well above 100% of the GDP, and closer to 200%. 

In nominal numbers the total GDP of four major economies is close to 60 trillion US dollars, it means their public debt will be close to 100 trillion US dollars and more. These 100 trillion dollars, have the other side of the coin, liquid financial resources in ownership of private households, non corporate or corporate businesses, financial and non financial. This amount will be in some form or other deposited in the commercial banks, or other credit institutions, and will potentially multiply as credit. 

This change in the debt structure and financial variables started after the financial crisis of 2008, when the  Federal Reserve bank and other central banks, to save the economy, overflooded the financial system by excess liquidity. To do so, the central banks used an unconventional policy, called “Quantitative easing”, meaning purchasing government bonds on the open market, and increasing their price, that causes decrease in interest rates on these bonds. This also meant that the central banks printed additional money to purchase these bonds. The commercial banks, where the additional money was accumulated at first, didn’t expand the credit to companies as expected, but they rather took a more cautious stance, piled the liquidity added to the system, and deposited it back in the central banks and Federal Reserve as excess reserves. 

Excess reserves is the most liquid form of money, and as such it is unpredictable. The only way to neutralise this pile of financial liquidity from unexpected fluctuations and high volatility, is to pay interest on these commercial banks deposits in central banks. This policy started to be implemented since 2008. With every new wave of government deficit, and new money printed. The need to be absorbed back from the commercial banks this excess liquidity, the central banks are forced to increase the interest rates on these deposits. 

Since excess reserves are with no risk factor, (the central banks, the depositors can always print new money) the interest rate on this deposits became the bottom interest rate on credit of the system, and one of the major tools to influence the cost of the credit price in the economy. On the other hand for depositors it became the top interest rate, the banks are ready to pay on deposits. As represented in the following chart, the total credit to non financial sector in US, dropped since 2008 from 170% of the GDP to about 150%.

From the side of the savers, low interest rates caused value dilution of savings, among them the pension funds and mutual funds, that are forced to invest in more risk taking assets, among them higher yield corporate bonds. It also caused swap from credit financing to other form of financing. From the side of the borrower, the low interest rate caused waste and misuse of the available credit. The best example are the shares buyback of the public company shares and bonds, that have driven their price to sky, financed by increased debt of the nonfinancial corporations.

https://images.app.goo.gl/thq4nCepfqsxR8A28

In 2008 the central banks and the FR, rescued the economy by purchasing government securities, increasing their price and reducing the interest rates by it. In 2020, because of the limit of negative interest rates, and lack of government treasury bonds on the open market, the Central banks will have to purchase corporate bonds. This will have a significant impact on the real resources allocation, and macroeconomic price will have to be paid for such a policy. Big companies will be supported to issue corporate bonds, as much as possible, without considering the aim of these emissions of bonds, while their price will be secured thru instrument of bailout. It necessarily will change the composition of monetary resources used by investors in the real economy.

A differentiation has to be made between two kinds of investors, the financial investors, that invest in financial assets, as bonds, securities and shares, and real investors, investing in production capacity to supply goods and services to the consumers and their subcontractors. 

———-

Governments, that are afraid of the collapse of the financial system, prefer to inflate the public debt, with every new crisis, to avoid collapse of a major financial institution, that would repeat the situation in 1929, at the time causing unemployment rate of 25% in America, without a social security system, that exists today. 

The metamorphosis of debts from private sectors, be it financial institutions or non financial institutions, to public debt, throughout the process of bailout of these institutions by the government or its affiliate, the central banks, means nationalisation of the debt. This anomaly of public debt and private assets as collaterals makes differentiation between those who have access to loans and those who have not.

The experience shows us, at the times of big debt crisis, only the small debtors must repay their debts, while the big debtors are relieved from their liabilities. The term ” too big to fail”, is reality, that proves to be the rule again and again. It gives advantage to big businesses upon middle and small size businesses, that usually are more flexible, adoptive, innovative and responsive than the big corporations.

As explained above all these processes will cause an unprecedented increase in public debts of all the big economies, that on other side of the coin mean more government treasury securities,  that partially will be purchased by the central banks against cash money injected into the monetary system. As explained above, the expected public debt in the major economies will be very soon about 100 trillion US dollars, or close to 200% of their GDP. This also means liquid financial resources of the same amount, in the form of money deposited in the banks or in form of government treasury securities. 

What does public debt of such level mean? Is it significant? What does such an unprecedented level of sovereign debts in sovereign currencies actually mean? Is it sustainable? 

Since money based on debt depends on the faith of the population, the answer lies in this trust, that is dependent on human behaviour, and as such it is unpredictable. The faith in certain currencies, as the US dollar, Euro, British pound, Swiss franc and Japanese Yen, are independent from any economic reality. The major common factor of these currencies is that the sovereign government with the right to issue them are all democratically elected, and their legal system is supportive for protection of the right for private ownership as one of the most important values. On the other hand, countries that have a tradition of disrupting the ownership right, their currency value is many times unsustainable. A very good example is Russia, and China.

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The main question is, how will the world economy come out from the economic crisis so abruptly blown up because of the coronavirus. 

There are two substantially different approaches, one is through increased competition,  and the strongest will survive.  (Strongest but not necessarily the best). The other way is through mutual solidarity on local and global level.

Several trends can be observe in policies implemented by now, and are expected to get increased momentum;

  1. The debts are growing and there is no other way to reduce them, but by hyperinflation that will degredat the savings values, and enrich the borrowers. Yet hyperinflation happens under two conditions:

a. It is always a local phenomenon, in a country with sovereign currency. For example not in Greece (using Euro) and not in Ecuador (using US dollars), whatever economic conditions prevail in these countries without sovereign currency, no inflation occurred since they adopted reserve currency as their own.

https://fred.stlouisfed.org/series/FPCPITOTLZGECU#

b. Hyperinflation occurs only if there is less aggregate production capacity than aggregate demand.

c.  It can’t happen to a country with currency that is accepted as reserve currency, or currency used for international commerce as the US dollar, unless the world production capacity of certain substantial commodity, without alternative is limited. That’s what happened to US dollars and other currencies in the early seventies, when the oil producing countries limited their production and caused huge hike in oil prices.

d. Hyperinflation degrades the value of savings, causes disruption in commerce and causes bankruptcies of otherwise healthy businesses with efficient production capacity, but with not very good financial management. 

  1. The Federal Reserve and the Central Banks are in process of nationalising at first government debts, then probably will follow the corporate bonds, and maybe even the private household mortgages, and then other forms of loans, such as student loans, and corporate credits.
  2. The nationalisation of debt means adding additional money into the financial system, that reduces the demand for credit, accumulates from the bank perspective unusable deposits in the commercial banks, that are as said above deposited in central banks as excess reserves. 
  3. The minimal interest rates on credits are not anymore decided by the market, but administrative decisions of the central banks. This makes the interest regulated and disconnected from the demand and supply of the money. The side effect of this may be unnecessarily high interest rate, in case of recession, while the demand for credit is decreasing and vice versa. The banks eventually may lose their sensitivity to what happens in the economy and in the markets. 
  4. The extremely low interest rates set by the Fed are disproportionately benefitting people with appreciable assets. What we’ve got right now is effectively subsidy for corporations and big businesses, with collaterals to secure loans, whereas no income for self employed businesses, their business is based on continuous supply of goods and/or services. 
  5. The continued US trade deficit is the result of the low saving rate of the US government and the US households. There were years, when the US net saving rates were close to zero. On the other hand, countries with high surpluses such as China and Japan, have also high saving rates. The result is much higher consumption level in US, if compared to China, and Japan.

 To balance this uneven, and on a way unjust situation, a new kind of cooperation has to be created between the US and these countries.

  1. The  increasing income gap between the rich, and the poor, between those who have access to borrow cheap money, and those who have not such access,  while the borrower is becoming rich, the saver who gives loans is getting poorer. The major cause of the increasing inequality between the rich and poor, seen in all the indicators, is caused by the policy of Quantitative easing. Even if the helicopter money goes to the poorest, at the end, it will find its way through the bank loans of commercial banks to the hands of the borrower, who are the collateral owners. 
  2. Such imbalances in income are unsustainable politically, and bring at the end political and social disruptions, in form of radicalisation of the masses, who feel to be left out of the party. 
  3. Other result of government deficit is too much volatility in the financial markets, that influences the performances of the real economy.

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So what can be expected after the coronavirus pandemics will be gone?

The modern so-called “capitalistic” economy is based on network of commercial relations, enabling transfer of goods and services between every element of this network against easily transferable tool, representing equivalent value to the price of the good and/or service transferred. The participants of this exchange need to have faith in the agent, enabling evaluation of products on the market, the money. Money has to keep its fixed exchange value and the participants of the exchange have to believe it will keep its value. 

The strength the US dollar represents, is not about the money itself and its objective value, but the economic activity, the US dollar can generate. While a local currency can generate only local activity, reserve currency as the US dollar can generate activity world wide. This position of US dollar came to existence after WWII, when no other country could compete the US with its economic strength, to supply all the needs of the world, totally impoverished by the war. At present 75 years later, the US dollar still represents this strength, but decades of mismanagement of US policy, that resulted destruction of the fabric of voluntary cooperation of the US society, intensified since the collapse of USSR, the ultimate enemy, the stratification of US society and politics has deepened, to unprecedented level. The main danger of the Corona virus is not production capacity of commodities or services, that remained untouched since before the pandemic outbreak,  but the breakdown of the social economic network, on which the supplier-purchaser relation is based. This breakdown can be caused by disruptions in the monetary system, too high concentration of financial resources, and bankruptcies of essential chain in the economic networking because of temporary difficulty, creating unsustainable situations for a whole range of entrepreneurs.

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