According to the US Government, its debt stands at $35.210 trillion having grown 57% in the last five years. As the chart below shows, there was a big step up in early 2020 due to Covid. But subsequent attempts to control the deficit and therefore indebtedness have been absent.
This article looks at the dollar’s debt trap, which despite being the greatest threat to the entire fiat currency based monetary system has attracted little notice from the financial media and investment commentators. Furthermore, the mechanics of a debt trap are poorly understood. It is timely, because with signs of America’s economy slowing down and formally reliable recession indicators such as the Sahm rule being triggered, the Keynesian response is for the government to increase spending to support the economy.
The US Government’s debt to GDP is already at 130%, a record. In the wake of WW2 it stood at a high of 119%, falling to 31% by 1974. That the 1946 peak is now surpassed by excessive peacetime spending goes generally unremarked.
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There was certainly more spending control in the three post-war decades. Nevertheless, Federal Government debt rose by 41% while GDP grew by 240% and the debt-to-GDP ratio fell.
Mainstream economists miss the crucial point, which is that excess government spending (the budget deficits totalled $144 billion between 1969—1974) did not lead to prices rising sharply. The reason is simple: the Bretton Woods gold standard stabilised CPI prices which increased on average by about 2% annually between 1948—1970. But something had to give, and the disparity between government deficits and price stability led to the erosion of US gold reserves, finally reaching a crisis in the late 1960s when the London gold pool was established and failed. Finally, in August 1971 the Bretton Woods arrangement was abandoned along with all anchors to the fiat dollar’s value.
Without the stability of a gold standard, inflation and bond yields would have been far higher, a situation which is developing today rather like it did in the 1970s. And with continuing budget deficits and consumer borrowing, the hope that inflation has gone is a triumph over experience. That is bad enough, but the consequences for government debt have been nothing short of catastrophic.
As a cast-iron rule, to stop a drift into a debt trap the growth in income must be greater than the growth of debt. At the national level, income growth can be taken to be growth in GDP as proxy for growth in tax revenue. Courtesy of the gold standard, that was the situation between 1936—1970, as described above.
The results for the US Government since the turn of this century are shown in the chart below.
Positive figures above the pecked line represent an alleviation of debt trap conditions, while negative ones below the pecked line show their intensification. The debt consequences of the Lehman crisis and covid shutdowns are clearly demonstrated, as one would expect. But today, the acceleration of debt creation in a low-growth economy is already dragging the government into a debt trap again.
We might think of the debt problem as relatively recent, though it is already a phenomenon of the last two decades. Funding it in the past has not been too much of a problem, because of foreign demand for the dollar as a reserve currency. But the next chart shows how this appetite has failed to match the expansion of federal debt in recent years, with the portion owned by foreigners falling from over 48% to just under 30%. The burden of funding is increasingly borne by domestic institutions.
The reliance on foreign funding still depends on foreigners being net buyers, but the two largest, Japan and China have turned sellers for different reasons, making it progressively more difficult to fund the deficit.
To be noninflationary, domestic funding must be matched by an increase in consumer savings. The next chart shows how net savings, while volatile, have collapsed in recent years. Even at their peak, they were not even close to covering the deficit, let alone funding the spendthrifts among them.
In the Bureau of Economic Analysis, which is the source of net savings statistics, net saving is defined as “A measure of the saving that is available for adding to the nation’s net stock of fixed assets and for lending to the rest of the world.” Simplistic, maybe, but it serves our purpose of visualising the degree of stimulus behind price inflation, because loan demand in excess of savings for unproductive purposes (i.e. government and consumer borrowing) is inflationary: not only can this be proved by reasoned analysis, but it is confirmed by economic history.
The plunge in savings at a time of high levels of nonproductive borrowing simply undermines the purchasing power of the dollar, which means that in time interest rates will rise to compensate. The Fed’s Jay Powell’s belief stated at Jackson Hole recently that inflation is effectively done and dusted and that interest rates can now decline is simply wrong. Pursuing that line will undermine the dollar, already evident, making foreign funding of the deficit even less attractive.
This is the second lesson of the debt trap, making it clear that debt is a problem that cannot be inflated away. As the debt trap begins to scare off the marginal buyers of US Treasury debt, it will become progressively more difficult to fund. It is simply a matter of excess supply over demand. Not only is the expense of funding new debt going to rise, but there is the increased cost of replacing maturing debt.
The problem for foreign holders of US debt is wider than just US Treasuries, because they also have bank deposits, commercial debt, and equities altogether totalling about $32 trillion, over four times their holdings of government debt. For this reason, in his recent speech at Jackson Hole Jay Powell was playing with fire when he pivoted from controlling inflation by maintaining current levels of interest rates. The consequence is a weakening dollar, already evident on the trade weighted index:
This chart’s bearish message is clear: the process of foreign dollar liquidation is about to hit the markets. Domestic US investors have yet to catch on to this danger but are sure to in time. Initially, there is likely to be a portfolio switch lowering equity exposure in favour of bonds, but that will be insufficient to address the funding issue other than on a short-term basis.
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In the mid-seventies, this was similar to the situation faced by the UK which led to a collapse in sterling, an IMF rescue package, the Labour government forced to balance its budget by the IMF’s loan conditiions, and 15%+ gilt coupons. In this position today, the dollar is offered no such comfort, if comfort be the right narrative.
Whether the Fed institutes a new programme of QE is irrelevant. In the absence of budgetary discipline, the only way a slide in the dollar triggering massive capital outflows can be stemmed will be to raise interest rates, almost certainly dramatically and eliminate the budget deficit. Raising interest rates coupled with a balanced budget might protect the dollar, but it will collapse all subordinate dollar credit values from bank loans, to term debt, and to equities.
As a solution it is simply inconceivable.
Eventually, the Federal Government will have to face the reality that its profligacy will be the reason behind the collapse of the entire fiat currency system, because with the fiat dollar dominating the financial system it simply will take down everything else.
A word to the wise: get out of all forms of credit!
Reprinted with permission from MacleodFinance Substack.
