Peak Debt

There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved. - Ludwig von Mises

The Government Bubble has burst. This is the last bubble, after housing (2005), stocks (2007) and commodities (2008). The Tea Party spirit has infected concerned citizens worldwide as part of the Global Political Awakening, a term coined by Zbigniew Brzezinski to describe the effect of technology (television and the Internet) on the global community. The awakening has been a reaction to transnational elites and manifests in many ways locally. In the West it is leading to a pullback from stimulus and a return to fiscal austerity. 

The recent G20 meeting was a repudiation of Obama's call for more stimulus. Before the meeting, Geithner revealed the US agenda, to encourage the rest of the world to stimulate so as to improve US exports. After the meeting, although Obama tried to spin it as a success, the G20 communique roundly rejected any further stimulus, with a target of halving deficits by 2013 and reducing debt-to-GDP levels by 2016. 

We are all Greece now (see picture): austerity measures are being put in place well beyond Ireland, Greece and Spain, and now include the UK, Germany and France. The German efforts are focused on more than deficit reduction; they plan to cut spending as well as debt. 

China has been tightening for a while, and the effects are beginning to be felt: slower car sales, softening manufacturing, beginnings of a collapse in property sales, and rising risk to Chinese banks. The Baltic Dry Index, which measures ocean shipping costs and is driven by Chinese activity, has continued to fall: down over 50% and falling for 31 consecutive sessions. It is now back to March 2009 levels and seems headed to the generational lows of the Lehman crisis in Sep 2008. 

Even the lone holdout, the US, is having difficulty pushing the Stimulus Agenda forward. The Senate blocked Stimulus III and seems unlikely to bend. The House has tried a Stimulus Lite bill to extend unemployment through November (mid-term elections - get it?) but that too is likely to fail in the Senate. 

The US may still pass the financial regulation bill (FinReg), although even that is a bit uncertain with the passing of Senator Byrd, Democrat. (And in a truly odd moment where politics make strange bedfellows, or perhaps he just has a tin ear, the first Black President, Obama, spoke at Byrd's funeral, even though Byrd was notorious for being a leader in the Ku Klux Klan and for leading a filibuster against the 1964 Civil Rights Act.) Despite characterization as a major change in regulation, so far the banks which are TBTF seem to be unconcerned. The FinReg bill has been denuded of most of the major changes (eg. derivatives, proprietary trading), turning it into vacuous soundbites without teeth. 

The FinReg bill will have the perverse result of further freezing credit to consumers and small businesses. Instead of setting rules, it primarily sets up new regulatory bodies who will take several years to promulgate new rules. Community banks and business credit to consumers is expected to stay frozen during that period, exacerbating the credit crunch that is stifling the growth of American business. 

There was some recent blather about an improvement in consumer credit, but this was due to a new reporting requirement, not any change in the real world. (Tea Partiers like to describe the government as incompetent; but it is also ceaselessly dishonest.) As this chart from the Fed shows, consumer credit continues to fall:

 

A report today on consumer credit was stunning: it fell in May by $9B, almost $7B more than expected; and that blather about a rise in April mentioned above was revised from a $1B rise in April into a $15B drop instead! The apparent flatlining seen in the chart above did not happen; instead we kept falling and the April flatline at the end of the blue line is now a huge drop. Consumer credit is back to March 2007 levels and has fallen for 18 of the past 20 months. The only holder of consumer credit which had any growth was .. (envelope please) .. the US Government. Once again all that is going on this economy is government life support, and that is no longer capable of withstanding the drop in the private sector: 

 

Karl Denninger dissects this report into charts that show consumer spending broken into revolving (credit cards) and non-revolving (cars, etc.). The YoY drop is revolving is quite steep:

 

The drop in overall consumer credit of both sorts is also clear:

With Peak Debt comes the spectre of deflation. Since credit (debt) creates money, a tightening of credit and lack of lending can lead to a fall in money aggregates. The FinReg bill combined with the shrinking of debt worldwide will shrink the money supply as well as lower the velocity of money. The money supply has been growing slower, and on some measures actually shrinking; Peak Debt might send it negative on all measures. This is the formula for deflation. The Keynesian Cheerleaders such as Krugman are oh so worried about it now that we are hitting Peak Debt.

There is confusion around the Fed's emergency measures last year which created a $1T increase in bank reserves - why isn't that hyper-inflationary? The Fed has patiently explained what they did but this seems to be largely ignored in the blogosphere, and so this 'hyper-inflation!' meme keeps circulating. At the risk of grossly oversimplifying, consider that one of explosive risks during the Fall of 2008 was inter-bank lending. A lot of checks wing back and forth between banks, and rather than physically move cash reserves around, they lend to each other. With Lehman cratering, the risk of counter-party insolvency loomed large. If some banks went under, all those inter-bank loans with them would go down too. In order to keep the checks circulating, the Fed used various methods to assume the inter-bank risk, creating reserves in the Fed but not creating new money - simply assuming existing liabilities. (This is not inflationary, simply prudent central banking.) Money of Zero Maturity (MZM) jumped $1.5T, but total debt did not - instead it peaked at $53T just as the crisis hit and began declining on the Fed's moves:

 

A little broader explanation (than just inter-bank lending for checks) of why the new reserves created no inflationary spike  is as follows:

How is this possible? It's a direct consequence of the massive intervention by the Federal Reserve: it took problem loans and structured bonds onto its own balance sheet, removing them from the likes of Lehman, AIG, Bear Stearns. In exchange, the central bank essentially "printed" money, i.e. obligations of the US federal government. Many of those bonds have since proved to be worth a lot less than the money printed in exchange, and many of them are entirely worthless.

The increase in MZM in 2008-09 was $1.5 trillion, the same as total debt. Net-net, therefore, zero. Obviously, no 10X multiplier effect came into play here, since the Fed's money went to replace debt gone bad and not as high-powered money to make fresh bank loans.

The US is about out of weapons to throw at deflation. The final play is more quantitative easing (QE) where the Fed buys up Treasuries and other financial assets, putting fresh money into bank accounts of US agencies. A target of $5T is being bandied about. Not all Fed directors are on board to set sail on QE2. 

The problem with QE2 is the marginal productivity of debt makes it of limited if not negative value. I have posted versions of this chart several times, and it shows the same phenomenon: for each new $ of debt, we get less and less increase in GDP. We are now approaching a point of no return, where we get zero improvement for every $ of debt. If you ponder this for a moment, you realize we could borrow ourselves into a hole so deep only default would get us out: more debt with no increase in production to pay for it.

With the Fed's QE1 a sinking ship, how would they do QE2? Ed Harrison speculates they would Federalize the muni market to keep our Greeces afloat (Cal, Ill and NY in particular). The Fed has already tried QE with Treasuries, MBS's from Fannie and Freddie, and similar agency paper. 

QE2 would also mirror what is happening in Europe. The ECB is buying sovereign debt to bolster its Greeces, and although its stated policy is to sterilize those purchases by selling Euro bonds (buying sovereign bonds puts money into the system; selling bonds sucks it back up), it has had at least two failed auctions where it couldn't sell enough to cover its QE purchases. This may be its policy, disguised to avoid spooking the bond vigilantes; or it may reflect diminished appetite for Euro bonds. The Bank of International Settlements put out a warning about QE, that trying to cushion austerity with purchases of bonds to keep rates down risks continued speculative bubbles and misallocation of capital.