In 2008, we were at the end of a major debt supercycle. The frenzied mortgage lending and securitization in the financial sector, along with massive consumer credit borrowing, had set the U.S. up for a major crisis. In relative terms, we were at a 27% HIGHER total debt to GDP ratio than the Great Depression.
These massive debt loads were coming home to roost, manifesting first as a crisis in subprime but then quickly moving to prime mortgages, corporate debt markets, money markets, and even the consumer credit markets. As discussed in Part 2, NY Fed Pres Tim Geitner stated that during the darkest days of 2008 the inter-bank lending market was freezing up, and we were “days away from the ATMs not working”.
Total US (Public+Private) Debt to GDP
But, this didn’t happen. Ben Bernanke, the Chairman of the Federal Reserve, was a self avowed student of the Great Depression- and was determined not to let it happen again. He, along with Treasury Secretary Hank Paulson (Former CEO of Goldman Sachs) and Tim Geitner, created new lending facilities and MBS purchase programs in order to swallow the massive amounts of toxic assets the system had created.
Paulson and Bernanke technically had no legal authority to create these programs, but in a crisis, all caution goes out the window. TARP and other programs authorized by the Treasury bought billions of dollars of MBS, funded by T-bond issuances. This chart shows US Govt Debt as a % of GDP through today: (notice the spike in debt during and after 2008)
US Government Debt To GDP
The US borrowed heavily- TARP alone was authorized for $700 billion. The Treasury did not have the funds to support this so it issued billions of dollars of T-Bonds. Banks, hedge funds, other governments, and the Fed all bought these bonds en masse.
Remember, only the Treasury has the ability to SPEND, and only the Fed has the ability to LEND/PRINT. The Fed was created as a private institution to “protect” the government from reckless money-printing. The Primary Dealers (banks approved to trade directly with the Govt) buy Govt bonds from the US Treasury, and turn around and sell these bonds to the Fed or other third parties. If you’re confused about how the system works, I recommend watching this video on how the financial system functions.
In the equity markets, as we started bottoming in the first quarter of 2009, hedge funds, banks, and family offices began loading up on margin debt again. This renewed confidence in the banking system and overall lending capacity began pushing equity markets back up.
Margin Debt and Stock Market Rally
Further stabilizing the markets was the Federal Reserve with their massive Quantitative Easing program. In 2008, the Federal Reserve’s Balance Sheet ballooned– assets (Treasuries and MBS) grew from $880 Billion pre-crisis, to $2 Trillion immediately after, and eventually over $4T by 2014. Many economists, particularly those with a libertarian bent, such as Peter Schiff, immediately decried this reckless behavior and predicted immediate hyper-inflation as early as 2011.
Federal Reserve Balance Sheet
When the Fed buys assets, it is completely different from any other institution buying. Pension plans or mutual funds use the savings of the investors of the fund. Because that money came either from working, or from other investments, it represents NO net increase in money supply. The money they received HAD to come from someone else, for a good/product/service/asset they created or provided.
However, the Fed has no taxing authority, no savings, no funds to speak of at all- EVERYTHING the Fed buys it purchases through money it PRINTS. Thus, Fed Balance Sheet expansion=money printing. The Fed printed $2T in the two years following 2008.
This rampant money printing rightly worried experts and pundits in the media- but the inflation they feared never came. They were flat out WRONG. Why?
Most of the new money that was printed went directly into the banking system. Lyn Alden describes it brilliantly-
“Leading into the financial crisis, only about 13% of bank reserve assets consisted of cash (3%) and Treasury securities (10%). The rest of their assets were invested in loans and riskier securities. This was also at a time when household debt to GDP reached a record high, as consumers were caught up in the housing bubble.
That over-leveraged bank situation hit a climax into the 2008/2009 crisis, coinciding with record high debt-to-GDP among households, and was the apex of the long-term private (non-federal) debt cycle. When banks are that leveraged with very little cash reserves, even a 3% loss in assets results in insolvency. And that’s what happened; the banking system as a whole hit a peak total loan charge-off rate of over 3%, and it resulted in a widespread banking crisis” (I can’t link source, it keeps getting the post taken down- I will post it in comments).
Thus, the new money went to recapitalize banks and shore up their balance sheets to defend them from bankruptcy- it stayed in untouchable bank reserves, and never entered circulation.
The money that didn’t go to repair bank balance sheets flowed directly into the markets – Let’s walk through it.
There are two different economies- the real economy, and the financial economy. The tidal wave of new money the Fed was creating did not cause inflation (in the traditional sense), because the money did not flow into the real economy- the goods, products and services that everyone consumes on a daily basis. The money instead flowed into the Financial economy- bond markets, stock markets, private equity funds, commodities, Forex markets, etc.
Financial Economy vs Real Economy
When you give a bank $100M, it doesn’t go out and buy $100M worth of Big Macs and Kleenex- the bank puts these funds into investments, generally either in the form of loans or in the form of equities or equity derivatives. Thus, the funds that flowed into the banks are stored up almost exclusively in the financial system, or get pushed into loans to consumers.
“Wait a second!”- you say. “The Fed printed money to buy T-Bonds- The Treasury usually spends funds that go into the real economy– so THAT should have caused inflation, right?”
Yes, this is typically what happens. But, during and after the 2008 financial crisis the majority of Treasury expenditures went to programs that were stabilizing the financial system (TARP+ TAF+ TLGP+ Others). So, the money that would have been spent by govt agencies in the real economy instead just flowed back to banks and financial institutions.
Typically in a recession the Treasury will increase spending to cushion the blow to workers- and in 2009 they did extend a few unemployment benefits. But, by and large, Congress authorized few benefit programs for workers, and the average time on the benefit decreased after a slight bump in 2009.
Average Time on Benefit
Thus, the amount of freshly-printed money that reached the real economy was minimal, and whatever money did reach it largely acted to counteract deflationary forces- it wasn’t enough to actually induce inflation. The government did little to stop foreclosures, or provide aid to small businesses. Unemployment spiked, and due to the Phillips Curve Principle (covered in Pt 1), this put a dampening effect on inflation.
The funds the Federal Reserve had created, therefore, created no inflation in the real economy- instead they flowed to the financial economy and inflated financial assets. This started off the largest and longest bull market run in U.S. Stock market history– easily beating emerging and other developed countries’ equity markets.
Massive US Stock Market Rally
Keynesian economists lauded this as an accomplishment- they believed they were creating what is called a “Wealth Effect” – a theory that stated that as people’s financial wealth increased, they would be induced to do more spending and investment- thus, by propping up the stock market, they would stimulate the real economy. This is awfully convenient for the rich- the top 10% own 85% of the equity markets, and thus have seen their wealth balloon by over 186% while growth for everyone else stagnated.
Ironically this theory has it exactly backwards- real economic growth should drive the stock market, not the other way around. But, convinced of their theories, economic policymakers continued to pump ever increasing sums into the financial system.
When you divide stock market performance by the Fed’s Balance sheet, you see that there has been basically NO real growth since 2008.
The Rally is an Illusion
The entire “rally” we have experienced for the past 12 years has been nothing but an illusion- it is simply the result of vast money inflows into the financial system. Banks and financial institutions will do everything they can to convince you that the high stock market valuations are justified by fundamental growth.
This is wrong- these valuations are NOT justified. Insane levels of money printing and debt leverage have created extremely dislocated equity markets. For example, Square (SQ) has a forward PE ratio of 499.87- it currently doesn’t pay a dividend, but let’s assume it paid a 3% dividend payout ratio (which is rare for tech stocks) – if that were the case, it would take 14,996 YEARS for the dividends to pay pack the price of ONE SHARE. (449.87/0.03).
To summarize, see this image from a post I made a month back- all the warning lights are blinking red. The markets are at the extreme end of the range by almost every valuation metric- and no one seems to care.
Summary of Recent Warnings
The markets are slowly being “walked up” every day. Today, the ultimate price insensitive buyer (the Fed) is now plowing $120B a month into Treasuries and MBS, and the Primary Dealers now have to turn around and put their money somewhere. The bond market is already a trap with 2% yields, and 5% inflation. There’s no more profit potential there, so these institutions are forced to buy equities if they want any returns. The Fed is killing whatever is left of price discovery.
SPX grinding higher daily
Four billion dollars or so a day is being pumped into the system- and going straight to the stock markets.
Further, to stimulate growth in the real economy, policymakers dropped interest rates to near 0% in late 2008 to induce bank lending to get consumers to borrow and spend again. (70% of our economy is consumption due to the factors discussed in Part 1).
This did create massive loan demand- basically every sector of the US economy began borrowing en masse. The Fed was able to “reflate” the bubble and allow the economy to survive on debt financing to “re-invigorate the economy”. Fast-forward to today, and a decade of pinning rates to the zero-bound has us breaking records in terms of debt loads:
Student Loan Debt
Corporate Debt to GDP
Consumer Credit as % of GDP
I could go on and on, but you get the point. Now, the entire system is overleveraged- the cancer has spread, and it has infected virtually every single sector of the economy.
People keep saying that we “kicked the can” of 2008 down the road. This is WRONG. We kicked the can UP THE STAIRS- meaning, we not only delayed the problem, but made sure it would get WORSE, since we borrowed MORE to paper over the old debts and worthless securities the system had created.
A fascinating aspect of our recent financial history is that the bailouts are exponentially growing– this is due to the simple fact that the entity giving the bailout has to have a balance sheet multiples larger than the firm receiving the bailout, and government guarantees of banks induce reckless speculation. For example, to bailout a bank with $10B in mark-to-market losses, you need a bank with a $20 or $30B capital surplus, to absorb the loss and keep the depositors and creditors satisfied that the bank giving the bailout won’t go under.
In 1998, a hedge fund called LTCM was near collapse- it had leveraged itself over 25-1, using complex algorithms made by Nobel Prize winning economists to predict bond prices. They had made massive derivative bets buying Russian bonds (among other things) – and when the Russian government defaulted in August 1998, their positions began to unravel.
The massive debt and derivative exposure they had created was threatening to pull several large banks down with it. The Fed stepped in during September to organize a $3.5 Billion bailout, funded by 12 large banks. According to James Rickards, General Counsel of the LTCM Bailout- the US equity and bond markets were “close to being completely shut down” during the worst of that crisis. (start at 16:30)
In 2008, the entire US financial system was nearing collapse and desperately needed a bailout. A massive bank run had begun. Congress stepped up and provided- in the end spending over $498 Billion of taxpayer funds. However, the Fed also provided a bailout (though QE), eventually buying over $1.7 Trillion of MBS.
Since the Great Financial Crisis, the banking system debt crisis has now become a government debt crisis, and indeed an economic debt crisis- and this debt has spread worldwide. Equity and bond markets have continued to march up, despite fundamentals. This new financial paradigm was rightly termed “The Everything Bubble”
Total World Debt
Total (Govt+Private) Global Debt now stands at staggering $281 Trillion, or 356% of GDP. We’ve never been here before- we are now navigating uncharted waters. The next bailout will have to be bigger- a LOT bigger.
Imagine a snowfield on an alpine slope, above a small town. A few inches of snow falls. Everything is fine. More snow falls. Still nothing happens. A blizzard moves in. A day later, the snowfield reaches critical mass. Then, a disturbance happens- it could be a deer foraging for food, or a hapless skier exploring the backcountry. The snow starts sliding, pushing the snow below it. Positive feedback loops start to engage. The field begins to slide- now an avalanche has begun. The town is wiped out.
The financial crisis was the beginning of a debt avalanche- it’s likely that over 70% of the major banks, mortgage brokers, and other financial institutions would have gone bankrupt, superseding the Great Depression-era record of 30%. Thousands of private and public companies would have gone bankrupt. Real estate and equity markets would have entered a freefall lasting for years, and unemployment would likely have spiked past 30%, bringing back the soup lines not seen since 1936.
Instead, policymakers kicked the can up the stairs- they issued massive amounts of government debt to paper over the 2008 crisis, and incentivized excessive borrowing in the private sector. The fundamental factors that caused the crisis (unregulated derivatives, bank combinations, excessive leverage, lack of oversight) were never resolved. As u/Criand so elegantly puts it, 2008 never ended. Now, with US Government Debt standing at over $28 Trillion, there are only tough choices ahead. We will soon reach a point where the interest payments alone on the debt supersede all US Tax Revenues- when that happens, we will have traveled beyond the event horizon- there will be no coming back. The debt will be IMPOSSIBLE to pay off. (This is according to the governments own projections!)📷
US Government Debt Projection
The US Government continues to borrow- running a staggering $2.1 Trillion deficits for just the first half of 2021. There is no end in sight. The Biden Administration is pushing for another $1.2 Trillion in infrastructure spending this year ON TOP of the already massive deficits. Some politicians are demanding that it be more.
Day by day, we are adding snow to the mountains above our village. When will end is anyone’s guess, but borrowing more will only make the end worse.
Through the magic of Fractional Reserve banking, institutions can loan out much more debt than cash that actually exists. This increases systemic risk.
As a result, over 90% of all capital created is in the form of debt. This supercharges debt cycles and can cause massive bank failures.
When debt super-cycles crest, and begin the march downwards, massive deleveraging and defaults begin. If the banking system is weak, bank runs begin. (1930s)
We were hitting another end of the 80 yr debt cycle in 2008 (1929-2008 (79yrs)). We never de-leveraged the system. Instead, we re-leveraged EVERYTHING even MORE.
The Government and the Fed swept in and bailed out the banks. Now the Federal Government is deeply in debt to the tune of $28 Trillion.
The trillions printed by the Fed were almost exclusively routed to the financial system- creating a new bubble in every single asset class, larger and even more widespread than the 2008 bubble.
We never resolved 2008. We only kicked the can up the stairs. The Derivatives monster from Pt 2, along with a massive debt avalanche, will come back with a vengeance.
Almost every sector of the US economy, and indeed the world economy, is now greatly overleveraged. Global Total Debt to GDP broke past 350% during Covid.
Options are running out for policymakers. Debt borrowing and money-printing cannot continue forever.
The debt crisis will return, but this time, it will be the financial system, US government, and indeed the ENTIRE world economy that needs a bailout- and who has a big enough balance sheet to absorb that? The only answer is the ones with an infinite balance sheet- the Central Banks.
The idea that anyone can borrow forever, or print money forever, with no consequences, defies basic financial logic. Impossible Objects cannot exist forever. History shows deadly consequences for the nations that venture down either path. The United States is no exception.
The Fed has already tried to escape this trap in 2018. It failed. Sovereign creditors are losing faith in the US Treasury, and have been since 2015. The walls are closing in, and the ultimate decision must be made. (More on this in Pt 4)
The avalanche is coming either way- and we only have two choices. Either we allow ourselves to be buried under a mountain of hyper-deflation, creating a new Great Depression, frozen credit and equity markets, and massive bank failures- or, we burn our way out, using the inferno of money-printing and hyper-inflation.
(Adding this to clear up FUD- My argument is for hyperinflation to begin in a few years- this is a years- long PROCESS, and will take a long time to play out. It won’t happen tomorrow, but we are in the same situation as Germany after WW1. Hyperinflation is GOOD FOR GME— DEBT VALUE COLLAPSES, MONEY CHASES ASSETS (EQUITIES) pushing the price UP, so shorts will have to cover) BUY AND HOLD.
Nothing on this Post constitutes investment advice, performance data or any recommendation that any security, portfolio of securities, investment product, transaction or investment strategy is suitable for any specific person. From reading my Post I cannot assess anything about your personal circumstances, your finances, or your goals and objectives, all of which are unique to you, so any opinions or information contained on this Post are just that – an opinion or information. Please consult a financial professional if you seek advice.
*If you would like to learn more, check out my recommended reading list here. This is a dummy google account, so feel free to share with friends- none of my personal information is attached. You can also check out a Google docs version of my Endgame Series here. (ALL THESE LINKS ARE GOOGLE DRIVE LINKS, FROM A DUMMY ACCT!)
(Side note: I’ve been accused of being a shill/FUD spreader for the first two posts- please know this is NOT my intention! I cleared this series with Mods, (PROOF) (THIS IS A GOOGLE DRIVE LINK, I WASNT SURE HOW ELSE TO SHARE IT) but if you think this is FUD/SHILLY then downvote/comment and I can discuss further.)