The Great Inflationary Deleveraging — A Great Depression Redux
“History doesn’t repeat itself, but it often rhymes” — Mark Twain
The Great Depression was one of the defining periods of the 20th century, in which post-industrial economies were not able to provide sufficient resources or jobs for their populations, leading to significant social issues.
Although it coincided with exacerbating events such as severe drought, the Great Depression was primarily triggered by a stock-market crash and related financial instability.
Leading into the 1929 crash, new debt had been created at an irresponsible rate, helping trigger a speculative boom during which the Dow Jones Industrial Average gained an extraordinary amount of value.
The reversal of this sharp, upward movement led to severe financial losses that went on to severely damage market sentiment.
The systematic effects of these events helped cause cascading defaults and bank failures, a binary and permanent outcome as a result of systemic risk. With such dramatic outcomes occurring as a result of this systemic risk, modern central bankers such as Bernanke suggested that institutions could have intervened earlier to support aggregate demand for goods and services — for the system to backstop systemic risk.
The lessons can be interpreted today to show how institutional responses to modern event risk contribute to systemic risk in the global financial system, and we explore the current setup of markets and the financial system as an analog to the Great Depression markets and financial system.
Part of this discussion explores the idea that the systemic risk created in response to event-risk in the last 26 years (from the Tequila Crisis under former Fed Chairman Alan Greenspan onwards) has created a false reality of economic and financial conditions that rely on axioms that may no longer be taken for granted — because of this additional systemic risk.
We then argue that economic decisions (especially capital allocation and the use of debt (supply) as well as assumptions of demand) made in this environment are based on a false and unsustainable reality, and that this creates further and unknown risk, especially during a time of reversal in sentiment — and during adaptation to a new paradigm.
We also explore the expectations of institutional policy response in the case of a similar major reversal in sentiment resulting from such a significant “deleveraging” event. We suggest that this time, “deleveraging” and re-organisation of the risk/reward profile of assets will occur in a very similar archetypal event, but showing up in different ways — such as debt haircuts through inflation.
The Problem
Nearly 100 years after the Great Depression, the global financial system is staring down the barrel of a problem it can no longer escape.
After struggling with stimulating demand, creating debt-fueled overcapacity, reversing a decades-long trend of reducing global trade frictions, with technology and frothy asset prices hiding inflation and most threateningly of all, the financialization of the economy through central bank intervention and financial industry-led regulation, there is nowhere left to kick the can down the road.
The End of the Road?
After years of experimenting with pitting individual and institutional will against the power of the market, axiomatic assumptions (assumptions made without scrutiny) about the global financial system are being brought into question. (Find more information on that history in this article).
In my opinion, two of these assumptions await consideration and dismantling. The first is the ability of centralised, authoritative decision-making hierarchies in capitalist societies to make optimised decisions.
These individuals and their institutions are faced with and corrupted by the prisoner’s dilemma.
This force sees suboptimal decision-making occur as a result of environmental conditions in which other choices are not possible — often as a result of fear. This type of system is degeneratively self-referential, in that its key stakeholders are not able to perceive the necessity for painful sacrifices that guarantee the system,
Further, these stakeholders believe they have an unrealistic level of control over economic outcomes, and they are capable of justifying the superficially (sometimes personally) beneficial, but systematically destructive, course of action as a result.
This kind of hard-reality, first-order thinking proposition of those in power that benefits those in power is reminiscent of the detachment of French aristocracy pre-revolution.
The French peasant had significant barrier to entry in economic life, now an analog for prohibitively expensive housing in a financialised housing market in most Western countries (besides other suppressive factors in day-to-day life for the class not adding, holding and developing capital), and the managerial class have a blind spot worthy of Marie Antoinette for how this affects both the larger population, as well as the systemic health of society, culture and the economic and financial system.
These days, the insiders’ benefit is hidden in technocratic structure and language — although the kind of in-group sense of superiority is also there to be seen, even in places (that ought to be incredibly humble) such as Western middle-class — who have become a kind of petit-bourgeoisie.
The second, related issue, is that the preeminence of the U.S. dollar as the global reserve currency is as good as finished, at least as far as this writer is concerned. To read more of my thoughts in this matter, check out my article here.
That the U.S. dollar is trusted (and is indeed the global reserve currency) is a financial system axiom that was relied upon to justify and validate decisions — extravagant monetary policy — that have now destroyed the axiom. The reader will imagine what the world would say if Zimbabwe pursued these strategies, and must ask the question of why it should be any different for the United States. The reality is that there is a binary state of trust in the U.S.-led global financial system, that the U.S. dollar is trusted or not trusted.
This inherently anti-systematic (read, fragile) paradigm in which the assumptions of a system are not respected in maintaining the health of the system is, obviously, a systemic risk. We saw in December 2019, before the global pandemic erupted, that the U.S. dollar repo markets were broken, dependent on enormous amounts of extraneous liquidity, and we believe that the extraordinary policy decisions of 2020 will go on to highlight this again in due time.
A final, related consideration is that debt levels are too high for debt servicing capacity (the ability to pay off debt) — especially in the context of the new economic paradigm — with enormous amounts of debt created in a false economy, meaning specifically that key stakeholders are making decisions that are net negative while claiming they are, in fact, positive.
With economic interventions undertaken in a mistaken belief in their ultimate economic good, and efficiency, we are left to realise that the assumptions that central banking decision-makers have made, that global supply and demand capacity could be increased merely through their (apparently) astute decision-making, are incorrect.
Besides the problems of that monetary policy (which relies on extraneous intervention like asset purchasing, debt that has been created in these false environmental conditions) (it artificially and temporarily lowers financial risk, as well as creating higher, yet false aggregate demand), we must hold the assumptions of that economic/financial reality (assumptions made in the capital decision-making process) in their place in the complex structure of global capital markets. But these assumptions and their necessitated reality are, as stated, a false economy.
These forces, along with the false environment and false economy offered by this reality, create the problem of a systematically dysfunctional financial system where the value of debt is too high to be sustainable in the financial-economic system at its (now obfuscated by public policy) natural equilibrium, especially with material changes in macroeconomic factors.
A Depressing Analog from History
Alarmingly, the Great Depression offers a great analog for today’s markets and institutional responses.
Money Supply
After a stock market crash that took place in 1921 (similar to the one in 2008), the central bank at the time expanded money supply by 61.8% between 1921 and 1929, according to America’s Great Depression by Murray N. Rothbard.
Today, the U.S. Money Supply (M2) is more than 100% higher than it was during the 2007–2009 recession.
Debt
Debt levels around the Great Depression are difficult to single out. However, one measure of such obligations, known as “individual and noncorporate debt,” rose sharply between 1920 and 1932. During this period, the ratio of gross domestic (GDP) to this particular metric increased from 55% to 97%.
At the time of this writing, total U.S. government debt was more than 120% of GDP (up from roughly 60% in 2006).
Government debt in the U.S. is around 130% of GDP today (up from 62% in 2006) while corporate debt is around 50% of GDP.
Stock Markets
The stock market crash of October 1929 came after a period where the Dow Jones Industrial Average climbed 500% in five years.
Compared with today, the market has already traded 513% higher from the lows after the global financial crisis, with room for a parabolic increase.
Although the parabolic increase of 1929 might seem too incredible at this point, we believe that there is the potential for the U.S. stock market to trade much higher, for reasons we can outline later. The forces that exist in markets — in systems — may even necessitate it as inevitable. As a nominal (rather than real) figure, it may stay high.
The Why
There had been a type of arrogance, a belief that all problems could be solved through power — political power more so than market power (and with the two becoming increasingly hard to separate as a result).
It has been a feeding frenzy for individuals, institutions and those in the market — at first periodic but now ongoing — that came as a result of the inability to separate money from politics. Government employees intimately connected with big banks (people working for central banks and the U.S. Treasury) routinely created public policy to reduce the effect of event risk on the economy.
These risky events include The Tequila Crisis (1995), the LTCM failure (1998), the NASDAQ bubble (2000), the Global Financial Crisis (2007–2009), the repo market intervention (2019) and the coronavirus response (2021).
Those familiar with these will recognise that the systematic response to single events begin to bleed into the next event-risk event — where the response to the Tequila Crisis and LTCM exacerbate the event risk in the NASDAQ bubble.
Event risk solutions become systemic risk.
That policy benefited a small group of insiders, where modern and high-minded theory would cover for the more ancient fact that insiders look after themselves, incentivising event risk in the meantime.
So as each individual event occurred, it was not necessary that there would be self-awareness of the corruption of the global financial system inside of the institutions…until now.
Now, institutional corruption (in the sense of fundamental inconsistency between the mandate and operation of an institution) may be impossible to deny or ignore.
This is because the Fed has no other option but to pursue inflation with policy (and we go on to propose the precise equation they must consider) — but that they can not, will not and are not publicly stating the breadth and depth of this as strategy. So we must postulate that the Fed officials know today that their public messaging is radically different from the explicit behind-closed-doors plan.
The evolution of the economics public policy expert into a full political apparatchik is made necessary in the environment that these historical decisions created — we are all now bound by the lies created in the prisoners dilemma — of the power of Moloch necessitating that we do not all make it together, in order for any of us to make it.
It may have started when that environment explicitly benefited a group of insiders.
In part due to this shift toward crony capitalism, the economic-financially framed problem at face value today is that there are no more policy options available at a desperate time. Maximum global supply capacity was likely reached years ago, and maximum global demand is likely not sustainable, being created on debt justified by a false economy.
In addition, global trade frictions were at an all-time low during the Global Financial Crisis of 2007–2009, yet another aspect of disaster striking in a false economy — with a change including major trade frictions yet to haunt us on the other side.
Institutional Delusion
One of the best examples of this institutional delusion is where Paul Schmelzing, a Harvard-educated economist currently working as a postdoctoral research fellow at Yale, suggested that interest rates “could soon enter permanently negative territory” in a paper he wrote.
Schmelzing used hundreds of years’ worth of interest-rate history to make his argument, in which a straight line through interest rates that drop over time eventually results in them falling below zero.
How somebody could suggest this, of course, beggars belief. Markets have become more efficient over that time. Globalisation creates more efficient capital markets.
The information available to commercial decision-making is deeper and has been analysed in more sophisticated ways, business practices have been refined and a type of commercial ideology that perceives goods and services in the highly abstract global common markets create enormous efficiencies. Of course they should become more efficient over time.
But the ability of public policy experts at the Fed to experiment with new monetary policy was allowed through the 1971 decision to end asset-backed currency (in this case gold) in a state of crisis known as the Nixon shock. Afterwards, this post-Bretton Woods global financial system was not created, but rather inherited through default in the failure of the Bretton Woods agreement. This uncontrolled, chaotic evolution was eventually normalised.
Through socio-cultural developments (in this case we argue these developments are delusions) a role of individuals and institutions was allowed in manifesting economic growth through a kind of pet project of Alan Greenspan, leading to rampantly expansionary monetary policy.
(Let’s not even begin on the role of technology in producing efficiencies, hiding inflation, and the false deflationary pressure of technology in hiding what could otherwise be far more catastrophic failure.)
Above this, enormous economies of scale were expected after trade frictions were systematically removed worldwide in a series of free-trade agreements that maximised the effect of these forces — all the way up until 2019 when former President Donald Trump put tariffs on Chinese goods, reversing a long trend.
But the prospect of negative interest rates, as the result of a trend — as the manifest destiny of a straight line drawn across seven centuries — is preposterous, of course. Efficiencies are about reducing risk, not about agreeing to lose your capital.
Understanding this pure nonsense, and how it might come about, would help the reader gain an appreciation for the fundamental delusions and failure of previously seemingly reputable institutions.
Part of the reason it is so pernicious is that it normalises the false economy in which so many trillions of dollars have based their raison d’etre — but the idea is so wrong that we must consider whether it could even be malicious. Not knowing if malicious cause is too far is another indication of the state of the institutions.
Debt
Then there’s the debt.
The recognition of debt as a problem goes back over a decade — in fact a Forbes article from 2009 ‘It’s All About Debt’ by David O. Beim of Columbia Business School, states:
“The underlying problem is deeper: For the past 25 years we have been over-consuming and over-borrowing to do it. The problem is debt itself.”
Beim’s comment highlights the systematic instability we covered earlier. His observation was made around the time of the red cross.
Although this is true, consider the post-global financial crisis false economy in which this enormous amount of new debt is created and the risk-based assumptions that depend on this false economy.
Global Supply
As stated elsewhere, there has been a persistent problem in which maximum economic capacity has been achieved and surpassed– even before a debt bubble. But when ultra-low interest rates are normalised (with attempts now to normalise negative interest rates!) in an environment of a false economy, and supply decisions have been made in this environment — at least the last 15 years, and arguably longer again, it is very fair to argue that it is a contraction in global supply that would achieve a systematic equilibrium.
This is especially the case during a time of reversal of free-trade agreements, geopolitics frictions, unstable input pricing as well as instability in the price of the reference asset — the U.S. dollar — itself.
Global Demand
Similarly, global demand is unnaturally high over a similar time. Although wages have been stagnant, demand has also benefited from the false economy of debt. Demand sentiment had been satiated whenever a decline looked possible, with fundamental factors as well as positive sentiment. There is good reason to believe that both of these aspects face headwinds this time around, with long term globalisation trends reversing and a contraction in optimism about the future, among other new factors.
Inflation — The Only Possible Course of Action
The reality is that deleveraging is not achieved by defaulting on debt, which would risk a contraction in economic activity and possibly cause cascading defaults of otherwise competitive companies.
Instead, inflation must give a haircut to debt by devaluing debt relative to hard assets and income-producing assets that both act as collateral (hard assets) and debt servicing (income-producing assets) — in new, inflationary conditions with a reversal of global trade frictions across the many vectors we have discussed.
So where we have reached maximum capacity already with trade frictions already falling to a historical low, a saturation of manufactured goods on enormous economies of scale that we may not see again for some time with today’s geopolitical issues, with enormous levels of debt that were not only artificially suppressed from experiencing natural market forces on interest rates, but whose economic and financial assumptions are comprehensively obfuscated under a false economy, the only possible way out is inflation.
We highlighted inflation as the next major issue of markets in the January 2021 inflation report.
Now we may face the end of a super-cycle, in which global capacity and demand had already reached structural limits that we may not surpass again for some time — especially given the enormous amount of debt and money that was required to get us there originally.
With terrible consequences from allowing cascading defaults on the debt of otherwise marginally profitable institutions during the Great Depression because of short term fluctuations in financial markets (especially around debt and credit), today’s institutional decision-makers have already shown us what they are going to do — firstly with Bernanke’s perspective after the global financial crises.
Bernanke studied credit markets after the Great Depression, concluding that short-term market inefficiencies were responsible for suppressing aggregate demand and that this extended recovery time for the U.S. economy. This “extended recovery time” of the depression became the devastating socio-cultural event we know of as “the Great Depression.”
The idea for intervention in debt markets is that otherwise competitive businesses — especially financial institutions — would fail if the central bank did not intervene with short-term asset purchases to stabilise the cost of debt.
The central banks would therefore guarantee a minimal amount of systematic risk in the financial system.
We can see how the prospects of a forced deleveraging are haunting for institutions who had tried to avoid it. This is a key reason why they will avoid it at all costs, and why inflation is the only possible outcome.
Disorderly defaults, with cascading failure of marginally profitable businesses, will simply not be allowed so easily.
The only possible course of action for the Fed is to allow inflation. They must decrease the value of debt, firstly to hard assets (that act as collateral) and secondly to income-producing assets (assets that service debt). Then, they must also take into account the fact that a large amount of current debt was created in a false economy.
After that, new conditions must be considered, beginning with the reversal in globalisation (with its immense economies of scale), of the rate of new debt (and stimulus) slowing dramatically in a new risk environment and of maximum supply capacity and global aggregate demand stabilising at a lower, natural equilibrium.
But then the reflexive, second and third-order consequences of this course of action become very hard to predict.
Why could the market trade much higher?
With deleveraging through inflation as a strategy, lower real returns compared to the cost of hard assets is possible while still seeing a nominal increase in the price of equity in companies. Inflation rationalises higher stock market prices where the discounted cash value today in a highly inflationary environment means a much higher asset price today.
The caveat to this is when policymakers determine to normalise policy, in which the ability to pay back debt must be established.
When hard assets are capable of fulfilling the role of collateral for existing debt in a new environment of policy normalisation, and when income-producing assets can pay debt servicing costs in the potentially high-inflation, high-interest rate environment of policy normalisation, this is where we might see the end of this super-cycle.
But now, the elephant in the room.
The only possible solution to this problem — inflation — relies on the axiom of the U.S. dollar as the global financial system’s reserve currency.
But did you know that the U.S. had more money supply growth than Botswana in 2020?
Besides the supply problem, the purchasing power of the U.S. dollar has deteriorated over time.
Strategic reserves show that the U.S. dollar is not being favoured, with figures from the International Monetary Fund indicating that by the fourth quarter of 2020, the fraction of central bank reserves made up of U.S. dollars had dropped to a 25-year low of 59%.
And for the first time, legendary investor Stanley Druckenmiller can envision a world in which the greenback loses its status as the global reserve currency in a few decades.
“I can’t find any period in history where monetary and fiscal policy were this out of step with the economic circumstances, not one.”
“If they want to do all this and risk our reserve currency status, risk an asset bubble blowing up, so be it. But I think we ought to at least have a conversation about it.”
“If we’re going to monetize our debt and we’re going to enable more and more of this spending, that’s why I’m worried now for the first time that within 15 years we lose reserve currency status and of course all the unbelievable benefits that have accrued with it.”
The use of the U.S. dollar as a geopolitical tool and the development of China’s digital yuan may accelerate this trend, in addition to growing interest in gold.
Of the major economies, China is leading the race to develop a central bank digital currency, with some potential in the story that this currency would be backed by gold. China is almost certainly the world’s largest holder of gold (official reserves of around 14,500 tonnes are more likely to be 15–20,000 depending on who is estimating, compared to 9,000 tonnes for the U.S.).
So, the casualty of this strategy, which might save a cascading default of businesses, is that the U.S. dollar, and by default, the fiat currency systems worldwide, are discredited in favour of asset-backed currencies.
When you devalue your currency and fixed-interest investment products by 10%, 20%, or 30% relative to hard assets and income-producing assets, then you change their investment characteristics.
The U.S. dollar loses its reserve currency status. …
And it is impossible to consider the second-order effects of this — we might end up with a situation where fiat currency risk is hedged with gold, giving us a “de facto” gold standard.
So the calculation for desirable inflation is where hard assets can act as collateral and income producing assets can service debt.
But for those income producing assets, there will be reduced economic activity, less efficient global markets with trade frictions (amongst other inefficiencies) but the implications of the U.S. dollar losing status make figuring out what kind of inflation is desirable more complex again.
In spite of this reflexive complexity, Fed officials have stated that they are capable of dealing with inflation when the time comes. But a fundamental axiom of their strategy, the global pre-eminence of the U.S. dollar, is likely to have proven itself incorrect sometime through this process of deleveraging through inflation.
These are, of course, major claims about the implications of the historical policy decisions of the Fed, especially with regard to the market timing of the implications of these claims, if they are correct. Readers should understand this analysis with that in mind.
But if there is something to this narrative, it introduces a systemic risk to global financial markets that had been overcome 20–30 years earlier, with the rolling put offered by successive Fed chairs.
So what happens next if it is accurate? It is truly hard to say, but it may be prudent to act accordingly.
By Thomas Kuhn, CFA
Thomas is the author of ‘Bitcoin: A Revolutionary Investment’ and has previously written for the Asia-Pacific Research Institute of the Chartered Financial Analyst Institute, Hackernoon and Medium.
Get my book here: Bitcoin: A Revolutionary Investment
Disclosure: The author of this opinion piece has been heavily involved with cryptocurrency for several years and holds a cryptocurrency portfolio, including bitcoin. Thomas is an analyst at Quantum Economics.
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