Only by fully appreciating the role that credit expansion played in creating the economic boom of the past 30 years can investors begin to understand how the bursting of the credit bubble will shape their economic and financial future.
In the beginning
Following WWII many western nations took steps to prevent the severe economic depressions that had plagued their economies prior to the war. These measures included the introduction of financial and economic safety nets, such as deposit insurance and social security programmes, as well as the deregulation of financial markets. This allowed banks to increase their leverage from around 12 to 1, to around 33 to 1.
When economic downturns did occur, authorities responded by immediately lowering the cost of borrowing and injecting additional liquidity into the economy through the banking system. Their actions did prevent harsh economic depressions, however, they also dramatically increased the burden of public debt. This long-term build up of debt was described by BCA Research (Bank Credit Analyst) in Canada as the Debt Supercycle.
As the charts below show, the Debt Supercycle really began to get going in the US and the UK in the 1970’s.
US Gross Public Debt 1900 to 2012
Source: Chart courtesy of usgovernmentdebt.us
UK Public Sector Net Debt 1945 to 2010
Source: Chart courtesy of ukpublicspending.co.uk
Between 1978 and 2012 total debt in the US grew from $719 billion to $56 trillion, a 7,688% increase. Over that same period total debt in the UK grew from £79.5 billion to £2.27 trillion, a 2,766% increase.
The beginning of the end
With the arrival of the global financial crisis in 2008, the Debt Supercycle reached an important inflection point. As the global economy fell into recession consumers stopped taking on new debt, and instead, began the process of deleveraging, i.e. paying back debt. In order to prevent a global depression reminiscent of the 1930’s, governments around the world slashed interest rates and began rapidly taking on new debt to keep the credit bubble inflated.
Since 2008 all categories of US private sector debt, that is financial, nonfinancial and household debt, have fallen relative to GDP. According to the McKinsey Global Institute, the US “may be two years or so away from completing private-sector deleveraging. The United Kingdom and Spain have made less progress and could be a decade away from reducing their private-sector debt to the pre-bubble trend.”
However, while the private sector has begun the process of deleveraging, the public sector has increased its levels of debt markedly, particularly in developed economies. According to the IMF, the average levels of public debt in the advanced G20 economies increased from 60.6% of GDP in 2007 to an estimated 110.3% in 2011. This sharp increase in government expenditure was due to a number of factors, including higher social expenditure, unemployment benefits, and lower tax revenues. Over the same period debt levels in emerging G20 economies increased by less than 1% to 37.0% in 2011.
Hitting the wall
Governments can only borrow and print money to stave off a deflationary depression for so long. Eventually they too will hit the fiscal wall and when they do the Debt Supercycle will come to a violent end. As we have seen in Portugal, Ireland, Greece and most recently Spain, governments can only continue to rack up huge public liabilities while bond markets have confidence in their ability to repay their debts and manage their economies.
The moment that confidence is lost the bond market will “rebel” and demand higher rates of return, and it is this rate rise that directly threatens the solvency of many nations, including the US, the UK, Japan, France, Italy, Spain, etc.
John Mauldin, author of the excellent book The End Game: The End of the Debt SuperCycle and How It Changes Everything, likens the end of the Debt Supercycle to pressing the reset button on a computer, when you have to kill the power, wait for fifteen seconds and then reboot it. In an interview on the subject with Danielle Park in September 2011, John explained, “we’re hitting the reset button, and instead of fifteen seconds it’s going to take probably five to seven years”.
Bill Gross, co-founder of Pacific Investment Management (PIMCO) and manager of the firm’s $252 billion Total Return Fund elaborates on this process in his February 2012 newsletter.
“Where does credit go when it dies? It goes back to where it came from. It delevers, it slows and inhibits economic growth, and it turns economic theory upside down, ultimately challenging the wisdom of policymakers. We’ll all be making this up as we go along for what may seem like an eternity. A 30-50 year virtuous cycle of credit expansion which has produced outsize paranormal returns for financial assets – bonds, stocks, real estate and commodities alike – is now delevering because of excessive ‘risk’ and the ‘price’ of money at the zero-bound. We are witnessing the death of abundance and the borning of austerity, for what may be a long, long time.”
The new normal
In an attempt to perpetuate the Debt Supercycle, governments around the world are pursuing policies such as Quantitative Easing (QE) and our Zero Interest-Rate Policy (ZIRP) which are designed to get businesses and consumers borrowing and spending again. The reality, however, is that no amount of economic stimulus can recreate the economic boom of the last 30 years – the days of 3 and 4% annual GDP growth are well and truly over.
Instead, our future will be one characterized by increased government intervention, distorted financial markets and slower and more volatile economic growth.