Keynesian Credit Creation Meets Its Armageddon

Or how runaway government debt threatens to collapse the entire credit system

Few commentators are aware that the dynamics leading to an inevitable collapse of credit are increasing. When these dynamics begin to unfurl, there is bound to be a global rush out of fiat credit into gold. This is why prescient central banks have been accumulating bullion.

This week, the more observant among us will have detected a fork in the road of credit creation. Major nations are now officially in recession, suggesting that interest rates should be reduced according to the Keynesian playbook. But inflation is showing signs of rising again, mandating the opposite. These are a rerun of the conditions which discredited Keynesianism in the 1970s, leading to a common description of something that was to statist economists impossible: stagflation.

The only reason that the US is not in an official recession is the massive amounts of government spending in excess of tax revenue: in other words, it is printing its way out of recession. Inevitably, this will continually undermine the dollar’s purchasing power even further, an effect which feeds into the inflation pipeline. Any hopes of a sustainable reduction in interest rates can be dismissed on these grounds alone.

The US is not the only nation with this problem. Intractable budget deficits abound in the UK, Japan, and Europe as well. According to the Institute of International Finance, global government debt has increased from $33 trillion in 2008, to $71 trillion before the covid crisis three years ago, to $90 trillion today. With interest rates and borrowing costs having also risen inexorably, global government debt has gone parabolic.

The table below shows current estimates of some debt-to-GDPs and budget deficits by the same measure.

In inflation creation terms, the US and 9% budget deficit is the worst offender. That is likely to be the trigger destabilising the finances of the other nations on the list.

Now let us make some reasonable assumptions. Current forecasts are for a mild recession in most nations on the list in the table. They make no allowance for the likely depth of collapse in economic activity and the consequences for budget deficits. Furthermore, the general assumption in markets is that interest rates will decline now that consumer price inflation is “under control”. Consequently, interest rates and bond yields are expected to fall. But as this article’s opening comments points out, that is not how things are shaping up. Indeed, there is compelling evidence as to why interest rates will rise. A Diary from Dixie: A ... Chesnut, Mary Best Price: $5.26 Buy New $7.99 (as of 02:47 UTC - Details)

Put these two factors together, contracting economies and rising interest rates and we can see why the colossal mountain of global fiat credit estimated by the IIF to be $313 trillion is entering a crisis, driven at its core by indiscriminate government spending driving full tilt into inescapable debt traps. And when credit is in crisis, the only refuge for ordinary people is in physical gold which is true, legal money and has no counterparty risk. Owning gold is to opt out of a collapsing system.

Actors in the financial establishment are ill-prepared for such an event. They are learning the true understanding of risk the hard way, having had how to avoid it educated and regulated out of them. They think that cash dollars are the ultimate safety, when the issuer is a department of a government facing bankruptcy. And the risk-free investment is US Treasuries, the debt obligations of a bankrupt nation.

With this in mind, the establishment holds onto the erroneous belief that if interest rates are going to rise, then that’s bad for gold. And they think that a rising trade weighted index for the dollar is also bad for gold, when all the TWI does is compare pigs with pork. It is time for some re-education about debt traps, interest rates, credit, and gold.

Resolving debt traps

There is a simple solution to this problem. Eliminate the budget deficit by cutting public spending, not just to balance the books, but to reduce the tax burden on private sectors. But in common with their opposite numbers in other nations, US politicians are still asserting wasteful spending in this presidential election year with agreement from both sides of the house. As FX Hedge Newsletter points out ([email protected]):

Conservatives in the House GOP, led by Jason Smith, quickly passed a bill with a wordier but equally deceitful title: the Tax Relief for American Families and Workers Act of 2024.

As if it came right from Orwell’s Ministry of Truth, 91.5% of the money claimed as tax relief for American families and workers will instead go to expanding welfare, primary for those who are barely working, if at all, while disincentivizing the formation of stable families.

That’s what we call conservative values.

Not only are the politicians trapped by the wrong mind-set when it comes to acting with fiscal responsibility, but they continually add to the problem. It seems that there is no one in America’s political class willing to seriously consider where their destructive fiscal policies are taking them. And with presidential favourite Donald Trump likely to prioritise tax cuts over cutting public spending if he is elected President, the deficit problem is likely to get even worse.

Nor can we ignore the mechanics of a debt trap. Interest payments in the first quarter of this fiscal year were running at an annualised rate of over a trillion dollars, making up nearly half the deficit — and rising. According to the Congressional Budget Office’s forecast, net interest on government debt held by the public will total $870 billion and average 3.1% this fiscal year. This must include debt being refinanced which with this year’s budget deficit is approaching one-third of the $34 trillion outstanding. Clearly, the CBO’s figures which were released earlier this month are already out of date. Grow or Die: The Good ... The Good, David Best Price: $14.01 Buy New $13.99 (as of 02:47 UTC - Details)

So far, funding this profligacy has been easy. Cautious bankers have diverted balance sheet liquidity from private sector lending to buying T-bills, yielding over 5%. And money funds have also been winding down their lending to the Fed through reverse repos to buy T-bills as well. Since end-December 2022, RRPs outstanding have collapsed from $2.3 trillion to $532 billion. This represents a massive wave of credit debasement as it is spent into the US economy, unbacked by any increase in consumer savings. No wonder the GDP number is so buoyant.

Shortly, the US Treasury will have to secure term funding which means testing the appetite of investors rather than short-term credit providers. In recent months, there have been a few auctions with mixed results, perhaps reflecting demand for notes and bonds for regulatory purposes from pension funds and insurance companies, which is essentially limited. And with the major foreign holders in Japan and China having turned net sellers of Treasuries, term funding will almost certainly lead to higher bond coupons.

This is what a debt trap is all about: a realisation in the buyers’ minds that higher coupons are required, but that higher coupons increase the default risk. Investing in government bonds becomes like buying junk debt but from an issuer who doesn’t even pretend to deploy the debt productively.

For now, the US Treasury has $840 billion in its general account in the Fed system, suggesting that it has a few months’ liquidity in reserve. But that will run down and then the debt trap will be sprung against a deteriorating outlook for consumer price inflation.

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