Market Commentary



“Stability leads to instability. The more stable things become and the longer things are stable, the more unstable they will be when the crisis hits.”

Hyman Minsky

The world is borrowing more than it is producing. Global debt stands at $246 trillion, or 320% of global gross domestic product, according to the Institute of International Finance. This liability is more than 50% higher than ten years ago, fueled by easy credit, cheap money and monetary policies that embraced financial repression and persistent quantitative easing to stimulate tepid economic growth following the Great Recession. Ten years ago, global debt was 200% of economic output; in the mid 1970’s, just before interest rates reached their cyclical peak, liabilities were just 30% of GDP. The world’s love affair with debt shows no sign of abating. In fact, several ideologies popular today with some economists (and politicians, both Democrats and Republicans) suggest a collective shrug at the risk of indebtedness. The catchy sounding Modern Monetary Theory is very much in vogue currently, as the public seeks to understand (or rationalize?) burgeoning government debt and budget deficits.

Simply put, MMT states that the growth in, and the level of government debt, is essentially irrelevant, as long as countries borrow in their own currency. The implication is that governments are foolish not to borrow money in today’s low interest rate environment. In fact, as long as the US dollar maintains its global reserve status and inflation is low, monetary policy could guide to zero real interest rates without deleterious effect. Within this framework, ironically debt could be redefined as an asset – in and of itself a challenge to the principles of conventional economics. MMT works basically as follows. The government borrows (or prints) money. The money flows into the banking system which in turn funnels it into the private sector. Businesses and individuals borrow the available monies which they use to fund investment, education, and infrastructure – fueling jobs and consumption. The only constraint to government spending is inflation, theoretically controlled by fiscal policy which, among other things, sets tax rates to moderate excessive consumer and business spending. Under the auspices of MMT, debt is expected to fuel economic growth ad infinitum. It’s trickle-down economics – the government turns on the spigot and everyone benefits (in theory).

In late 2017, the Senate passed, exclusively along party lines, a tax bill that is expected to raise the budget deficit by $1.5 trillion over the next ten years. Shortly thereafter, bipartisan majorities in Congress voted to increase spending outlays by 13%. There was little pushback from either party on a “deficit neutral” policy – one that would pay for itself within a decade. Instead, the government intends to spend $2 trillion in excess of projected revenues. The federal deficit will almost certainly top $1 trillion this year, up from $587 billion in 2016. But if GDP growth falls below the projected nominal 4% annualized rate, the deficit could be considerably higher. If we are running these kind of deficits when the economy is robust, what will they look like in a recession?

But don’t worry! Proponents of MMT theorize economic downturns can be moderated and/or deferred by fiscal policies designed to spend freely on capital investments (again, as long as the dollar maintains its integrity and inflation is constrained). MMT and other supply side ideologies in vogue today say the government can get away with what the individual cannot. Unlike individuals, the government can print money!

Less volatile and higher annual GDP growth is MMT’s goal. But how does it accomplish this? What portion of the economy can a debt binge affect? Let’s look at the proposed 2020 federal budget; it is expected to be $4.8 trillion. Of this total, $2.9 trillion represents mandatory spending on programs such as Medicare, Medicaid and Social Security – increased spend is unlikely to stimulate GDP growth as the population ages and costs rise. Debt service on the deficit totals $480 billion – another drag on expansion. That leaves $1.4 trillion in discretionary spend. Half of this amount is dedicated to the military, including the Department of Veteran Affairs and other defense related entities. The $700 billion discretionary balance is primarily Health and Human Services, Education, the Justice Department, the IRS and Housing and Urban Development programs. The administration has proposed to raise military spending by 12%, while implementing a 12% cut to the Education Department, a 16% cut to HUD and a 31% reduction to the Environmental Protection Agency. So where is the money going to boost economic growth?

At this point, there are no actionable propositions regarding investing in this country’s infrastructure (transit, power grids, schools, aviation, water). Such programs could create jobs, safeguard the quality and safety of lives, and enhance our productivity and prosperity. Rather than investing in tangible innovation, is the massive increase in government deficits merely flowing back into the financial system, stimulating money supply and velocity - creating money from thin air? Perhaps GDP can grow indefinitely just by circulating ever increasing amounts of money through the system; but this looks like a house of cards if it isn’t combined with investing in substantive programs that create long term productivity gains. In fact, it appears that much of the tax “reform” windfall was spent last year on nearly a trillion dollars in share repurchases, not capital expenditures as hoped. Share buybacks fuel earnings per share growth but are not economically productive.

Exhibit 9: How is the money being used?

The hope is that the policies that are driving burgeoning federal deficits will stimulate business activity and consumer spending. The flip side is that very low interest rates hurt individuals and institutions that need to save and invest to meet their future obligations. In the last decade, extraordinary monetary accommodation and falling rates have necessitated that investors seek increasingly speculative corporate securities to boost investment returns, which corporate America and Wall Street have been happy to provide. Non-financial company debt has doubled since the Great Recession to over $5 trillion. Over $1 trillion of these are “leveraged loans”, the majority of which have been floated in the past few years. These securities are loans extended to companies that already have considerable debt or a poor credit history. Leveraged loan growth exceeded 20% last year alone; because demand for yield is so robust, less credit worthy entities have been able to issue lower coupon and “covenant lite” debt which place fewer safeguards on issuances. These leveraged loans are packaged and sold to investors, largely hedge funds and pension funds. Collateralized Loan Obligations (CLOs) are one of the fastest growing segments of the fixed income market. Sound familiar?? Wasn’t it just ten years ago that the global economy was brought to its knees by subprime derivatives? CLOs represent a much smaller proportion of the debt market and reside largely outside the traditional banking system. But the point is, are we suppressing the price of risk and fomenting moral hazard?

Several decades ago, the American economist, Hyman Minsky, postulated that (ironically) stability breeds financial instability. The “Minsky Moment” was coined in 1998 by Paul McCulley of PIMCO in reference to the Asian debt crisis the prior year. It is defined as “a sudden collapse of asset prices, following an abnormally long economic growth cycle that spurs an asymmetric rise in market speculation, sparked by debt or currency pressures”. The virtuous circle rapidly morphs into a vicious circle; investors and borrowers are forced to sell even sound assets to pay their debts, thus creating a liquidity crisis. This is what happened in 2008; it could happen again if risk is mispriced and there’s too much capital chasing too few (or too levered) investments.

Exhibit 5 & 6: Quality of corporate debt unimpressive

Since the recession, individuals have reined in their borrowing. The consumer balance sheet looks relatively healthy; indeed, consumer spending and confidence have been the underpinning of this, the longest economic expansion on record. But the government and businesses have been profligate in their debt issuance. Perhaps the proponents of MMT are correct – as long as inflation remains in check and one’s currency is stable, governments and corporations are incented to and rewarded for issuing increasing amounts of debt. However, debt represents consumption today at the expense of future consumption. We question how long debt expansion relative to economic output can be maintained before a crisis of liquidity. Unfortunately, in finance and economics we keep stepping on the same rakes.