Dazed and Confused #2
Debt rattle
In last week’s MBMG Flash[1], we covered part of the recent discussion with CNBC’s Will Koulouris about the disparity in mainstream perceptions of the health of Western markets and economies (positive analyst rhetoric atop ugly fundamentals) and developing markets, especially China (negative analyst rhetoric atop sound fundamentals) –
“anybody who is mainly worried about the Chinese economy and Chinese growth going forward is looking in the wrong place “
Paul explained how the main fundamental driver of long-term US interest rates has really been a “referendum on what long-term US growth rates are going to be” but in the short-term rates have been driven higher by a confluence of Chinese and Japanese selling and increasingly disproportionate issuance of long-term notes by the US Treasury, creating “a massive opportunity in long-term treasuries”.
This opportunity is being hugely augmented by the secondary effect of herd effects, creating a false level of confidence built on the consequences of the capital flows highlighted in last week’s Flash – “at the moment that the market isn't really responding to the treasuries opportunity because of the market’s misguided miscalibration of long-term growth expectations.” In short, not only did the best part of $1 trillion flow into the most liquidity-sensitive assets, but this created a ripple effect where additional capital also flowed out of the least liquidity-sensitive assets, chasing the bubble, what Argonaut Capital’s Barry Norris has termed “the dash for trash”.
It’s worth taking a step back to ask why there’s seemingly such disproportionate Treasury issuance of longer duration, which requires an even greater step back to try to understand how we all got here.
The Genesis of U.S. Debt - The War of Independence and the birth of a nation
The first US ‘debts’ were effectively incurred prior to the formal ratification of the new country, with the Continental Congress racking up huge bills and issuing IOUs during the War of Independence. At that stage the Congress lacked the power to impose taxation or levy duties. These can therefore, unlike today’s government outlays, be considered genuine borrowing obligations, which potentially undermined the new country following its founding. [2]
A disproportionate amount of debt was incurred by what were to become the Northern states. Part of the agreement by which the new Federal Government assumed these debts involved accepting that the seat of the new government be located further south, where the new states had much lower indebtedness. Hence the location of US Government in swampland that was to become the District of Columbia, on the border between Maryland and Virginia. James Swan, a wealthy Scots-born Bostonian financier, arranged to assume the French debt and re-sell it, at higher interest rates, to wealthy private American investors in 1795. Swan later died in debtor’s prison in Paris.[3]
The fledgeling country, influenced by the policies firstly of Treasury Secretary Hamilton (the eponymous hero of the musical Hamilton) and then by those of Jefferson, typically ran significant budget surpluses by imposing high duties. Revolutionaries who had rallied around the mantra of no taxation without representation were discovering just how expensive representation could be. Opposition was often forceful, such as the Whiskey Rebellion of Pennsylvania in 1794.
Perceived to be on a sounder footing, USG was able to tap international debt markets to fund ongoing adventures, such as the ‘Louisiana Purchase’ in 1803. The first blip in this early trend (see the chart below) came about due the costs of waging the war of 1812, but by 1835, US Federal ‘Debt’ was fully repaid and remained at low levels until the Civil War, when ‘debt’ surged 40-fold from $65 million in 1860 to almost $ 2.8 billion in 1866.
From Civil War to World War
Prior to the Civil War, government financing had largely relied on duties but the war also heralded the introduction of income taxes, although these were repealed once the ‘debt’ started to fall again (as a proportion of GDP, which is the modern way to compare equivalence over time, but wasn’t in usage at the time).
Government revenues (America at the time adopting a combination of high levels of duties and extreme degrees of protectionism) remained strong and, as the chart below shows, continued falling until the outbreak of and America’s entry into World War I, which, as in many countries, was financed by selling bonds and war bonds into the domestic market.
The Roaring Twenties and the Great Depression
World War I marked a sea change in that the post-war Republican-dominated administrations focused on reducing taxes (especially for the wealthiest and highest income earners). The post-war era also saw the emergence of American dominance in many areas of commerce and manufacturing. Together, these factors resulted in a dramatic volte face from the aggressive protectionism on which American development had been founded to the adoption of free-market policies that better suited America’s new-found post-war relative status as top dog.
One consequence of the changes in the American economy and in USG policymaking was the adoption of policy structures that might be viewed as the prototype of the debt ceiling approach which has become an annual hamstrung bone of contention.
The combination of tax cuts for the wealthiest, the antecedents of austerity policies for the masses and an obsession with reducing the national debt during the 1920s played a large role in creating the breeding ground for the Great Depression. By 1932, the Roosevelt administration sought to reverse this by providing greater fiscal support to the economy to try to combat the worst ravages of the Great Depression.
Too early reduction in government support during the mid-1930s reduced the effectiveness of ‘The New Deal’ but by the end of the decade, the spectre of World War II was posing an even bigger threat to USG finances.
The Second World War
In many ways, the seeds of the new deal only fully took root following World War II. The growth in the US economy following World War II resulted in a lower debt-to-GDP ratio without penalising the majority of Americans in the way that the policies of the 1920s had done, with post-war economic expansion continuing until well into the 1960s and 1970s:
However, by the 1980s the lessons of the 1920s had been completely forgotten and America once again repeated the mistakes of the past, this time re-badged as ‘Reaganomics’, once again fostering economic inequality, along with higher levels of private debt and financial instability.
A brave new world? Or just a stupid one?
By now, the Dollar was well-established as the global reserve currency but the groundbreaking attempts of economist Hyman Minsky and his intellectual heirs, including Michael Hudson and Steve Keen, to explain the actual functioning of the US economy were mainly falling on deaf, neoclassical ears of a largely Republican establishment. One such realisation that has been largely ignored was the awareness that US Treasury bonds are not really a form of debt so much as a form of interest-bearing currency. [4] Once it is understood that the US Government (and its agencies) has monopoly rights over Dollar creation it becomes apparent that, especially since the abolishment of the gold standard in 1971, there are no financial reasons that can cause America to ‘default’ on either its currency or its US-Dollar denominated debt.
The present is very different to the past.
In 1795, default was a distinct possibility.
During the period when the value of the Dollar was linked to gold, then the increasing risk of not being able to offer convertibility to gold of Dollars in existence was certainly at least a theoretical possibility. Since Nixon ‘closed the gold window’, abolishing convertibility of Dollars to gold in 1971, the Dollar eco-system is effectively a closed loop, in that USG actually has no need to borrow to fund expenditure. The Treasury can create Dollars in whatever form it chooses– coins, Dollar bills, Treasury bills or bonds. It suits US policymakers to exert economic control by influencing short-term lending rates by continuing to issue interest bearing currency, in the form of treasury bills and treasury bonds. Judging by the amount of ill-informed fearmongering that we see in our email inboxes, this point seems to be one of the most widely held misunderstandings in modern finance. In the next MBMG Flash, we’ll delve more into examining what form of Dollars policymakers have issued of late and what that means for markets and the economy.
[1] https://mbmg.substack.com/p/dazed-and-confused
[2] It’s worth remembering that one factor that coloured British attitudes towards American independence was the view that, unlike the colonies in for instance the West Indies, there was little worth fighting for in terms of valuable natura resources in America. However, the strategic value of the colonies waging war against the British Empire was sufficiently attractive that the French Government and Dutch lenders were willing to advance loans to fund what they might have viewed as a proxy war to weaken Britain.
[3] https://gratefulamericanfoundation.org/who-paid-off-the-2024899-u-s-national-debt-today/
[4] This is well explained in Stephanie Kelton’s book ‘The Deficit Myth’.
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About the Author:
Paul Gambles is licensed by the SEC as both a Securities Fundamental Investment Analyst and an Investment planner.
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