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The Fed's Playbook for Deleveraging

August 10, 2013


The era of market manipulation where indexes move to and fro following Fed comments continues to the point of nausea. Once upon a time in America, markets moved on fundamentals and actual economic data, but those days are gone as Cronyism and market manipulation has gone wild. The potential for exploitation of the timing of such market moving statements has never been higher, but insider trading by authorities can’t even be looked into now because it might breach “security concerns.” Investors are ultimately paying the price for these sickening rigged games.


We have argued for many years that one of the principle failures of a paper monetary system is that it fosters incentives to accumulate debt, leading debt to grow to unsustainable levels. When debt levels become too high on an economy-wide basis, deleveraging must occur. Today much of the developed world faces unsustainable levels of public-sector and private-sector debt, and is in some process of deleveraging as a result of the flawed global paper monetary system. The paper game has thus shifted from one of continued debt expansion to one of asynchronous deleveraging.


For the Federal Reserve the big playbook for deleveraging comes from the WWII debt accumulation period and the post WWII deleveraging period. To fund the War debt expansion the Fed fixed interest rates at an artificially low level in 1942, and to keep rates at these artificial levels the Fed had to buy nearly all short and long-term debt. National debt exploded from under 40% to over 108% at the end of the War (peaking near 120% thereafter). Private-sector debt however did not spike higher during this period, as it was a government spending spree. The Feds issued wage and price controls as well to try and prevent inflation from soaring.


For the US, V-E Day came on May 8, 1945, and V-J Day came on August 15, 1945. After WWII ended the government had to keep interest rates artificially low, and real yields negative (to reduce interest costs), and the Fed pegged long-term bond yields at 2.5% all the way until 1951. However soon after the War ended, wage and price controls were dropped, and inflation rose quickly, averaging 6.5% a year from 1946-1951 before peaking in the mid-50’s after prices had essentially doubled and money supply had essentially tripled. This was the era of financial repression that the Fed used to devalue and inflate away part of its huge war debt, bringing public debt/GDP back down to under 50% of GDP by the late 1950’s. The combination of high inflation and artificially low borrowing costs ate up a substantial portion of the huge US debt level, and this is the kind of deleveraging that many global central bankers are aiming for in the current debt crisis.


However there are many differences between the current global debt crisis and the post WWII excessive debt period that policy-makers may not be acknowledging or understanding. Years of rationing and soldiers coming home combined with GI bills to re-orient soldiers meant tons of pent-up demand. Private-sector debt levels had deleveraged during the Great Depression from nearly 240% of GDP at their peak in the early 1930’s down to nearly 40% by the time WWII ended. Thus while the public sector delevered after 1945, the private-sector began to re-lever, offsetting some of the economic pain that often accompanies deleveraging. The private-sector could re-lever and re-tool to accommodate shifting and growing aggregate demand from the new consumer market. Because deleveraging of government debt accompanied re-leveraging of the private sector and a release of pent-up consumer demand, the economic pain associated with broader deleveraging was less substantial, and GDP growth accompanied it. It is also much easier to cut spending on a war that is over than to cut other kinds of expenditures, and much less economically painful. Bombs, bullets, planes, missiles, and other tools of war that were being spent on are no longer needed in nearly the quantity they were when war was on. Factories used to build war munitions are more quickly and easily converted to supply new consumer demands then if those facilities were not being utilized. In addition the war had damaged much of the global production infra-structure, and particularly up to the mid-1950’s, the US was left with a huge global export advantage, while the profitability of rebuilding after war-time is a high-return investment that helped reward capital investment from re-tooling and re-building.


It’s politically incorrect to be so blunt, but the principle source of excess spending since the mid-1960’s in particular has come from transfer payments that are not working to create the world they promised at their inception. Food stamps and welfare don’t cure poverty, they just make it less visible and less directly damaging. Only real jobs, that produce new goods actually demanded by consumers, cure poverty. The US poverty rate (after changes in definition that tend to reduce it) in 2012 was 16.3%, compared to around 14.5% averaged in 1966-68 after the policies behind the “war on poverty” began to take effect (from the 1965 and 1967 legislation) - and all that after literally trillions of dollars of spending. The US has spent more in real terms on the War On Poverty than all other actual wars in its entire history, but the result is still negative in terms of poverty alleviation. Other entitlements in the form of transfers for Social Security and Medicare/caid now make up nearly 60% of Federal spending today. In 2012 Entitlement spending took up $2.053T (57.6% of total Federal Spending and 84.31% of Total Federal Revenues) of $3.563T of total Federal spending on $2.435T of total revenue. And you’ll have to add in another $100T+ of unfunded liabilities to get the amount of promises big government has made for Social Security and Medicare/caid benefits.


Thus while artificially low rates and massive asset purchases may have made at least some sense to fund a war with national sovereignty at stake, such policies are actually a negative today because they do not convey the real costs and urgency of continued debt accumulation. Market riot is put off. Hard decisions about failed social policies and false promises are not being made - in fact in the US false promises are actually being increased instead via Obamacare and Medicare/caid expansion. Incentives to innovation and capital investment remain poor and are not being improved at the very time that technology gaps and investment into productive assets are most needed to improve production and productivity in order for excessive debt levels to be paid. Taxation without representation is occurring on the largest scale in modern history as debts are rolled over to future generations who cannot even vote yet, while policies to put off the true costs which are rolled over and over. Meanwhile Congress continually tries to create greater barriers to abandon citizenship as an economic Iron Curtain is being drawn around our children who are increasingly viewed as tax surfs rather than free individuals. And, all around the developed world in particular, Cronyism grows as laws are bought and sold to garner favor instead of allowing markets and consumers to determine who gains from economic behavior, while speculation is rewarded and production is punished. This makes democratic reform of the failing system even more difficult. We can only hope that policy-makers lose control of long-rates more clearly and quickly ahead so that market incentives to face reality return sooner rather than later when costs are higher.


It's important to note that we are not dogmatic pessimists. We are actually cautiously optimistic about the future of mankind, but we are realistic about the folly of mankind (particularly government mankind).  There are tremendous innovations on the horizon that have the potential to make life for mankind better in the future. There will be new technologies and new industries that sprout creating opportunities for many.  However this will not come without cost. There is currently tremendous market manipulation going on right now on a scale that has never been seen before.  There is indeed a price to be paid.  The piper always inevitably gets paid.  Goldilocks does not last forever.  When the rooster comes home to roost, you may want to be invested in strategies that can potentially capitalize on the underlying trend of the markets regardless what's going on with the government or economy.


Past performance is not necessarily indicative of future results. The risk of loss exists.

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