Sam Altman, from the Valley, posted this question, which I know a lot of people have been asking:
I’m not an economist (although I was a securitization lawyer, so I have dealt with debt and default on a professional level) so here’s what I replied:
I’m a child of the global financial crisis. I was living in the City of London when Lehman went down. I remember the images of bankers clearing out their desks. I remember the long faces worn by all of the other bankers who remained employed, that week. I remember Bear Stearns going down earlier that year, and friends from university losing their first jobs. I remember the conference room in the shipping company headquarters across the street from my small (25m square) apartment I lived in in my final year of law school, ablaze with light at midnight as its officers tried to position the company for what everyone thought would be the end of the world.
I remember it being overcast, drab, and gray, just like the boring, too-small suits British professionals tend to wear. I remember reading about how the overnight lending markets froze up – completely. I remember, months later, hearing how the United Kingdom was less than twelve hours away from ATM machines not working.
I will never forget any of this as long as I live.
I started by first job as a junior lawyer in 2009. I spent the next five years drafting documents for transactions that restructured or unwound deals that went bad. The bonds in these deals went bad because they were backed by cheap debt, which itself was backed by worthless assets. This cheap debt never had any chance of being repaid. This cheap debt had no business ever being originated.
NIRP gives me the willies because it is the ultimate cheap debt. Cheap debt looks like a great deal at the time for happy borrowers. NIRP reduces the price of money itself – it makes low rates systemic across virtually every category of borrowing (unlike, say, mortgage securitizations, which confined cheap debt to secured loans). It turns every man, woman, and child in the Western world into happy borrowers whenever we borrow. But, as with the subprime crisis, debt cannot stay cheap forever. Cheap debt eventually becomes expensive debt. And when that happens, if the debt load is too high, you get a debt crisis.
That NIRP is creating a massive debt crisis will be as obvious to our children as the subprime bubble seems to us. “Well of COURSE people shouldn’t have overstated their income and taken out ARMs they couldn’t afford.” Well of course we shouldn’t have funded entitlement programs with trillions in low-interest debt and ensure our governments were all dependent on what are effectively revolving credit facilities writ large (more on this below).
Central bank rate setting is basically an adjustable rate mortgage for states and their entire economic systems.
The problem is that here the central banks, though nominally independent, are in fact subject to the whims of the political apparatus, and NIRP/cheap debt solves a lot of short term political problems. Not only does it juice the economy (longest bull run in history!) but it prevents governments from needing what Habermas identified in Legitimation Crisis as their most fundamental choice in resource allocation – between the demand for welfare by the populace and a low tax burden by enterprise – and putting that risk off for the future in the form of debt, which accumulates as and is quantified by the annual budget deficit and accumulated debt.
Habermas understood that this is a very dangerous game. States are, when they do this, creating expectations of satisfaction what he termed “programmatic demands.” The title of the book, Legitimation Crisis, refers to Habermas’ description of what happens when a state is ‘no longer able to satisfy the programmatic demands it has set for itself.’ The risk breaks out into the open, leading to the untethering of institutions and political expectations, upheaval, and revolutionary change.
We see this happening in places like Venezuela or Zimbabwe, but we think that it cannot possibly happen in the United States. We’re smarter than that. We’re bigger than that. We’re better than that, we think.
But the thing is, we’re really not.
The subprime crisis got its start when hitherto-illiquid markets for real estate got access to global capital markets and cheap debt. NIRP is the ultimate cheap debt. Cheap debt appeals to the eternal human proclivity towards high time preferences. So when we flood the world in it, it is going to be taken up and used.
Increasing central bank balance sheets and budget deficits across the Western world indicate this is exactly what’s happening. Yet central bank governors don’t see the monster they’re creating.
NIRP is fairly new, so I’m not saying that some debt disaster going to happen now, or next year, or even the year after that. What I am saying is that where deficit hawks might have been wrong in the past, a stopped clock is right twice a day – and NIRP might be a critical element, a missing piece, the unforeseen development, that finally makes that narrative, which while logical has consistently been wrong, relevant.
There are a couple of critiques I’ve seen of this view, that NIRP will create a debt crisis.
“So they’ll never raise rates again. Easy.”
Then they’ll have inflation. Which is already here in asset prices, and is starting to bleed over into the rest of the economy. Taco Bell managers are getting paid $100,000 a year.
“The Fed can always keep rates low by buying new notes.”
This is insane.
Debt hawks like Ron Paul are widely disbelieved these days, I think, because central bankers got away with QE without hyperinflation. As a result, they think they can get away with anything.
This critique works now. It does not work when there’s a crisis. As with all crises, the next one cannot be foreseen with absolute certainty, so folks usually assume that things will continue as they are and venerable institutions like the Federal Reserve will always have clever enough boffins with effective enough tooling to allow business as usual to continue.
It is not a stretch to assume that, in a future crisis those tools will have long since run out of potency. This is widely acknowledged across the banking industry.
BI quotes the CEO of Deutsche in September of last year:
The likes of the European Central Bank and the U.S. Federal Reserve have “no conventional measures left to effectively cushion” the blow of a “real economic crisis,” Christian Sewing said at the Sibos banking conference in London.
Or Larry Summers in 2015:
Central bankers bravely assert that they can always use unconventional tools. But there may be less in the cupboard than they suppose. The efficacy of further quantitative easing in an environment of well-functioning markets and already very low medium-term rates is highly questionable. There are severe limits on how negative rates can become. A central bank forced back to the zero lower bound is not likely to have great credibility if it engages in forward guidance.
NIRP can’t work forever. Eventually rates will go up or something will break. That may take the form of inflation or hyperinflation. I query how long the Fed will be able to keep rates low while people use wheelbarrows of cash to buy bread, which is where helicopter money eventually ends. If Venezuela is an indication it can do this for a long time, but I suspect political action would stop the Fed early.
Also, this isn’t a U.S. problem but a global one. Saudi Arabia, for example, as a $12 billion dollar-denominated note out there. If it were to redenominate to Riyals, print the Riyals and use that to satisfy investor claims, that would be a default. The privileges attendant with being the backbone of the global financial system only accrue to one country, the United States, and at the moment we seem to be doing everything in our power to lose that position.
“How do you default on a negative rate note?”
You don’t necessarily have to default on that note to suffer the consequences of a default. You can default on some other obligation you can’t pay because you have an enormous debt load and can no longer issue new notes because the market won’t lend to you affordably or at all. That’s still a default and will affect your ability to tap capital markets.
The first things to freeze up during the global financial crisis were revolvers like ABCP and short term loans like the overnight market. The government debt sector is basically a huge RCF. It can’t function unless it keeps issuing. A short term crunch could be enough to cause a major crisis.
So when will all this happen?
Who knows? This is a theory; it may never happen, and NIRP may herald the beginning of a glorious new era where debt is infinitely cheap and growth continues forever.
I don’t think that’s the end result. I think the end result is that large debts get accumulated, lenders begin to lose confidence that the loans will ever be paid back, rates go up, and debts accumulated can either no longer be serviced or revolving facilities no longer have buyers.
Crises generally break out when there’s a shock.
I think the shock required to shake the world will need to be of global proportions. Who knows what it’ll be. A big war? An invasion of space groundhogs dropping out of warp in low Earth orbit, sent here by the Marmot Star Empire?
Maybe. But I think it’ll be something that initially looks small and contained, but which scares the hell out of investors due to its macro implications, which will set off the next big crash. And we’re not talking about a correction (which we’re overdue for anyway) but a really, really big crash that could be years off.
If Ghawar Field ran dry in the next decade that might do it. Everyone’s growth projections would be revised down and it might become apparent that countries with huge debt loads can’t grow enough to repay them.
PS we definitely need to call this debt crisis “the Zombie Marmot Apocalypse” because Boomer names for these things were totally boring.
from Hacker News https://ift.tt/2TeuYYs
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