Debt Expansion and Bubble Formation — Update
There are several historical precedents that reveal the stages of a nation’s ultimate currency debasement that comes about as a function of fiscal excess and debt accumulation. Arguably, the final stage of currency debasement will most often witness an exponential rise in a nation’s currency supply. This has traditionally come about in the form of accelerated paper currency printing, or, as in the modern age, the digital creation of currency as electronic accounting entries on central banks’ balance sheets. Witness the rise in the size of the balance sheets of the Federal Reserve, ECB, and Bank of England as they continue to accumulate sovereign and credit-related assets from government treasuries, banking and non-banking (e.g. Fannie Mae) institutions, in exchange for digital dollars that these institutions have used to shore up their capital base.
The sovereign debt bubble formation discussed in a previous perspective article (http://www.financialsense.com/contributors/gregory-hajjar/2011/06/17/debt-expansion-and-bubble-formation) appears intact based on recent ECB action and Fed statements. In an August 7, 2011 interview with the press, former Federal Reserve Chairman Alan Greenspan responded to questions about the US defaulting on its debt obligations by stating that “The United States can pay any debt it has because it can always print money to do that. So there is zero probability of default.” Mr Greenspan appears to have to made no comment (nor was he apparently asked to do so) about the ultimate effect on the value of the dollar from printing exponentially growing quantities of dollars. The ECB at the same time has signalled its intention to buy Italian and Spanish bonds should the need arise, as it most certainly will, given the rising risk premium sought by investors at these nations’ auctions of government debt.
The Chinese government which has been an important source of global funding signalled its displeasure with US policy following the US debt downgrade. Using somewhat scathing and blunt language, the Chinese appear to indicate that they should no longer be relied upon to continue buying US government debt issuance, and may in fact be looking to accelerate a program of diversifying away from their existing sizable inventory of US government paper. The Chinese amongst other investors appear to have already tempered their enthusiasm about further US government debt accumulation in their portfolios. The recent growth in US government bond holdings on the Fed’s balance sheet testifies to the fact the Fed has been an aggressive buyer of excess US government debt supply at successive bond auctions, the size of which is growing at an alarming pace, helped along by continuing US government fiscal excesses.
In the absence of further Chinese and other important buyers of US government debt at successive auctions, and based on Mr Greenspan’s comment about the US printing more dollars to pay for its debts, it is conceivable that the Fed may be about to embark on an even more aggressive program of printing dollars in order to buy a growing share of the US government’s bond issuance program. As dramatic as it may sound, should the US find itself funding most if not all of its borrowing needs from the Fed, it would not be the first nation historically to have done so. It is furthermore known with certainty that the outcome for all nations that have embarked on such a path has been a catastrophic debasement of these nations’ currency, resulting in hyperinflation as the most important outcome with all of its adverse downstream effects.
The previous article mentioned above discussed the formation, in progress for the past 2-3 years, of a US government debt bubble (in terms of both size and perhaps more importantly price), using a 15-year trend in the S&P500, culminating in the bursting of this bubble triggered by a steep devaluation in the value of the US dollar. The same article had argued for a correction in the S&P500 to 1150-1200 as leading to a 3rd round of quantitative easing, which would ultimately drive the S&P500 index to approximately 1600, marking a triple top over a 15-year horizon. The S&P500 index corrected to a close of 1120 on Aug 8 and traded as low as 1100 before dramatically reversing direction to close at 1170 on Aug 9. Although a 1-day bounce in equities does not a recovery make, the S&P500’s ascent towards the triple top high of 1600 remains somewhat intact, as does the continuation of the US debt bubble formation; both of which may become reinforced should QE3 become more fully revealed. Although the Fed did not explicitly state an intention at its most recent meeting on Aug 9 to undertake QE3, its decision to maintain historically low rates for 2 more years points strongly in this direction. Further evidence appears to have been provided in terms of gold making new highs shortly before and following the Fed’s Aug 9 decision and statement.
If one is to take the former Fed Chairman at his word, the US may now be entering the final stage of its debt bubble formation and currency debasement, as manifested by a nation’s path of unsustainable currency creation and debt accumulation largely for consumption purposes. This outlook will be reinforced should the market one day find itself in a situation where the Fed has become not simply the buyer of last resort of US treasuries, but potentially the biggest, if not sole buyer. This cannot be achieved except through the Fed’s paper and digital currency printing presses working overtime, securing the US dollar’s ultimate demise with all of its transformative consequences.