The Breakdown - Will the Debt Crush Powell’s Volker Dreams?

Starting point is 00:00:00 Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexus.com, and ftX, and produced and distributed by CoinDesk. What's going on, guys? It is Sunday, September 25th, and that means it's time for Long Reads Sunday. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown pod. Also a disclosure, as always, in addition to them being a sponsor of the show,

Starting point is 00:00:46 I also work with FTX. All right, everyone, well, listen, I named my first show of this week bleak week, and boy, did that end up being true. It really was just a total sky is falling type of week to reference a quote that I used on yesterday's show, I continue to think that much of the gloom has to do with just how in between things feel, aka, are we in a recession or not, as well as just the severe cognitive dissonance of economic signals pointing in different directions. Whatever the case, it is gloomy out there. And for Long Read Sunday this week, instead of just reading one essay,

Starting point is 00:01:26 I decided it might be good to read a variety of threads on different topics. I haven't done one of these thread shows for a while, and I've noticed a couple recently that I liked, so I thought, hey, this could be a great time for that. We're going to kick it off with a thread from Eric Basmagian, who has rocketed into FinTwit as one of the best new threaders in the game. The thread I'm going to read is called America's Middle Classes Vanishing, and it comes from September 20th, 2022. In the last 20 years, the share of wealth held by the middle class dropped more than 8 percent, while the share of wealth held by the top 1% increased almost 8%. Why is this happening and is this trend going to continue? Let's find out.

Starting point is 00:02:09 Since 2002, the share of wealth held by the middle class has dropped from 36% to 28%. Over the same period, the share of wealth held by the top 1% has increased from 25% to 32%. In 2014, the share of wealth held by the top 1% exceeded the share of wealth held by the middle class, defined here as the 50th to 90th percentile. If we look at the share of wealth held by the top 1%, the trend looks extremely similar to the trend in the stock market. This makes sense. Wealthy people own a lot of assets, so if asset prices rise, that helps them. The middle class doesn't hold nearly the amount of financial assets as the top 1%, and are much more dependent on the real economy for wage growth. Therefore, what we really have

Starting point is 00:02:50 to analyze is why asset prices have outpaced the real economy so much. Wage growth is tied to economic growth. There is no way or around it. Weaker than normal wage growth is a symptom of weaker than average economic growth. You cannot generate 5% wage growth with 2% GDP growth. So we must also understand why economic growth has been so weak. Over the long run, economic growth is a function of population growth and productivity growth. Productivity growth is closely linked to debt levels. When a use of debt doesn't generate an income stream, this is an unproductive use of debt that crushes productivity. Since the 1980s, we've taken a path of massively increasing debt.

Starting point is 00:03:29 The increase in the debt to GDP ratio tells us that this debt was not used productively. Once debt levels became excessive, there was a sharp drop in economic growth and thus wage growth. So the high debt levels hurt economic growth, which reduced wage growth, harming the middle class. Why were asset prices in the top 1% unaffected by this reduction in growth? Over the last 20 years, each time the economy ran into a debt problem, recession, the answer was to lower interest rate. rates. Lower interest rates was an easy way to kick the can down the road rather than dealing with the root cause, too much debt. So interest rates declined and asset prices recovered because the debt was easier to service, but the debt load still remained, suppressing economic growth,

Starting point is 00:04:08 and thus, wage growth. Asset holders make it out alive while workers suffer the consequences of the debt. When interest rates hit 0% after 2008, we still didn't want to solve the debt problem, but we couldn't lower interest rates, so we started quantitative easing. This increased liquidity in financial markets, again, helping assets, but doing nothing for the real economy. The concept behind these policies was that the economy would rise to the level of asset prices. Asset holders were supposed to spend this newfound net worth into the economy, jump-starting the economic cycle. Ben Bernanke said this exactly. Quote, this approach eased financial conditions in the past and so far looks to be effective

Starting point is 00:04:45 again. Stock prices rose and long-term interest rates fell when investors began to anticipate this additional action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment, and higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

Starting point is 00:05:12 End quote. But, as Robert Schiller noted, as well as other academic research, the wealth effect, particularly for the stock market, is a flawed concept. It doesn't work. quote, the importance of housing market wealth and financial wealth and affecting consumption is an empirical matter. We have examined this wealth effect with two panels of cross-sectional time series data that are more comprehensive than any applied before and with a number of different econometric specifications. We find at best weak evidence of a stock market wealth effect,

Starting point is 00:05:40 end quote. So all that happened was that asset prices were bolstered by lower rates and increased liquidity, but the economy still had to deal with the crushing debt burden that refused to be solved. Policymakers are very worried about correcting the debt problem because that means people, asset holders, will lose a lot of money as the economy experiences debt deflation. So instead, the policy choice has been to support asset prices, but the outcome has been disastrous for the middle class. Asset prices, like homes, have increased way faster than wages, creating a situation of gross on affordability. 20 years of conducting policy in this fashion and what do we have? We have asset prices that are dangerously elevated relative to the underlying economy, and we still

Starting point is 00:06:18 have all the debt. Correcting the debt problem would result in short-term extreme pain, but longer-term prosperity for all people as growth and wages could accelerate without a crushing debt burden. Pursuing the same policies will result in the same outcome. Ever-increasing debt, lower economic growth, falling real wages, but potentially higher asset prices at the decline in growth is met with lower rates and more liquidity. This lower growth and inability to afford assets, homes, has resulted in delayed household formation and lower birth rates, worsening our demographics. This is happening in every major country pursuing the same policies, but that is a topic for another day. I think Eric is super sharp, and I think you should give him a follow.

Starting point is 00:06:57 At EPP research on Twitter. The risk with a thread on Twitter is that it inherently reduces things to a single vantage point. Eric is looking through the lens of debt, and this is a common lens for people on FinTwit, especially, and Bitcoin Twitter, too, to look through. I think broadly there's a ton of truth in what he writes, but I think that obviously there is more to the story of the holocausts. out of the middle class over the last 20 years, than just interest rate policy. I don't think you can have a realistic conversation about the middle class, for example, in that same time period without talking about China and the World Trade Organization and choices we made along those lines. Now, that's obviously not to diminish anything in that thread, and like I said, I think you

Starting point is 00:07:35 should give Eric a follow. My one concern is that I sometimes worry that this type of analysis actually contributes to our overestimation of how much power monetary policy has to both fix or cause our problems. Anyway, Eric, thanks again for the great thread and keep up the good work. We are loving seeing it. NXO is a security first platform built for the long run with everything you need for your crypto. Five key fundamentals, including real-time auditing and insurance on custodial assets,

Starting point is 00:08:11 safeguard your funds, making NXO the right place for you to buy, exchange, and borrow against your assets safely. Learn more about NXO's reliable business model and start your crypto journey at nexo.io. That's nexo.io. Eager to make more informed decisions around crypto, chainelysis is here to help. Chainalysis demystifies cryptocurrency by providing industry-leading compliance, market intelligence, and investigations support for all crypto assets. For organizations like Gemini, Crypto.com, and BlockFi, gain unparalleled visibility and maximize your potential with the leading blockchain data platform

Starting point is 00:08:56 by visiting us now at chainalysis.com slash coin desk. The breakdown is sponsored by FTXUS. FDXUS is the safe, regulated way to buy and sell Bitcoin and other digital assets with up to 85% lower fees than competitors. There are no fixed minimum fees, no ACH transaction fees, and no withdrawal fees. One of the largest exchanges in the U.S. FDXUS is also the only leading exchange that supports both Ethereum and Solana NFTs.

Starting point is 00:09:28 When you trade NFTs on FTX, you pay no gas fees. Download the FTX app today and use referral code breakdown to support the show. Next up, we're going to read a thread by James Lavish that's all about Chairman Powell. Fed Chairman Powell has mentioned Volker quite a bit recently, channeling his hawkish stance. But Powell is no Volker, and this is not 1980. Time for a Fed thread. Who is Volker anyway? So who is this Paul Volker character we keep hearing about, like a Federal Reserve superhero or something? Why do we keep hearing his name 40 years after his so-called moment

Starting point is 00:10:07 at the Fed? First, Paul Volker was an economist by study and trade, having studied public and international affairs at Princeton, then public administration at Harvard grad school, and finally at the London School of Economics. His first job was as an economist at the Federal Reserve Bank of New York. He then worked alternating stints at the U.S. Treasury and Chase Manhattan Bank, before returning as the President of the New York Fed. Then, 27 years into his career, he was appointed Chairman of the Federal Reserve. In contrast, current Fed chairman Jerome Powell is a lawyer slash politician by study in trade, having studied politics at Princeton and law at Georgetown. After a few years as a judge clerk and then an attorney, he moved into M&A work at Dillian Road,

Starting point is 00:10:45 a New York City investment bank. After that, Powell spent some time at the U.S. Treasury, where he oversaw investigations of Solomon Brothers Investment Bank, still an attorney, not an economist. He then moved back into the private sector working in M&A and then a fund that he founded himself. Powell then returned to D.C. to work for a think tank back into politics. This is where Powell worked to get Congress to raise the debt ceiling in 2011. He was subsequently nominated as a federal board governor by President Obama, and in 2017, he took the helm as chairman of the Fed, nominated by President Trump. Okay, so now we have an idea of their career and experience differences. Let's get back to Volker in the 80s.

Starting point is 00:11:20 What was Volker's moment? First, Volker was not a good. exactly a hero, no less a superhero for the U.S. economy. Long before his moment, Volker was a key advisor to Nixon, suggesting the U.S. suspend convertibility of the U.S.D. into gold back in 1971. U.S. went off the gold standard. This move has been defined as a major contributor to ongoing financial manipulation by the Fed, and hence potential fiscal problems for the U.S. Flash forward to the 1970s, and we saw many of these problems manifesting in the U.S. economy. See, for years before 1965, inflation was quite stable, hovering right around 2%. but increased spending by the government during the Vietnam War caused inflation to start running hot,

Starting point is 00:11:58 ticking up over that magic 2% rate. Then, when the U.S. came off the gold standard, it began to escalate. With the 1973 OPEC oil embargo, gas prices nearly quadrupled and inflation jumped to double digits before settling in around the 7% level for years. The Fed incrementally raised rates attempting to tame inflation, but by 1979, surging energy and food prices sent inflation to the 9% and 10% level, peaking at nearly 15%. Some context. When Volker assumed the chair at the Fed in 1979, US GDP was 3.2%, unemployment was 6%, and

Starting point is 00:12:30 inflation was 11.3%. To tackle inflation, even if it meant inducing a recession, Volker raised the Fed fund's target rate aggressively, eventually up to 20%. The effective Fed funds rate, with the market actually prices in from the target rate, reached 22% in December of 1980, bold, aggressive, effective. By 1982, GDP was negative 1.8%, unemployment was 10.8%, and inflation was 6.2%. The economy was firmly in a recession, people were protesting against the Fed, and prices were calming down. So Volker backed off, reducing rates again. The Volker pivot. And by 1983, GDP was back to 4.6%, unemployment was 8.3%, and inflation 3.2%. Mission accomplished. Inflation since the 1990s has remained relatively in check, hovering around the 2% to 3% level.

Starting point is 00:13:18 Until now, of course. With quarter three GDP expected to be 2.8%, unemployment at historic lows of 3.5%, and inflation at 8.3%, some people are calling for another Volcker moment, a shock raise of rates by current FedShare Powell to match the strength of Volker and tackle inflation once and for all. Not so fast, armchair economists, because today is not 1980, and the result could be absolutely devastating to the U.S. economy and ultimately collapse the U.S. Treasury. Let's walk through why, shall we? Party like it's 1980? If you already follow me on Twitter, you've heard me sound warning bells about the massive debt U.S. has on its balance sheet.

Starting point is 00:13:53 This, along with falling tax revenues, creates a hefty deficit for the Treasury that it can only meet by issuing additional debt. To put it simply, we are a nation now built on borrowing, period. For reference, in 1980, the U.S. federal debt to GDP was 30%. Today, it's 125%. Since we're no longer on the gold standard, the United States has virtually no check against the rate at which the money supply can be expanded. In other words, it can print money at will, and it can borrow endlessly.

Starting point is 00:14:19 TLDR, the U.S. perpetually operates in a deficit. As the deficit grows, it simply issues more debt to fill in the gap between revenue, taxes, and expenses, entitlements, defense, and miscellaneous. One problem. As interest rates rise, the cost of borrowing rises as well. To illustrate, here's the current U.S. budget situation estimated by the Congressional Budget Office. 4.8 trillion in taxes, minus 3.7 trillion in entitlements,

Starting point is 00:14:42 minus 800 billion in defense equals 300 billion left over for interest expense. Current interest expense on 30 trillion of treasuries, 400 billion. $300 billion minus $400 billion equals negative $100 billion. Oops. Now imagine Powell and the Fed getting tough, really tough on inflation. Imagine him taking interest rates up way up like Volker did. Let's say he jacked up the target rate to 10%. The annual interest costs on replacing the current $30 trillion of debt at 10% would be $3 trillion.

Starting point is 00:15:09 That's $2.7 trillion over budget. And that's before a massive reduction in capital gains tax revenues from the market crash it would cause, as well as the plummeting of corporate taxes due to increased borrowing costs and decrease company profitability. What's worse, the Treasury would have to issue an additional $2.7 trillion of debt to cover that gap at the new 10% interest rate. In reality, the replacement cost would be higher as longer maturities would have higher interest rates than the Fed Fund's target rate. Not going to happen. Okay then, what if, since our rates have been so low for so long, that we use comparable percentage of moves hikes rather than absolute percentage hikes to the Fed's

Starting point is 00:15:43 target rate. Right now, and editors note, this is before the FOMC meeting this week, we're sitting at 2.5% at the high end of the Fed Fund's target rate. Let's say Powell pulls a Volker and doubles that in two or three hikes all the way up to 5%. And let's say the average replacement cost of treasury debt would then be 6%. Replacing 30 trillion of debt at 6% would cost $1.8 trillion in interest annually. That's $1.5 trillion over budget. Again, this is also before reduced tax revenues for that budget. In reality, revenues would be far lower than even this estimate. And this is also before the Fed has barely sold any of the $5.7 trillion of treasuries it has on its balance sheet for its QT program. Hiking rates up to 5% would induce much higher unemployment,

Starting point is 00:16:22 severely affecting the mortgage and housing market, and would significantly affect consumer's ability to pay their variable interest rate debts. Forget soft-ish landing, as Powell keeps saying, he wants. This would be a nose-dive crash of the economy that could take a decade or more to recover from. Bottom line, it's not going to happen either. Remember, Volcker's approach was shocking, and it was done in a series of moves over the course of nearly three years. Far too much, around 50% of U.S. debt would mature and need to be replaced in a similar time frame today. If Powell used a vocal shock, hiked rates to similar 1980 levels and held them there for two plus years, the U.S. economy, U.S. Treasury market, and U.S. Treasury itself

Starting point is 00:16:56 would simply collapse. Then what instead? I believe the Fed has limited options. Powell can hike rates just enough to appear tough on inflation without causing a market crash and tanking U.S. tax revenues. He can hike two, maybe three more times, but only to a terminal rate of about 3.5 to 4% at most. Even if the inflation rate does not come back to the stated target of 2%, Powell may back off for a while pointing to the direction of change in the inflation rate. The Fed may then quietly accept a 3-4% ongoing inflation rate and declare victory. And then, he'll quickly do what Volker did in 1982, but this time he will have to do it sooner, by late 2023 instead. He will have to pivot and begin to lower rates again. Why? It's just math,

Starting point is 00:17:34 my friends. Math that is not in the Fed or Treasury's favor. Higher inflation they can stomach, especially as it helps pay off past debt with cheaper future dollars. And besides, the last thing Powell wants to do is crash the economy into a depression and cause the whole house of debt to crater and end the borrowing charade. So as an investor, what can you do? You've heard me say it before. I think it is essential to own hard monies and assets that hold their value over long periods of time. Holding some cash in these times of uncertainty is wise, especially if you have short-term needs. But owning gold, silver, and Bitcoin will help in either a U.S. Treasury meltdown and or a hyperinflation scenario, still a long way off in my personal opinion, or, much more likely,

Starting point is 00:18:11 for when the pivot comes and QE Infinity begins, which we have all come to expect eventually will. Back to NLW here, and I guess actually I'm going to close it after that one just because it was such a long and thorough thread, and I think actually goes great with Eric's thread as well. This, I believe, is one of the questions that most lurks if you take a medium-run view

Starting point is 00:18:31 of the economy and specifically monetary policy. That's the question of how long the Fed can keep tightened, And it's not a question that's based necessarily just on political will. It's a question based, perhaps, as James suggests, on math. You can bet that the longer this tightening cycle goes on, the more people are going to be asking exactly that question. For now, I want to say thanks to Eric and James for their great threads. To my sponsors, nexus.io, chainalysis and FTX for supporting the show.

Starting point is 00:18:59 And thanks to you guys for listening. Until tomorrow, be safe and take care of each other. Peace. I want to tell you about CoinDesk's new event, the investing in digital enterprises and asset summit or ideas. The event facilitates capital flow and market growth by connecting the digital economy with traditional finance. Join CoinDesk October 18th and 19th in New York City for a 360-degree investment experience, where you can source, invest, and secure the next big deal in digital assets.

Starting point is 00:19:30 Use code Breakdown 20 for 20% off a general pass. You can register today at coindesk.com slash ideas.

The Breakdown - Will the Debt Crush Powell’s Volker Dreams?

There aren't comments yet for this episode. Click on any sentence in the transcript to leave a comment.