Bernanke’s Playbook

Ben BernankeAt more than 2500 years old and just 24 words in length, the Pythagorean Theorem (a2+b2=c2) gracefully describes one of the basic spatial tools for calculating lengths and areas in construction and many other applications. Similarly, the US constitution with its 27 amendments establishes a government for freedom in just 7,818 words. On the other hand, the EU utilizes 26,911 words to regulate the sale of cabbage. Contending for ‘most inelegant’ might be the USA Internal Revenue Code which contains some 3,400,000 words – and growing. The point is that simple descriptions can carry more value than complex dissertations.

In investing, the sheer amount of available information and resulting interpretations thereof can be perplexing. So, with the year coming to a close what follows is an effort to distill the current state of the USA’s economic affairs into a single somewhat elegant chart.

Total USA Credit Market Debt Owed (in rogue)

The chart details the Total USA Credit Market Debt Owed (personal, corporate, and government) during the period from October of 1949 to present. Along with the rouge line, there lies a grey line too. The grey line extrapolates the amount of additional debt that is likely required to sustain the ‘standards’ of living that the USA has become accustomed to. During 2008, it can also be seen that the debt failed to rise along the curve and has since stalled between $53,000,000,000,000 and $54,000,000,000,000. This is not merely a coincidental relationship. Personal, corporate and governmental balance sheets have been unable to cumulatively support additional net debt since 2008. This is a combination of an inability to grow net incomes and already overextended levels of leverage. In short the economy has run out of its ability to organically expand, and to compound matters, the result is that we stand at the edge of a deflationary spiral.

Deflation is the decline in prices for goods and services across an economy. This might at first sound alright to individuals, but it is catastrophic to businesses. When businesses must cut prices in order to sell their inventories, they also must find ways to make this up in order to stay in business – often by reducing wages to employees. Worse, as real assets become less valuable, bank loan portfolios are suddenly under-collateralized to protect against loan defaults. Let’s not forget that it is your money that is deposited at the bank in order to make loans. If a loan defaults and the property is liquidated at a value that is less than the value of the loan then there is a loss to the bank. If this happens across a high percentage of the loan portfolio there will simply not be enough money available should you desire to remove your deposit. Thus, deflation can kill off banking systems. Deflation is what the current Federal Reserve Chair Ben Bernanke has vowed to fight at all costs.

In his seminal speech on the topic in 2002, Chair Bernanke detailed the following steps in order to avoid deflation. Items with a checkmark have already been tried, with limited (see chart) success.

  • Set short term interest rates at zero to stimulate spending
  • Recapitalize (inject money) the banking system as needed
  • Maintain a ‘buffer’ (print money) of inflation in the money supply
  • Purchase USA Treasury and agency debt securities
  • Distribute money to banks via low interest rate loans backed by just about any type of collateral, no matter how worthless.
  • Purchase domestic private assets or foreign government debt securities [foreign government debt security purchases have effectively begun if the following WSJ.com piece is accurate]
  • Announce explicit ceilings for yields on longer maturity US Treasury debt securities
  • Devalue the USA dollar via a program of gold purchases supported by unlimited domestic money creation.

In speaking with economists and scholars who repeatedly reference the 2002 speech as a playbook for what will next occur, I ask about the last item relating to devaluation. Nearly every one of them fails to recall how the current Chairman lists devaluation of the dollar via buying gold with unlimited printed money as the last resort to preventing a deflationary spiral.

This is why we should all understand the chart. As described above, the ‘stalling’ of total debt is unlikely to be remedied by a growing economy or some yet untapped source of capital to invest in newly issued debt by individuals, corporations, or the USA government. In order to avoid a deflationary spiral, the remaining items of Bernanke’s playbook will likely be employed in a final attempt to resume the trajectory of the curve and the implied ‘standards’ of living. This implies that approximately $53,000,000,000,000 ($53 trillion) of money could be created*** by June of 2016. An amazing number considering the broadest measure of the USA money supply (M3) is only estimated to be about $15 trillion. If, or perhaps when, this comes to pass then the world will see yet another period when cash and bonds fall towards a value of zero for the country that undertakes this endeavor.

There is a saying in investing; ‘don’t fight the Fed.’ Since Chairman Bernanke has demonstrated that he means what he says and has also followed his own checklist to each point, it is probable that he will do all things necessary to avoid a deflationary plunge. After all it is his primary job to keep the banks solvent. The chart shows the implied trajectory to sustain such an effort. As such, investments in productive real estate, real (non-service) companies, real stuff and areas outside of affected countries are about all that historically maintains, or increases in, value during this type of period. These are the areas where our primary focus resides for now.

*** Please note that this type of money creation would likely be out of thin air by agreement between the Federal Reserve and the USA Treasury rather than through the USA Treasury issuing bills, notes or bonds that could then be purchased by those with capital. As mentioned above, ‘purchasing’ of debt issuance is improbable as there is no large store of global capital at this scale that remains untapped. Further, for those expecting there might be some fiscal way to delay the day of reckoning for very long, the just released 2011 Financial Report of the United States Government dashes these hopes. The USA government continues to spend ($4.00 trillion – which excludes accruing social insurance expenditures) far beyond its taxes and revenue means ($2.36 trillion). Even a massive increase in taxes is not enough to cover current spending habits. Additionally, substantial issuance of debt securities by the USA Treasury to the Federal Reserve in return for money created out of thin air would only exasperate interest costs to the USA government and doom any hope of a balanced budget.