This Bubble Too Shall Burst

(879 words, four-minute read)

With problems abounding here and now, it is hard to get excited about a problem that is in potential, in the future, hard to understand, and worst of all, requires current sacrifice to address. Fat chance of selling that. Ever. Nonetheless, for anyone willing to engage, here goes.

We can’t borrow forever

The growing US debt and Federal Reserve balance sheet were looming problems  before COVID. Although I think the CARE Act and Federal Reserve response were both necessary, the reality is that they will leave us post-crisis in a far more fragile financial condition than we already were.

The capacity to borrow, even for the US, is not infinite. If we continue adding $1.0 trillion a year to what will already be a record debt of $25 trillion post-crisis, there may come a time when the US, like other countries before it, will be unable to service its debt or access the credit markets for additional borrowing. As with all bubbles, it is unknown when or how such a reality might manifest and the debt bubble might burst. The traditional definition of a bubble is that you don’t know you are in it until it is too late. This bubble is different. Everyone should know we are in it. The problem is, for the reasons mentioned above, virtually no one really cares.

There is no fiscal responsible party left

Republicans have traditionally been the party of fiscal responsibility. This dynamic took a momentary respite when Clinton left office after several balanced budgets. Since that time, however, neither party has governed as if debt matters.

Bush’s tax cuts produced record deficits and Republicans were silent. Their anti-deficit ardor resurfaced during the Obama administration but was again silenced when Trump reduced taxes and produced the current trillion-dollar deficits. Both sides now spend freely on their favorite projects and recently repealed several Obama-era taxes. In designing the current $2.0 trillion CARE Act, virtually no attention was given to the question of how it will be paid for.

The nation’s debt is money borrowed from the future, leaving our children with less capacity to invest in their own priorities. While the morality of this is questionable, the sheer risk of such borrowing is considerable. Here’s why.

Here is how it all unwinds

At $390 billion in fiscal 2019, interest on the debt is the second largest part of the discretionary federal budget, exceeded only by defense. Based on CBO projections, and as graphically displayed by the Peter G. Peterson Foundation, interest will grow to $807 billion by 2029, approximating all non-defense discretionary spending. (These numbers do not include the CARE Act.)

But this is only part of the story. Interest rates are at historical lows. What happens if rates return to anywhere near their historical averages? In this case, the cost of our debt could more than double and become unsustainable. It will be ballgame over. How likely is this?

Although rates are at historical lows, such levels cannot be explained by traditional economic theory. Based on four centuries of monetary theory,** economist Irving Fisher (1867-1947) pioneered the quantity theory of money. His belief that inflation is a purely monetary phenomenon provided the basis for all monetary policy until very recently. In essence, when central banks create money at a rate faster than the growth of the real economy, all other things being equal, inflation increases. The more inflation, the higher interest rates must be to give investors a real return.  

In order to fight the 2008 financial crisis, the Federal Reserve expanded its balance sheet by over $3.5 trillion, thereby creating an unprecedented amount of new money. During the current crisis, they have already expanded it by another $1 trillion and have communicated a willingness to continue to do so. Based on conventional theory, this new money should have resulted in significant inflation by now. Mystified that it hasn’t, and unable to provide a viable explanation, most economists have simply abandoned the original theory and put their heads in the sand. They hope that “this time it will be different.” 

Bubbles don’t burst with advance notice

And I hope so too. But hope, as they say, is not a strategy. If we experience inflation commensurate with the level of money supply creation, interest rates will rise, and the cost of our debt will be potentially unsustainable. As our ability to support our debt diminishes, so will the willingness of the markets to continue to lend. When the markets retreat, the bubble bursts. 

Unfortunately, bubbles don’t burst with advance notice. Nor do they slowly deflate. They burst without warning and with fury. Note as examples the collapse of oil prices in 1980, the 22% single-day decline of the stock market in 1987, the Mexican peso crisis of 1994, the Russian debt collapse of 1998, the burst of the tech bubble in 1998, the subprime collapse in 2008 followed by the European debt crisis in 2009, and, most recently, the precipitous decline in the stock market only a week after hitting new highs. Each of these took investors and institutions by surprise, resulting in bankruptcies, bank failures, recessions, and government bailouts. Most were avoidable. 

This bubble too is avoidable, but only if our elected officials start to act like responsible adults, pay for what we consume, and refrain from borrowing from our children and their futures. 

 **The quantity theory of money was expressed in the equation MV = PQ. M is money supply, V is the velocity with which the money supply turns over, Q is the quantity of real goods (GDP), and P is the price level. Therefore, assuming V is constant, and M increases more than Q, the only potential outcome is an increase in P.

In the past 10 years, V has declined to offset the increase in M. Economists are at a loss to explain this development. Were V to return to historical levels, P would be likely to increase significantly.