Financial Dominoes

Capital structure is relevant.  Promises are significant.  Contracts are definitive.

This will be short (it better be, I’m tired and want to sleep), but I have no end of friends asking me how bad it is out there.  First I tell them my opinion is a minority opinion.  Second, I tell them that debt-laden economies are inherently inflexible.  Third, I tell them that when the banks are compromised, ordinary monetary policy is useless, because there is no way to make a bank that is worried about its solvency lend more.  Fourth, even extraordinary monetary policy may not work, as the Fed tries to target lending markets, and finds that they can absorb bad assets, but can’t readily recycle them.

The aggregate capital structure of the economy is not a matter of indifference.  If there are many debt claims, and firms with debt finance other firms via debt, who finance other firms via debt, etc., then we set up a bunch of financial dominoes, where a disturbance can knock one down and carry others with it.

This is why the total debt to GDP ratio matters so much.  Economies stop functioning when they have high levels of embedded debt and a slowdown hits.  That is where we are now, at levels of Debt to GDP that exceed those of the Great Depression.  Until we get that ratio down from 350% down to 150%, normalcy will not return.  Air is leaking out of the debt bubble, and the ability to reflate is not there, because the market value of the assets have sagged to such a level that even a zero Fed funds rate will not raise the market value to the levels where the assets are booked.

People are not reliable; they sin; they default.  Economic systems that are primarily equity financed are better able to deal with the nature of man, because they have more flexibility.  Economic systems that are more heavily debt financed face more problems when someone cannot live up to his promises, because it means that others relying on the performance may not be able to live up to their promises also.

Things are different now.  In past economic cycles, there were sectors of the economy that could be stimulated by the Fed lowering the Fed funds rate.  But now, because of too many fixed committments, there is no sector of the American economy that can absorb more debt, and stimulate everyone else.

Thus the task of levering up falls to the Federal government.  But will they be able to honor all the promises that they have made?  Given that they control the printing press, the answer is yes in nominal terms, but no if in inflation-adjusted terms.