Thanks to many for your questions about this deleveraging cycle, which have stimulated my mind.  Let me put down some of my thoughts into words!

I agree that we are at “risk” of seeing the Post World War II “Great Debt Super Cycle” come to an end. Just as this long term post-WW2 credit expansion has boosted GDP growth rates enjoyed in this Post War Era, a gradual reduction in such credit would tend to depress GDP growth, (hence the reason for my belief that we are mired in an economic depression that is qualitatively different from the previous Postwar recessions).

Although this depression scenario has been a long held view, I see some prospect that this Great Debt Super Cycle could eventually gain a second wind due both to (1) short term government stimulus and (2) depression fatigue (aka Euro Fatigue) on the part of U.S. consumers. With pent up demand to replace aging autos and effect long-deferred household formation, such “second wind” seems less fanciful when viewed in the context of the many mini-recoveries enjoyed in Japan during their two lost decades of the 1990s and 2000s.[ii]

Like the Japanese, we have mitigated our depression with massive fiscal stimulus (although our Debt to GDP ratio has risen to “only” 100%, a level half that of the approximately 200% Japanese Debt to GDP ratio created by two decades of their proverbial “bridges to nowhere” and business bailouts.) The Japanese are sadly finding that their more shame-based culture may have less resilience[iii] (i.e. display greater fragility in the language of complexity theory) in shame-based cultures that recoil from facing failure absent a face saving utter defeat.[iv] While they may feel partly protected by their high savings rates, such protection is weakened by the “security” of questionable investments in Japanese and other sovereign bonds[v] (aka “paper” & “electronic” IOUs that some fear are ultimately not going to be worth the paper they are not printed on!)

While the Japanese may be running our of time, we “fortunately” have the theoretical ability to grow our destructive debt snowball as a result of our reserve currency status and heretofore greater economic dynamism, innovation, and protection found in the rule of law. The U.S. also faces far less dire demographic trends than Japan or even Europe.

Given all the relative advantages we enjoy as Americans, it seems likely that this recession, which was “knocking at our door” in the summer and fall can be delayed for a while longer. If this happens, the second recession within what I am still characterizing as a depression might be delayed long enough to give us time to turn our Ship of State toward a more sustainable course.

My hope is that we use any respite to get our fiscal house in order. My fear is any success in holding off this depression’s second recession will give our society apparent license to edge back toward its more profligate ways and allow debt problems to fester to a point sparking a new crisis that will require even more sacrifice to deal with. If history is any guide, elected politicians will opt for the easy solutions to continue to their Faustian Bargain until we reach the Keynesian Endpoint. The good news is that pain can be delayed. The bad news is that our condition worsens so long as we allow the cancer to grow.

Of course the choices are not limited to two extremes but rather include a range of treatments including a gradual withdrawal from our debt addiction in a manner that allows us to safely de-lever. The “fly in the ointment” relates to the difficulty (bordering on impossibility) of happening onto wise, democratically elected politicians able to sustain public support through the short term “air pockets” and mini-crises that inevitably occur during the most difficult part of the treatment! In the end, our best hope may be that we “muddle through.” More likely, we will first need a political crisis to force a response to the Gathering Storm.

Inherent Path Dependency

Which brings us to the economic concept of “Path Dependency,” popularly associated with economics Ph.D.s at least since the time of Harry Truman who famously lamented that he could never find a “one armed economist.” Like all good economists, Truman’s economic advisors were criticized for seeming to temper their forecasts with the caution of what, “on the other hand” would occur if events unfolded in a different direction.

Fasting forward from the 1940s & early 50s, we should better understand how seemingly small events create huge changes in what we now understand to be complex systems (i.e. interconnected and interdependent economic agents that adapt to change based on their differing incentives and circumstances). Throwing in the potential for staggering domino effects, we understand that almost no elected politician would willingly accept an economic catastrophe so long as the consequences can be pushed forward to a future administration or even future generation![vi]

Sudden failures are of course sometimes allowed once memories of previous economic tsunamis have faded from memory. This is what happened in 2008 in response to a growing drumbeat of populist opposition to bank bailouts such as that which “saved” Bear Sterns in the Spring of 2008. The growing chorus of calls to avoid “moral hazard” and allow failure was girded with the intellectual framework of Austrian School Classical Economists which ignores sticky labor markets, assumes economic rationality, and assumes full employment and equilibrium ensured by a quick “regression to the mean.” Using the “laws” of economics, these economists with what I like to call “physics envy,” foresee a quick return to equilibrium with a certainty bordering on that associated with Newtonian Physics.

 Once the systemically important Lehman Brothers was allowed to fail, the consequences of letting “the letting the chips fall where they may” became clear. Either we were going to accept the so-called “moral hazard” of a bailout or we were going to face a second Great Depression! Neither Hank Paulson or George Bush (or even Nancy Pelosi) wanted to undertake trillion dollar bailouts. But they understood that failure to bail out the banks would ensure a world wide depression that was orders of magnitude greater than anything ever seen since the founding of this country. Such bailout was soon aided and abetted by Keynesian Economists focused on deficient demand in ordinary business cycles and concerned about containing the short term pain than safely defusing a growing debt time bomb.

 Fast forward three years to the 2011 chapter of the European Crisis and we see the possibility of a cascade of falling dominoes sparked not just by the seemingly limited failure of an investment bank but by the possible failure of an entire country! While first contained to relatively small countries such as Ireland and Greece, the falling dominoes began to undermine confidence in Portugal, Spain, and then Italy. The feared catastrophic consequences of the collapse of Lehman Brothers, as bad as they were, paled in comparison to the prospect for failure of entire countries, including Italy which is the third largest country in Europe!

 The fear of another “Lehman Moment”[vii] led certain individual countries such as Ireland, the U.K. and Greece to tighten their belts and get their fiscal houses in order. This raised the unfortunate specter of the “fallacy of composition” under which we can sadly find that actions that appear helpful to a single individual (or entity) turn out to worsen the problem when (almost) everyone tightens their belt at the same time!

 To make matters worse, Jean-Claude Trichet began to tighten monetary policy to fight nascent (and largely non-core) inflation precipitated by the massive monetary stimulus in the US (which exported inflation to Europe and China while still failing to sufficiently debase the US dollar to help both stimulate its exports and partially inflate its way out of our excessive national debt). Tight European monetary and fiscal policy left Europe on the edge of a serious depression with a second recession prematurely knocking on the door of the already depressed US Economy.

 Super Mario Brother (at Least Temporarily) Saves the Day

 Facing depression and social unrest from the disorderly collapse of the Euro, the Mario Draghi quickly reversed Jean-Claude Trichet’s contractionary fiscal policy. In his first major move as the new President of the European Central Bank, Draghi helped to orchestrate one of the greatest feats of financial legerdemain in modern history. Absent the monetary authority available to the more independent U.S. Federal Reserve Board, the MIT-educated Draught’s ECB orchestrated a solution in which local governments unable to borrow money at hopefully more reasonable terms from local banks which suddenly found themselves funded with 3 year notes at 1% from the suddenly accommodative ECB!  To restate:

  1. the ECB lends 3 year paper to insolvent European banks at 1% (replacing wholesale monies withdrawn by U.S. money market funds and institutions which could not bear the risk of default
  2. the suddenly less insolvent European banks now have funds to lend to overly to local business that would otherwise be unable to obtain loans
  3. ….unless such businesses are viewed as too risky, in which case bank funds might be “temporarily” parked in bonds issued by the indebted (& effectively insolvent European countries in which they are located
  4. enjoying potentially new “investor” demand from their ECB-funded local banks, it is (or was clandestinely) hoped that lower interest rates paid on European sovereign debt might both help fund the local countries and at least partly mitigate European bank losses from the extent of the write down that they will almost certainly need to recognize when they report earnings for the fourth quarter of 2011!

Like two staggering drunks propping each other up, Draghi may have helped Europe buy time to safely and gradually get their fiscal house in order! Before markets fully recognize the financial slight of hand, it would help if the important European banks could raise the additional equity capital that they failed to raise in 2008 when major U.S. banks were effectively forced to raise the new equity capital. Whether European Banks can raise enough new capital is an open question. The extent to which they succeed will go a long way to determine whether they can avoid a major financial accident and avoid turning a deep “Club Med” depression into depression throughout the entire Continent. The U.S. may be able to delay a new recession if Europe can avoid debt contagion and depression. It would also help if India could contain its collapsing currency and China can orchestrate a soft landing! But that’s a subject for another day.

The $64 Trillion Question: Will the First Installment of Super Mario’s Bailout Be the Last?

While the Super Mario’s $638 Billion Dollars of Loans remains far too small to meet all of Europe’s needs, it does provide a first step toward providing breathing room for governments to facilitate some path to safely reducing leverage. Once it is understood that Euro was widely believed to have been within only days of collapse, one can better appreciate the importance placed by certain politicians on offering additional financing sufficient to stem the flight of Euros  before it morphs into panic. Assuming that this large but limited monetary leash provides a first installment of an effective monetary bailout, Europe may be able to avoid the deflationary debt trap that would otherwise come from sapping real resources that would crowd out other spending. And to help mitigate the liquidity drain that could crowd out excessive amounts of European resources, the World’s “Uncle Ben” (aka Helicopter Ben) Bernanke also stands ready to provide “Euro-Dollar Swaps.” If the ECB is a little short of dollars, they can simply exchange some Euro-denominated debt for newly created U.S. Dollars! All courtesy of Uncle Sam! Let’s just hope everyone appreciates how nice it is to have such friendly uncles!

The result is that we possibly forestall a European collapse and debt contagion that would otherwise spark a new U.S. recession and create even worse consequences in Emerging Markets dependent on strong consumer demand from the so-called developed Western World. With memories of Lehman Brothers fresh in everyone’s mind and elections looming in the U.S. and Europe, politicians have a strong incentive to go down this path[viii] of kicking the can down this long and winding road.

Possible Near Term Paths For US Consumption and GDP

Assuming Europe takes the path of this bailout and complacency sets in, it is possible that the recession weary US consumer spending might continue on a path of new borrowing over the past few months, as evidenced by a drop in savings from 5% to 3.5% of income. If this continues, the economy may remain on its sugar high for a number of months or years[ix] before facing the painful steps of financial deleveraging.

Of course the longer they wait, the greater the cost. But the near term course of the economy critically depends on the path that is chosen. My hope is that we move toward a relatively safe and orderly deleveraging. My fear is that it will take a much bigger crisis to motivate myopic politicians to make the tough choices to nudge us toward a more sustainable path. Considering all known facts and circumstances, the path of least resistance is to palliate the pain while stretching out or even delaying attempts to get control of excessive debt.[x]

In fairness to the US consumers, one should recognize that reduced savings may be at least partly explained by the loss of jobs in certain relatively high paying jobs in finance and government in favor of new employment opportunities for lower paying jobs such as those who’ve helped us with our annual Christmas shopping and our friendly Wal Mart. To maintain living standards, laid off government workers and employees working lower paying jobs inevitably display a higher Marginal Propensity to Consume. In addition to (a) reduced savings, the economy has been goosed by (b) new energy developments, (c) lower gas prices, (d) the payroll tax holiday and (e) accelerated capital spending due to special tax breaks that expiring December 31, 2011.

Payroll tax holiday. 

To maintain this stimulus, we are extending the payroll tax holiday and hopefully encouraging a further drop in energy prices that could happen if domestic energy resources continue to explode, Europe, India, China, and Brazil continue to weaken, and/or contagion extends to our shores.  The payroll tax will eventually need to be restored (or more likely a “soak the rich,” “progressive” tax is initiated) and the Bush Tax Cuts may someday expire, something that is especially likely to occur if President Obama is re-elected. If savings also renormalizes, we could easily find that our recent 2.5% growth in GDP again slips perilously close to recession. If we can skirt recession in the first half of this year, the pent up demand for automobiles and gradual bottoming of the housing market could set the stage for modest growth. But in the end, the future is path dependent, regardless if one argues from the left the Left or the Right. George Soros made billions from understanding reflected in his theory of reflexivity which profits from bubbles that Neoclassical Economics said could not exist (and which the Nobel-Laureate laden Chicago School economists ignore to their peril based on what Talib might label their Procrustean Theory of Economics which lops off the limbs of important detail in an attempt to force their reality to fit with the skeleton of mathematical models. I’d call it an exercise in futility at best and the cause of both the 1998 Long Term Capital Management catastrophe and the 2008 Financial Panic.[xi]

Rays of Hope From Innovation and Change

Despite stifling new regulations that delay recovery in a manner reminiscent of FDR’s counterproductive populism of the 1930s, I continue to pound the table for the new rays of hope that could mitigate the depths of this depression and set the stage for solid growth by the 2020s. At least partly offsetting many aspects of our dysfunctional education system, we have virtually unlimited potential for better educated immigrants who seek a land of opportunity made possible by our greater respect for human rights and the rule of law.

Along with an arguably fewer number of U.S. educated students (the population of which could be expanded with more enlightened educational policies), we have the potential for continued technological innovation and cheap, abundant and cleaner energy.

The revolution in fracking and our abundance of Natural Gas is already allowing for significant U.S. energy exports.  It is hard to think of a group of private investments that will create more stimulus and do more to strengthen national security than new energy investments that help to free us from Middle East oil. The Keystone Pipeline, fracking, and renewed energy developments in Alaska and the Gulf of Mexico will take us a long way toward energy independence. While this must arguably be balanced with enlightened environmental protection, the economic and worldwide environmental benefits of cleaner (albeit not perfectly clean) energy offers a way forward that seems almost impossible to stop. While debt and demographic issues create important headwinds, the tailwinds of innovation and creativity of (relatively) free people offer a strong basis for hope of a much better tomorrow!

Comparison With Your Bridgewater Claims

While gold would correct further if a Fisherian-style debt deflation were to emanate from Europe, a mild deflation contained by Central Bank easing would continue to support precious metals even if base metals such as Dr. Copper remain weak after its strong 2 to 3 year bounce. If we take the path of monetary debasement, an eventual inflation would come near the end of a possible bubble in gold which started to become evident earlier in the year.

One assumption I would carefully question is the near-universal assumption that the Chinese RMB will continue to appreciate against the dollar. Helicopter Ben Bernanke’s Quantitative Easing many not have succeeded in creating inflation in the U.S. but it has succeeded in exporting inflation to China and other emerging markets. Higher food and energy costs represent a larger portion of the Chinese budget and represent a source of labor unrest. Higher Chinese labor costs make it more difficult for them to compete in manufacturing low value added products that have begun to move to areas of even lower labor costs. Any inability to sustain their breakneck growth runs the risk of painful retrenchment which could lower the Yuan’s value when combined with inflation and loosened controls.

Like Bridgewater, I also remain bullish on U.S. Treasury Bonds which were by far the best investment of 2011. Whether Treasury yields shoot up after mid year depends on whether money continues to flee to the relatively safe haven of the U.S. Dollar or whether new stimulus sparks more rapid growth from a another sugar high from the drug of new debt creation. As I’ve argued throughout this discussion, our economic outlook remains unusually sensitive path dependence.


[i] This is consistent with the view I’ve held since my premature expectation of a nasty downturn by 2006 which was did not begin to kick in until 2007 & did not fully materialize until 2008. One thing I’ve learned from this premature call is that the economy can remain resilient for much longer than a presumed rational analysis might otherwise suggest.

 [ii]  FWIW, I recall seeing references by John Mauldin to oral statements made by Martin Barnes to the effect that he sees this Great Debt Super Cycle extending at least several more years as governments do everything in their power to delay facing the consequences of decades of our imprudence. His characterization of this Super Cycle has of course evolved over the years since his predecessor Tony Boeckh first coined & popularized this term. This great postwar credit expansion should also be seen in the context of our demographic time bomb and the “need” to placate civil unrest from rising wealth and income disparity that has reached extremes not seen since the late 1920s.

 [iii] Using the language of complexity theory, we might say that a shame-based culture tends to have greater fragility.  The more fragilized the economy or society, the greater the potential for that proverbial last snowflake to create a landslide. If history is any guide, it will not be until after cataclysmic landside that the politicians will lead the mobs to jail whoever happens to represent that unhappy last snowflake or snowflakes that touched off the landslide. In the end, the voters will demand someone be sent to jail (so long as it’s someone other than the next crisis’s Barney Frank, Chris Dodd, or Franklin Raines who will have turned out to be most responsible for creating the systemic fragility and then (in the case of Raines)raking in the ill-gotten gains.

 [iv]  The Atomic Bomb of 1945 and the Tsunami and nuclear meltdowns of 2011 are two possible examples of overwhelming power that permits a face-saving defeat. If so, widespread business failures in the wake of the Tsunami could prove to have the silver lining of allowing for the Schumpeterian Creative Destruction to set the stage for some form of renewal from redeployment of capital previously trapped in failing enterprises that up to now have not been allowed to die.

 [v]  The Japanese sovereign bonds held as security for retiring Japanese could have just as easily been dubbed “paper” IOUs that some fear are ultimately not going to be worth the paper they are not printed on!  Germans in the Weimar Republic at least had paper to burn. Holders of today’s currencies seem content with electronic impulses!

 [vi] The devastating economic catastrophe resulting from cascading bank and sovereign failures are simply too great a cost to allow them to pull their metaphorical fingers from weakening dykes. Unless all other options were exhausted, it is reasonable to presume that they will at least attempt to alleviate the symptoms. Perhaps the best that can be hoped for is that some pain is accepted during a period of gradual deleveraging in an attempt to safely let the proverbial “air” out of the economic balloon. Before dismissing this as too pessimistic, consider Churchill’s comment that democracy is the worst form of government. Except for all others!

 [vii]  This “Lehman Moment” point of crisis has also been dubbed the “Minsky Moment” by Paul McCauley for the now famous economist Hyman Minsky. Minsky’s insight was that economic stability breeds complacency that fragilizes systems and temps people to take more and more risks. Such fragility was unwittingly aided and abetted by economists who measured risk based on historical experience that was limited to the expansion phase of the Great Debt Super Cycle. As still waters and the Greenspan Put bread growing complacency, “too big to fail” financial institutions took greater and greater risk with more and more leverage and counterparty risk from derivatives dubbed many years ago by Warren Buffet as Financial Weapons of Mass Destruction. Unhappily, Buffet was proved right. Even more unhappily are the even greater destructive consequences we could face if we don’t adopt strategies allowing us to safely delever. The apparent decisions of Bank of America and JP Morgan to shift a combined $154 Trillion of derivative exposures to the FDIC and the taxpayers could be said to be a giant step in the wrong direction! For anyone making the counterargument of a more moderate ‘net’ exposure, I would point to the counterparty risk shouldered by AIG which was unable to make good on its Credit Default Swaps counted on by other parties to neutralize risk. Absent the US Government’s bailout of AIG, many “too big to fail” U.S. financial institutions (including Goldman Sachs) would have almost certainly been bankrupted.

 [viii] Perhaps this was the path that Jon Corzine’s MF Global foresaw when deciding to “bet the ranch” on some form of government bailout. With 37 to 1 financial leverage, it would a 3% move against Corzine’s MF Global was theoretically enough to wipe out all of their equity!
[ix] and we could even theoretically enter a new and even more dangerous leg of the Great Debt Super Cycle
[x]  It is of course possible that our withdrawal pains will be mitigated by a new spurt of noninflationary growth that allows for slow but steady growth reminiscent of the 1950s. Such happy ending would be made more likely by a new spark of Schumpeterian innovation in which new ideas mitigate the pain and again prove the wisdom of Schumpeter’s insight of creative destruction.
[xi] The Efficient Market Hypothesis, along with the conscious decision to ignore what I’ve long referred to as “Event Risk,” is also said by Jim Rickards to be at least partly to blame for the 1987 crash on page 191 of his just released, great insightful new book,  Currency Wars. For my money, this is the book of year whether one refers to the year as 2011 or 2012.  Combine this with the less definitive but equally insightful Great Reflation published in 2010 by Tony Boeckh to develop a perspective on the most consequential economic developments of our lifetime.

3 Responses to Path Dependence & How the World Turns: Dominoes, Prospects & New Hope‏

  1. Santi says:

    Extremely helpful artilce, please write more.

  2. Nathanaely says:

    I don’t know who you wrote this for but you hpeled a brother out.

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