Quantitative Queasing

In practice, the Federal Reserve effectively increases the amount of consumer, mortgage, and corporate debt via the “discount rate.” The discount rate is the interest rate at which the banks borrow from the Fed.²² By lowering the discount rate, the Federal Reserve reduces the banks’ cost of funding and allows them to issue loans at lower interest rates. When loans are offered at lower interest rates, more consumers and businesses borrow, which increases the overall level of debt in the economy.

The Federal Reserve also increases the amount of debt in the economy by buying government bonds in the processes known as “open market operations” and “quantitative easing.” It creates new money out of thin air to buy government debt, which reduces the average yield of that debt and reduces the interest rates on any new pieces of government debt that are benchmarked against the existing debt. Since the interest rates of all other forms of debt (corporate and consumer) are priced against government debt, this lowering of government debt yields/rates results in lower interest rates for all types of debt across the economy. Again, lower-cost debt causes people and businesses to borrow more.

Additionally, the reduction in interest rates on government debt allows the government to fund greater budget deficits by reducing the interest burden associated with the incremental debt. $20 trillion of government debt at an average interest rate of 3% is no worse than $10 trillion of government debt at an average interest rate of 6%, provided that lenders are willing to hold the incremental debt because they believe they’ll be repaid their principal and interest without significant capital loss due to inflation. But there is undoubtedly a limit to how much debt a government can incur before its lenders refuse to lend more.

If the dramatic rise in debt in the United States and across the world had been of the productive type rather than the unproductive, consumption-driven variety, we would expect to see an increase in economic growth. More specifically, we would expect to see an acceleration in economic growth subsequent to the incurrence of the debt, and such acceleration would be expected to result in the economy growing more rapidly than the debt burden. This would result in a decrease in the ratio of debt to GDP. Instead, we observe the opposite: a dramatic rise in the ratio of debt to GDP. The only thing that has kept the interest expense of this debt from crushing borrowers has been the inexorable fall in interest rates due to policies of central banks such as the Federal Reserve.

John Kenneth Galbraith is one of the great thinkers on financial economics and specifically financial bubbles. In The Great Crash, 1929, he wrote about a concept he called “the bezzle.” ²³Economist John Kay later summarized “the bezzle” as “that increment to wealth that occurs during the magic interval when a confidence trickster knows he has the money he has appropriated but the victim does not yet understand that he has lost it.”²⁴ When the perpetrator of a fraud knows he has the money but his victim still thinks he has the money, the same dollar gets counted twice. Cases such as Bernie Madoff, and many before him, including the great Charles Ponzi (who lent his name to Minsky’s “ponzi” debt category), illustrate the concept. Schemes such as these are either fraudulent from the outset, or from the point in time at which the scheme ceases to be able to support all the claims of the investors.

Today there is a much larger bezzle. We call it government debt. Our own governments (federal, state, and local) know they cannot satisfy the debt claims that citizens have on them. As noted earlier, in the United States the accumulated liabilities, including outstanding debt and unfunded Social Security and Medicare, exceed $210 trillion in addition to the growing commercial and consumer debts. Those claims are legal, but they are unpayable. Not only can the economy not support the principal owed, but the interest cost alone is unserviceable at interest rates above the rock-bottom ones that prevail today. I don’t know when or how it will end. But I do have high confidence in one conclusion. The greater the accumulated debt when the unwind occurs, the more devastating the unwind will be. So, as with a heroin addict, we must do our best to get him off the junk before he overdoses.

While the addict’s plight is tragic, it might be argued that at least there is some level of self-infliction. In contrast, the cost of the debt problem, including the unfunded pension and healthcare programs, won’t be borne by those who incurred it. It will be borne by later generations who neither benefited from this massive wealth transfer nor voted in favor of it. So how did the world get up to its eyeballs in what is essentially a ponzi debt that will be owed by future generations? A full treatment of this topic is too lengthy for this book, but I will invoke a few anecdotes from my own professional experience to illustrate some of the causes.