Why low rates and rising global debt are causing civilization to decline.

The cause and consequent missteps.

No need to grumble, you could argue, in a situation where the world debt has been growing for a century at a continuous pace. The world’s central banks are setting new records in the competition for who can stuff the economy with more fiat money. Governments are breaking through the debt ceilings — but, at least, they are not making people break it.

Meanwhile, the size of the global debt is already more than it was during World War II, and, apparently, this is not the end, but only the half way.

Even before the pandemic, the level of corporate leverage began to look alarming. At the end of last year, the IMF said it was worried that more than $19 trillion —  the total corporate debt of eight countries led by the US, or 40% of the global debt, - could become another vulnerability if there was a "significant slowdown" in the economy. A scenario that a year ago no one could have imagined has become our reality, and it looks like it is here to stay.

The number of companies filing for bankruptcy is growing at the fastest pace since 2013, and governments in many countries have been forced to take unprecedented measures to save jobs and prevent more companies from going bankrupt. So, the Federal Reserve System has been buying trillions of dollars of debt since April 2020, most of which was issued by the corporate sector. Fed's balance sheet almost doubled from $4.2 trillion, now reaching the figure of $7.4 trillion. In addition, the government has developed a small business lending program for $500 billion, then $900 billion package at the end of the year. Governments along with the central banks are continuing their quantitative easing programs printing billions of dollars, euros, yen etc.

The ambitious President Biden's $1.9 trillion covid-19 relief plan would bring more harm than benefits due to its political nature not economic one. Loose monetary conditions, dollar weakness, the booming stock and corporate bond markets are not the signs of healthy market and economic conditions looking at incremental deficits relative to GDP. Not to mention inflationary pressures and rising inflation expectations which it could create eventually and put the Fed into an awkward situation, whereas they have not even started "thinking about thinking about raising interest rates". There is no doubt that such vast amounts of stimulus are incredible steps into the unknown.

"Zombies".

Unlike the 2008 crisis, the financial sector was not the immediate cause of the turbulence: investors can legitimately claim that it was a force majeure that caught them off guard. Regardless of what caused the collapse, the Fed, fearing that it could become even worse, was again forced to maintain (= buy back) a wide range of debt instruments, most of which have dubious credit quality — "junk" and "pre-junk" ratings, i.e., BBB- and BBB, respectively. Companies with those ratings or below are referred to as "Zombie Corporations" or just Zombies.

At the prospect of possible insolvency and bankruptcy of a new generation of "Zombies" once they prove unable to pay off their debt and interest, the debate resumed about whether it makes economic sense for the corporate sector to take on such a large amount of debt. Is there a way to increase it without prompting a wider crisis and new risks of economic collapse? The 2008 crisis sparked a similar discussion of excessive pyramid schemes, but the response in the decade after the crisis was to increase leverage and debt burdens even more rather than to eliminate or at least reduce it.

Consequently, we can draw a simple and uncomplicated conclusion - debts give rise to new debts, and low (negative) interest rates not only do not lead to inflation, but also stimulate market subjects to behave irresponsibly and accept excessive amounts of risk that would be dangerous in a normally functioning market conditions.

Just take the recent example with Hertz (car rental service). By the way, Goldman Sachs lost more than $150 million only as part of the bankruptcy of this company. The company has existed since 1918. It used a build-up of corporate debt as a strategy in previous crises and it worked out well. But this time, it suffered a fiasco due to the accumulated excessive debt burden of $ 17 billion. After 15 years of active financial engineering and implementation of the "Debt-Stockpiling" scheme, Hertz owed $ 12,400 for each $ 10,000 car.

Hertz's death has drawn attention to the endless growth of corporate debt in the US, where companies now owe a record $ 10 trillion, equivalent to 49% of economic output. When other forms of business are added, this figure rises to $ 17 trillion. This begs a simple logical question. What is the magic that keeps a modern business like Hertz, or Tesla, or numerous of other companies afloat for years even as they are perennially in the red and accruing bigger and bigger debts. And for all that, they only have promises of a bright future and advanced technology to show. 

How can they exist so long without generating profits? The simplest and easiest way refers to continuous government support and endless credit lines, issue more bonds to solve old problems, and then bonds for past and forthcoming bonds. While effective innovative managers are entitled to bonuses of hundreds of millions of dollars.

Back to the point.

The existing debt dependence has been developing for five decades cumulatively. Inspired by tax breaks and bonuses, corporate bosses quickly embraced this trend. Pension funds and insurance companies bought up debt in bulk, while private equity firms rolled them off the assembly line. The result has been a dramatic change in how the US economy channels savings into finance capital that drives growth.

One explanation for the breakdown has to do with investments, the main driver of long-term economic growth. The investments are funded through savings. When investments are high compared to savings, it raises interest rates as more people and businesses want to borrow. If the savings are high compared to the investments, this lowers the rates. This means that structurally low investments, coupled with high savings from businesses and households, can explain both slow growth and low interest rates... Yes, the Fed is pouring more and more liquidity into the markets, but the real sector is barely getting it. The rate of lending to the real sector is decreasing from year to year, it is easier to "pump" the stock market than to create new production in conditions of global overstocking. More tellingly, as asset prices rise, their returns, such as bond or dividend yields, decline. Once the yield approached the yield on cash or cash equivalents such as Treasury bills, there was no incentive to lend or invest in these assets. Therefore, the Fed can no longer stimulate spending.

It could be argued that this made America more competitive as public companies diminished or gained new opportunities and access to an endless source of credit. However, financial engineering and the implementation of the "Debt-Stockpiling" scheme in recent decades have contributed to the weak performance of both the US and global economies. Adapting companies not only survive, but also receive more unsecured loans, which inflate the prices of financial assets, reduce the performance of the economy as a whole and create long-term problems in its development, thereby inflating unsecured market bubbles.

Thus, we come to such a phenomenon as inflation of financial assets or Asset Price Inflation. Any lending activity is based on the pledge of assets. In other words, you need collateral in return for lending funds to secure a debt or loan. In a stable time, everything goes on smoothly, but what happens if the bubble bursts and the prices of pledged assets go down rapidly. That is why central banks have turned their close attention to the weakening of financial balance sheets after the fall in the value of assets backed by collateral.

Case study.

Imagine a situation. A random citizen, Mr. A, with a budget of X, monthly income of X/12, is planning to start a business in 2021. According to preliminary calculations, to implement it, he will need an amount of 5X. For this event, he applies to the bank and borrows the required amount at 4% per annum in US dollars. The project implementation period is 10 years, the loan term is 5 years.

In the result of the calculations, we find that, in 5 years, citizen A will need to return the total amount of 6.1X. In this case, the amount of his annual income is also subject to discounting, considering inflation of 2%. Thus, we get that in 5 years his discounted income will be - 4.5X.

As a result, we reduce the debit with the credit and we get that, taking into account the initially accumulated capital X, the financial result becomes negative already in the 5th year of the project (5.5X - 6.1X = -0.6X).

At the same time, based on the current conditions, the project does not generate profits, at best, it works at zero, the funds invested in the amount of 5X do not bring the desired result, and objectively - the investments are unprofitable, i.e. cash-flow is negative.

Based on this result, losses begin to accumulate. A person is forced to apply for a new loan to repay the old one and for the further implementation of the project, which requires more and more new investments, but does not generate profit. Then he comes up with a brilliant idea for issuing corporate bonds and raising borrowed funds in the debt capital market to finance his activities, repay existing loans and "develop" unprofitable activities. But given the general abundance and falling demand, overall economic efficiency continues to decline exponentially. Under these conditions, only one strategy remains successful - "Debt-Stockpiling"! While the general shindig (=disorder) continues, he manages to attract creditors, banks make money on the sale of his unsecured debt, not caring especially about reserves and sources of coverage for obligations, but as soon as the situation changes, the source of funds dries up, then creditors, institutional investors, private debt holders will remain with nothing, not to mention the citizen A himself, stuck in the debtor’s prison up to the neck.

Nowadays, all these are practices and realities of the global financial system, business environment and the immensely inflated debt bubble that hangs like the sword of Damocles over the economic stability and world economy.

Productivity and economic growth.

Get back to the concept of labor productivity and economic growth. As you know, labor productivity is a key source of economic growth and competitiveness. A country's ability to improve its standard of living depends almost entirely on its ability to increase productivity per worker, that is, to produce more goods and services for a given number of hours of work.

Global labor productivity has remained flat or declining for over 40 years.

At the same time, from a theoretical point of view, there is absolutely no reason why productivity should fall on a global scale during the period of expansion (the recovery phase in the economic cycle). This is an aberration.

Neither the size (growth) of wages, nor the change in cycles in the commodity market lead to an increase in labor productivity. Productivity grows due to a profitable investment of available funds or effective investments, which in turn leads to higher wages and a growing phase of the cycle in commodities.

As a result, we come to such an economic concept as Total Factor Productivity or TFP. In simple terms, this is the growth of gross domestic product (GDP), which is not explained by an increase in the number of labor force, its quality and capital costs (cost of use).

A drop in investment during a crisis (recession) leads to a drop in TFP, and hence in GDP. But since 2010, the incredible has begun to happen! Ultra-soft monetary policy and debt stimulation, which have been the main instruments in service with the world's central banks in the past 11 years, are destroying the fundamental principles of our economy. This has led to stagnation in global growth in labor productivity since 2012.

Creative Destruction.

Take a closer look.

Long-term economic growth is driven by innovations and technological advances such as automation, which improve production efficiency and hence productivity. In fact, they increase the efficiency of a person, which increases his wages and reduces the cost of manufactured products.

Innovation and new technologies are gradually flowing into production. Thus, more efficient (more productive) methods replace old, ineffective means of production. This is a natural process that takes place both within the company and in the economy.

This process is called Creative Destruction. It implies that old, unprofitable firms collapse, and that new, more profitable ones take their place, which will stimulate productivity growth, allowing technological innovation to be introduced into production. In other words, it can be described as follows - the successes (profits) and failures (bankruptcies) of enterprises contribute to economic progress and technological development. Gains from the profitable production of goods and services accumulate income and capital, while failure contributes to the survival and development of sustainable businesses. Capital strives for this kind of sustainable business, after which the cycle repeats.

The government is to ensure regulation and encouragement of this process, create infrastructure, guarantee the protection of human rights and property rights, guarantee income through social security.

But it is the private sector, households, investors, corporations, entrepreneurs, and capital markets that drive the process of creative destruction.

All experiments in building a manageable socialist "market" economy have failed miserably because risk-reward ratios are necessary for creative destruction, and therefore for the economy, to ensure long-term improvements in living standards and increased social stability. That is why the level of technological lag of the Russian economy with the current model of "state capitalism" will only grow. As sad as it may sound, this model is doomed to failure due to its quasi-market nature.

How it actually works?

Political leaders and central bankers have seriously distorted risk-reward relationships with limitless financial injections and monetary easing around the world since 2008. Losses and risks in the market were socialized, but rewards and profits remained in a private pocket.

When interest rates fall super low and banks are forced to lend under pressure from governments two things happen:

1) Less profitable investments become "profitable".

2) The process of capital allocation is distorted.

The interest rate is essentially the cost of "time". The future is riskier than it is now, and therefore the "price" tomorrow is higher than today. When we borrow from the future to invest, the interest rate reflects the future value of money.

This ensures that:

1) Money is only available for potentially profitable investments.

2) Unprofitable investments fail because they are not able to generate the cash flow necessary to cover future obligations (as in our example with Mr. A).

In the case of very low and negative interest rates, money also becomes available for potentially unprofitable investments, and since the supply of money is unlimited, such investment projects do not crash, and companies do not go bankrupt, only deprived ones but purely for subjective reasons.

All of this means that capital allocation is becoming less and less efficient, as many notoriously unprofitable investment projects receive funding. Because of this, capital becomes "tied" to such unprofitable projects that continue to exist no matter what, thereby depriving financing of new projects and potentially more profitable investment ideas. This is called "Zombification".

With extremely low rates, an abundance of cheap money, more and more unprofitable firms have appeared. That is why the productivity of the economy has begun to decline. A high proportion of zombie corporations are more likely to spontaneously collapse global capital markets and the world economy.

If you add even more debt and lower interest rates to negative ones, unproductive companies will multiply even more, and the world will sink deeper into debt. At the same time, our ability to pay off debts decreases exponentially. Therefore, the current "stimulus" policies of governments and central banks will only encourage the growth of unprofitable firms and inflation of market bubbles, while reducing our ability to pay those debts.

The outcome.

It is unfortunate that central banks, with their endless incentives for debt accumulation, have broken the economic growth model that has contributed to our steadily improving living standards over the past several hundred years! The centralized economy controlled by the state does not work, but only generates inefficiencies, economic stagnation and human suffering.

This is exactly what Ronald Reagan hinted at when he spoke of the nine most terrifying words in English: "I'm from the Government, and I'm here to help."

Of course, it is possible to save the world from economic depression at the expense of government spending financed by the government and the Central Bank, but at the cost of "eternal" economic stagnation and endless growth of debt burden for future generations.

There is only one way out - it is a return to the principles of a market economy through catharsis and self-purification, a return to the fundamental principles of management with the help of the invisible hand of the market itself.