A Lot to Explain

One of my sons sent me a podcast recently featuring a conversation with Kyla Scanlon. Her mission is to explain finance and economics to the millennial generation. She has a podcast, a website, a TikTok, and presumably all other relevant social media tools capable of reaching that generation. The subject of the podcast was whether the Fed is going to break something (possibly the world) by continuing to hike interest rates.

Kyla is spot on in her analysis. Perhaps her depth of experience is not close to that of most of the market commentators in the blogosphere, but her capacity to absorb and reframe is remarkable.

So, what is going on?

The context is the post-global financial crisis (GFC) expansion of the money supply where the Federal Reserve has injected vast quantities of capital into the financial system for the stated purpose of maintaining liquidity and preserving the smooth functioning of financial markets. The liquidity has ended up in risk assets – equities predominantly (public and private) – whose investment custodians have come to rely on the much-discussed Fed put and have also become accustomed, because of that reliance, to buying the dip whenever markets declined.

A zero interest rate environment, while pleasant for borrowers of all stripes – government included, has distorted the investment landscape by forcing investors into risk assets offering higher returns – the so-called TINA (there is no alternative) approach.

This period of easy money has witnessed overall US Federal Debt to GDP growing from approximately 67.7% in 2008 to 137% in 2021. This average growth of 5.6% compares to the average growth in GDP over the same period of 1.6%. Why worry? After all, the USD is a global reserve currency and the US can continue to print money to service debt…as long as markets tolerate it. Japan has a debt-to-GDP ratio of 231% and it’s doing fine…

Stepping back for a minute, we should reflect on why the US is the global reserve currency. After WWII, the Bretton Woods conference established a system where the US would promote world economic recovery by allowing the rest of the world to export more or less everything it produced to the US, in exchange for collaborating with the US in its struggle against the Soviet Union. The US would guarantee, with its unparalleled naval strength, the shipping lanes that facilitated worldwide trade and hence allowed the growth in globalization. Everyone benefitted.

An additional step, after the US abandoned the gold standard, was to effectively move to a US dollar-centric petrodollar standard where oil would be priced in USD. Since oil is in everything – plastics, fuels, agriculture, electronics – and because the world has to pay for oil in USD, the world is dominated by USD. At times, this has been painful – for everyone except the US. When the USD is strong, everyone but the US suffers because their currencies weaken against the dollar – they have to sell their currencies to buy the dollars they need to buy oil.

In terms of energy and climate, it has been known for some time that carbon fuels have been making our environment worse to live in. The planet is indifferent, but we are not. Unfortunately, the transition away from carbon-intensive fuels is a slow one. It would be quicker if we embraced nuclear energy, but ill-conceived fears about the environmental risk of nuclear energy and nuclear waste have resulted in less of this zero-carbon, extremely efficient energy source than would have been ideal. So, coal is better than wood; oil is better than coal; gas is better than oil and renewable energy is better than gas. Nuclear is better than all these, but…

We have become accustomed to thinking of the world economy in terms of financial assets, bond and equity prices, and the role of central banks in keeping all this in balance. The GFC underlined the correctness of this understanding. Central banks bailed out banks and banks bailed out the economy.

Now, coming back to today, two things have come to a crisis point at the same time; the overwhelming burden of debt in developed economies; and the shift away from economies being driven by financial assets to energy as the primary driver. This second shift has been highlighted by the war in Ukraine and the squeeze that Putin has put on Europe, actually the world, by exploiting the world’s reliance on Russian energy.

Russia, for context, has a debt-to-GDP ratio of under 20% and has by far the largest concentration of natural resources. It is not, however, an industrial power and has based its economy, in the post-Soviet era, on selling vast quantities of cheap commodities to the world. Germany, for example, has built a formidable economy on this trade.

Recognizing the leverage that this gives him, and realizing that this is possibly the last moment that he will have the demographic resources – young men to fight in an army – to prosecute a war, Putin has chosen now to make his move. He may have made a bad choice, and his choice may lead to his demise, but his choice has presented the world with a dilemma. It cannot allow this aggression to go unchecked because, if it does, Putin will not stop with Ukraine; and yet, the world cannot yet survive without Russia’s resources.

Stapled in time with the disparate recovery from COVID-19, this coincidence of debt and energy crises has created mayhem in developed economies. The constraint on supply chains and the increase in energy prices have contributed to a sharp rise in inflation. This rise in inflation has been exacerbated by the injection of yet more liquidity into the economy to support consumers during COVID-19. As a result, the Federal Reserve has begun to raise interest rates and stated an intent to start selling government debt it holds (or letting it mature without issuing new debt) – so-called Quantitative Tightening. These are basically the only tools available to it to dampen economic activity in an attempt to get inflation under control.

The problem with this is…a debt-to-GDP ratio of 137%. The government has to finance defense spending, entitlements, and interest expense on government debt from the tax receipts it receives from corporations and individuals. If economic activity declines, tax receipts decline. If interest rates increase, so does the cost of servicing government debt. As interest rates rise, the USD strengthens. As the USD strengthens, the cost of energy to those non-US consumers increases…

So, there are all sorts of challenging economic factors at play in the macro-economic picture we face at the moment. These factors have a logic and a path of their own. None of them are comforting. A somewhat independent factor is geopolitics. The expression of geopolitical will is the resolve of the EU to starve itself of Russian energy to its own economic detriment by imposing sanctions on Russia. The move is clearly designed to counter Putin’s war efforts but is equally clearly causing a recession in the EU and the UK. This will probably spread beyond those borders.

If Putin’s war in Ukraine is lost and Putin is removed, the geopolitical outcome is somewhat unpredictable but is assumed to be aligned with beginning to sort out some of the energy-driven economic problems that have manifested over the past few months. The operative word here is “beginning” because the problems that have been highlighted – unsustainable debt levels; flawed thinking about energy transition; and the inevitable unraveling of the globalization engine – will remain.

More on all that next time…