Guest Post: The End Game

Via Kevin Muir of “The Macro Tourist” fame


We all know the terrifying debt statistics. We are bombarded every day with bearish reports about the gargantuan Federal debt, and when combined with the growing private sector indebtedness, the monolithic entitlements problem, and the looming pension fund shortage, it is easy to wonder how we will ever get out of this colossal mess.

I do not dispute the numbers one bit. We have too much debt. It’s simple math. We are screwed. Full stop. All of this debt will never be paid back in real terms. Truth be told, I am probably one of the most bearish people out there when it comes to our debt problem.

But I differ greatly from the vast majority of my peers about what that means for the economy and financial markets.

There are three solutions to the problem of over-indebtedness.

The first is to grow your way out. Maybe you cut some spending, hunker down, trim up the sails, and right the ship through good old fashioned economic growth. This solution is a pipe dream left for little children and romantics. In a balance sheet challenged economy, the moment you cut spending, the paradox of thrift kicks in, and the economy rolls over. This is a lesson Japan has learned all too well over the past couple of decades. Not believing Japan’s example, the U.S. repeated the error after the credit crisis of 2008. Thinking overspending was the cause of the problem, the U.S. government (led by the Tea Party) cut discretionary spending to the bone. Remember the 2013 budget sequestration? All of that hullabaloo caused the government to shrink from 2011 to 2015.


Whoa! That doesn’t follow the typical narrative of Obama as a spendthrift fiscally irresponsible President. Didn’t Federal debt balloon under his watch? How does that work? Well, the reality is much of the spending that caused the increase in overall debt was the result of automatic stabilizers – unemployment insurance, etc… Although Obama probably wanted to spend much more, he didn’t. And this is one of the reasons the U.S. economy experienced its weakest post recession recovery. Just look at that chart above. Over the past three decades there has never been a government spending decline of that magnitude.

Now I realize many of you will probably be saying “good – that’s what’s needed. The idea of increasing spending to solve a problem of too much debt is ridiculous. The reason for the anemic recovery is that we didn’t cut enough.” Which brings me to solution number two.

In an environment of over-indebtedness, the economy will naturally try to correct through the private sector paying down debt. But over the past half dozen decades, we have been muting regular business cycle declines through overly easy monetary policies. This has encouraged too much borrowing. We have piled more and more debt on the problem. The trouble is that we have done this for so long, the consequences of allowing the cycle to play out has become catastrophic.

Have a look at the total U.S. credit outstanding (minus financial firms) over the past few decades.


See the slight leveling off in 2007? That is the horrific debt de-leveraging that caused the greatest financial crisis since the Great Depression.

So far all those economists of the Austrian ilk, I acknowledge that if the government and the Federal Reserve would allow the natural business cycle to operate, we would have debt destruction that would cause the financial system to reset. After this event, the economy would be all set to grow again. Yet this reset would make the 2008 credit crisis look like a warm up. We would have 1930’s style breadlines.

I don’t buy for one second that the public has the stomach to sit through this type of event. Maybe when the problem of over-indebtedness was smaller, we might have done it. Perhaps in the 1980’s, or maybe even the 1990’s when Greenspan first brought the irrational exuberance problem to the fore, but not today. The pain that would accompany a true debt destruction reset would be too immense. The amount of social upheaval and instability would probably mean the end of the Western world as we know it.

We can’t grow our way out the debt problem, and we certainly can’t allow it to reset through a cleansing business cycle flush, so what’s the solution?

That leaves the one tried and true solution. For thousands of years when societies have gotten in trouble with too much debt, they have solved their problem by printing their way out of it. To think the modern day situation will be any different is naive.

Yeah, sure there will be moments when governments flirt with the idea of prudent monetary and fiscal policy. But those periods will be fleeting. Faced with moribund growth and a steadily increasing debt burden, at the first sign of trouble they will quickly turn on the presses and resort to the time old tradition of inflating away their debts.

Which brings me to the end game. There are many forecasts for a 2008 style collapse. The consensus is that eventually the debt burden becomes too big to bear, and the next Great Depression rolls in.

I don’t think that is how it plays out. Most traders hedge for the previous crisis. Visions of 2008 still fill the nightmares of investors. This explains why “gurus” like Carl Icahn have long presentations where they advocate hedges that worked so well in the last crash.


But what’s going to happen the moment things look dicey again? The governments and Central Banks will inflate. We saw it with BREXIT. We saw it with Eurocrisis of 2011. In fact, governments are becoming more and more quick to step on the gas pedal. They realize the costs of over inflating are far less than the costs of delaying.

Now you might have philosophical problems with these responses. For the longest time I railed on about the dangers of irresponsible monetary policies. It got so bad that on my ski trips, my pals banned me from talking about Greenspan’s reckless behaviour.

Yet today, I have come around to the idea that the debt problem is so pervasive, there is only way one forward – inflate. We are going to end up there anyway, so let’s just inflate away the burden and restart with a system that prevents this from ever happening again.

All of this talk is just that though – talk. As traders we need to concern ourselves about what is, instead of, what should be.

I don’t really care to argue about the morality of these decisions. The internet is filled with idiots shouting their opinions at the top of their lungs. The last thing you need is one more.

But I want to leave you with this idea. Given the enormous debt problem, the notion we will pay it back in real terms through growth, or even more improbably, the idea of allowing a massive debt destruction event to reset the system, is unrealistic. Any economic weakness will be met with more printing, and more stimulus. Maybe governments allow one or two quarters of weakness. It might even drag on for a year. But then as sure as day follows night, they will inflate again. They simply cannot afford not to.

They will do anything (and everything) to ensure the financial system doesn’t implode on itself. They will engage in massive Quantitative Easing programs. They will venture out to buy risky assets. They will even take interest rates to negative levels. It is only a matter of time before they are simply dropping cash right into individuals bank accounts.

I wish I could take credit for this, but it was Bill Fleckenstein who said it first. They will keep printing until the bond market takes the keys away.

Many market participants are worried about the economy rolling over. Although I understand it would cause some declines in financial markets, what would be the end result? Central Banks would ease, governments would spend, and they would find a way to prop everything back up again.

I am not smart enough to know if we are going to get another cyclical dip that is met with more easing over the next few quarters. If I had to guess, I would say this is probable – especially in the US. I am not predicting the medium term squiggles. But if this sort of decline were to occur, it would not be the big one.

The true end game won’t come from weakness, it will come from strength. What happens when economic growth picks up and causes inflation? Given the massive indebtedness, Central Banks will be loathe to raise rates enough to cool inflation. This will only cause more inflation.

Eventually we will hit a point where governments will be unable to raise rates because it would crush their balance sheet, yet inflation will dictate rates be higher. This will be checkmate. Governments will have no moves. Inflation will soar, the yield curve will steepen (to record wides), and the inflationary reset will be upon us.

The end game won’t come from a recession, it will come from a boom that gets out of control. I know that it a non-consensus minority opinion, but it’s always the story that no one is expecting that ends up being the problem.

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10 thoughts on “Guest Post: The End Game

  1. Interesting take. I have felt this way since 2007. But some how CB’s have been unable to create real inflation and higher nominal growth. Instead they created asset inflation that ultimately around 2014 (the end of the corporate profit rebound) has lead to an explosion in corporate debt and investor margin debt.

    At the corporate level, I think it started out as the paradox of thrift . Where corporates cut costs to raise margins and share repurchase replaced investment. The initial share repurchases were conducted with true free cash flow and at good prices- large discounts to intrinsic value. The market rewarded CEO’s and by extension shareholders for this and after true free cash flow peaked corporates began using debt to continue share repurchases at an increasing rate and at prices that in most cases are at premiums to intrinsic value destroying value for shareholders.

    At the investor level, investors have increasingly added debt to leverage their exposure to rising asset prices. Central bank policy has and will continue to encourage asset appreciation and drive investors to increase their leverage (bears will say force). As long as global central bank policy remains excessively accommodative asset prices will continue to rise and leverage will continue to build. The assets that go up will change as investors rotate to various asset classes and global markets but in aggregate prices will go higher.

    A fourth option you left out is war (both trade and combat) and subsequent defaults to enemies i.e. China. If we really want to even out our economic relationship with china forget tariffs just cancel the iou’s that will change everyone’s behavior.

  2. Totally agree. Imo, the timeframe for the big reset is 10-20 years from now another spike in interest rates. We are only now entering the very beginning of a long secular boom. There will be lots of up and down noise that may obscure the long term tend.

  3. Very interesting. As a young grad assistant in Finance one of the first truths i learned from my supervising prof was the notion that more firms die from too much growth than from too little. The way the cash cycle works fairly dictates that outcome. Fifty years of experience working with real companies since has largely supported that notion. And on top of the mechanics of growth add in the insatiable demands from public markets that we must grow everything, all the time, at whatever cost (again, it’s in the math, total return = div + growth) and everyone is pushed to the max. — Enron, Worldcom, Wells Fargo ….. Booms are all potential killers.

  4. Well considered and, in my opinion accurate. The history of the late 1960’s and the decade of the 1970’s could very well repeat except with greater volatility. I fell there is a 70% probability that inflation ( and severe inflation at that) is the only way out of the sovereign debt mess for most of the g-7. I can only pray that my previous experience with the S&P priced at 7X earnings has left me unreasonably jaded and this will not come to pass.

  5. I believe this scenario is already well on its way i.e. real dollar purchasing power, $6.00 cup of coffee, $10.00 burrito, $200.00 pair of work boots, $70,000 f150 pickups, $200,000 john Deere tractors, $400,000 grain combines

  6. Agreed we are well on our way with no end in sight. Central banks yap about low inflation which anyone who has a brain knows is bullsh*t. War will probably be the biggest factor moving forward. Good luck folks.

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