The Fed – From Glass-Steagall To The Fed Dominating The UST Market In 11 YearsVW Staff
Longboard Funds: The Path Of Least Resistance – Even Donald Trump probably can’t buck the economic status quo
2016 proved the impossible was not only possible, it was global.
Negative interest rates. Brexit. President-elect Donald Trump. All symptoms of a larger sickness: people are tired of the path of least resistance. Historically, politicians on either side have taken this path, kicking the can in favor of easy wins during their term.
The result is now the world is awash in debt. What’s more, any actions taken to address it (like raising taxes and cutting funding for social programs) is paramount to political suicide. Meanwhile, Trump’s view on debt is: if you borrow enough, debtors become partners.
It all points to a world in which the $19 trillion in debt America owes will be a number that rises, not falls. With the global debt levels nearly three times their pre-credit crisis levels, we are not alone.
At some point, however, that status quo will lead to more debt than a country can manage.
As Japan has found themselves struggling under a similar burden, they’ve printed money, hoping to devalue their own currency and default. Yet, Japan’s massive quantitative easing measures have had increasingly fewer effects since the 1990s. Despite the weakness of its economy, Japan has $6 trillion of debt in negative rates while the U.S. is forced to pay to borrow money.
Now, the rest of the developed world is taking a hint from Japan and is printing money in an attempt to deflate away their massive debt. However, since currency markets are relative, meaning when one currency goes down another must go up, no one can make any headway. Instead, at its peak nearly 40% of all global debt had investors paying for the right to own it.
We’re neck deep wading through the path of least resistance. So how did we get here? And, more importantly, will we get out?
Longboard Funds – The beginnings of the path of least resistance
We could go back to the beginning, but let’s start at the new millennium.
- The Glass-Steagall Act was largely repealed in 1999.
It was originally designed to separate the nation’s banks from investment risk, and without it today’s consumer banks are allowed to act as investment banks and engage in securities trading.
- The Securities and Exchange Commission allowed exemptions to the net capital rule by 2004.
This paved the way for both banks and securities firms to take on an unprecedented increase in risk/leverage exposure that led directly to the financial crisis.
- In 2007, the New York Federal Reserve let Lehman Brothers go bankrupt.
They had already let Bear Stearns be acquired by JP Morgan and essentially threw up their hands. The big difference (and problem) was that, unlike Bear Stearns, Lehman Brothers was a primary dealer in the derivatives market. So, the effects to the system were massive: public bail-outs of “too big to fail” private banks changed the basic tenets of capitalism.
- To pull the U.S. out of the 2008 credit crisis, the Fed began a series of quantitative easing and securities purchases (a.k.a., debt monetization). By, 2010 the Fed became the largest holder of U.S. Treasuries.
Global patterns were similar. As an example, the European Central Bank swapped holdings of Greek government debt by forcing private sector creditors to accept a more than 53% loss on holdings. This showed that no one was safe from too big to fail. Currently, Greece is even taxing cash withdrawals.
All of these points seem like random events until you look at them all as steps on the path of least resistance. They all point at kicking the can to appease people today only to pay the price tomorrow.
Are we now at a turning point?
As countries see that QE is having less and less of an effect, they are trying to make government bonds unattractive to hold. If governments continue to force investors to accept extremely low interest rates, savers may suffer from a high opportunity cost. Today, savers are losing opportunity cost from low rates. Investors are fleeing from historically safe haven assets to those with more risk. Even economies are continuing to monetize in hopes that currency decline will bail them out of their own debt situations.
In effect, this reduction of QE measures is evidence that the path of least resistance is starting to show its cracks. Historically, when these fiscal and monetary policies lose their juice, civil unrest and nationalism rises. As the distance between the haves and the have-nots grows, the likelihood of Brexits and Trumps elevate.
What could happen next
However, even Trump can’t come in and gut America’s entitlement programs or make trillions of debt disappear in a day. And as such, we can look to the past to guide a future prediction – the path of least resistance will remain. The future could pan out something like this:
- As politicians continue down the path of least resistance, governments will follow Japan’s lead and monetize debt. Soon, more governments will be the largest holders of their own debt.
- Mandated purchases of U.S. Treasuries by retirement plans such as social security accounts, pension plans, too-big-to-fail banks and insurance companies will help prop up the financial system.
- Banks will de-incentivize holding cash as short-term interest rates plunge into the negative. Even CD and money market funds could be forced by negative rates to break the buck.
- Small and mid-size banks will struggle as low rate loans and cash balances eat away at profits. This could concentrate risk at larger banks, making the too-big-to-fail of the past look like chump change.
- Safe haven assets like physical gold could skyrocket in price while new taxes discourage people from buying it.
- As defaults rise around the world and the euro as a singular currency crumbles, social unrest at home and abroad will continue. This could crush growth and further separate the 1% from the rest, which will in turn cause more unrest and more nationalistic tendencies as immigrants seek a better life outside of their current countries.
Choose your own adventure
The next step contains a choice for the U.S. and the rest of the developed world: war or a peaceful compromise?
Since any global war would likely lead to the nuclear destruction of life as we know it, global leaders will (hopefully) choose the only other solution available to them. Especially if it’s a solution much more in line with the path of least resistance: a peaceful compromise. Here’s how that could work:
- Global leaders meet in secret to work through the untenable social unrest that’s rising to the level of outright rebellion in some parts of the world. This unrest essentially forces the powers that be to fix the system.
- Now that every developed country has quietly monetized a huge percentage of their own debt, each agrees to simply eliminate the debt each country owes to itself.
It may seem radical, but when the only other choice is war, it may also seem necessary.
Of course, corresponding securities laws, banking laws and international treaties would be passed in order to try and curtail an event like this from happening again. But once developed nations are free from crushing debt, real economic growth and a new cycle of prosperity could emerge. For those emerging countries not in the debt-relief club, the high foreign ownership of their own debt will leave them flat-footed as a new race to the top emerges.
But saving major economies and sacrificing smaller ones is par for the course on the path of least resistance.