Sunday, July 23, 2023

The Gathering Economic Storm - by Karl Denninger

This is no longer a "will get us five or ten years from now" problem, as it was when I wrote Leverage.  It is now a problem that threatens to blow up in our face in a year or two, exactly as I warned was coming in 2007 and which happened in 2008.

Time's up folks.

You may think "all is well" or at least "all is reasonably ok".

You're wrong.

Just as in early 2007 it was clear that we were staring down a monster problem and whistling past the economic graveyard, we are once again doing the same thing.  In early 2007 I called out the fact that WaMu was paying dividends out of money they didn't actually have; it was a (legal) accounting fiction created by negative amortization loans that made it appear they had "value" that didn't really exist.  Of course it could have been ok in that case because perhaps people could have eventually paid all they owed at an ever-increasing rate, but to believe that you had to believe that infinite re-finance activity at ever-lower costs was going to continue forever, because either that had to stop and people had to pay on what they owed (in which case the "value" stopped going up and earnings stopped happening), it must continue (to keep the trend going) or there was soon going to be a crash.

The latter happened.

What we're facing now is much worse.  Then it was speculators in Real Estate whether people were admitting it or not; anyone claiming income they didn't actually have was committing fraud on top of it -- bank fraud, I remind you -- and deserved what they got.  And got they did get.

But over the last 30 or so years government has come to believe that continual deficit spending was not inflationary.  That's a lie. The lie has been propagated by buffers that were set up for entirely-different reasons, specifically trade sequestration occurring as a result of international supply lines, Social Security and Medicare programs and, after the '08 crash, "QE" and monetary abortion it produced, specifically paying banks to park excess reserves and keep them out of the economy.

But just as when you commit incest bad things tend to happen so do these sorts of machinations.  Specifically the latest game-playing has been in the overnight reverse repo market.  But this is declining and, at present rates of change will run out early next year.  The other big problem is CMS -- Medicare and Medicaid spending and the bonds the trustees hold against previous deposits.  The latter is headed to zero and offsets the deficit impact of said spending that is wildly in excess of tax receipts -- for as long as that lasts.  When that reaches zero there is no more cushion against that and all of that spending in excess of tax receipts immediately shows up in the deficit.  At the present run rate of about $1.9 trillion for this fiscal year ending in September when that happens it will add close to 50% to that number.

Remember that the excuse to huge deficits was that we were in a health emergency -- a pandemic -- and we had to force people out of work and businesses closed, thus taxes would go down and so would wages; we couldn't let people starve.  Ok, fine and well, that's a decent political argument but the pandemic is over.  So why are we running $2 trillion in fiscal deficits for this year ending in September?

We reset the baseline federal spending to $6 trillion, more or less, and contrary to the claims that all this new economic activity would mean there would be more output and thus more taxes as it has actually turned out that was a lie and tax receipts are falling.

This of course makes the deficit larger but even at $3.2 trillion annualized in tax receipts with $6 trillion in spending you're close to a 50% fiscal deficit and a roughly 11% inflation rate given that GDP is approximately $26 trillion.

We're not seeing 11% inflation right now -- or are we?

Friedman put it quite-succinctly: Inflation is always and everywhere a monetary phenomena.

He was right, of course; mathematics just is.  But our Congress has gamed the numbers for the last three decades through both monetary games, playing with the Social Security and Medicare bonds along with foreign trade impacts.  The latter is gone due to the Ukraine-related sanctions, the reverse-repo game is about to run out and the big daddy of all, CMS, is about to run out too.

Social Security, by the way, is not part of the problem; it is actually reasonably-stable.  Fancy that but it neither helps or hurts as a result.

Now add another trillion to the deficit when CMS exhausts its bond sources and all of that impact shows up in the inflation data immediately and either the government cuts this out right now, in total, or you're looking at a 15% inflation rate and rapidly rising because the rate of interest to borrow will price upward immediately which makes it worse because Treasury must, of course, pay interest on all those bonds.

If the government does not stop spending in deficit then rates will spiral higher, the deficit will spiral higher and it will all collapse -- stocks, real estate, everything.  All done, have a nice day, any asset that relies on access to borrowed funds will be cut to a tiny fraction of today's value which means stock prices, real estate, cars and similar.  All of it simply because the cost of financing any of that will rise rapidly into double-digit territory and stay there.

To cut the inflation rate to a true 2% the federal government would have to run a maximum deficit of about $500 billion on a forward, indefinite basis.  That in turn would mean cutting roughly 2.5 TRILLION, or every penny CMS currently spends plus a bit, out of the budget on a permanent basis.

But even that won't reverse any of the already-existing price increases that are making life wildly unaffordable for a huge percentage of the population.  To do that the bubble must come back out and that means the government run a durable surplus and the market has to believe it in order for rates to become lower on a reasonably-durable forward basis.

No, you can't get all of this that out of defense or any of the other tropes that people like to run; there simply isn't enough money there nor could you more than double the average personal income tax rate (that is, increase revenues) without collapsing people's ability to buy food, shelter and transportation -- the basics of life.

I put forward a plan to solve this before it happened.  You will note that in that article (and the linked one after it on implementation) there were pro-forma graphs showing what was going to happen to the federal budget and its impact if we did not take those steps.  Well, we didn't take the steps and it happened.  This would have been difficult before and now its more-difficult but if we don't do it all the indicators of so-called "prosperity" you think you have today are going to go up in smoke and the headline numbers in this (and every other) Ticker may in fact prove optimistic.

This is no longer a "will get us five or ten years from now" problem, as it was when I wrote Leverage.  It is now a problem that threatens to blow up in our face in a year or two, exactly as I warned was coming in 2007 and which happened in 2008.

Time's up folks.