Strategy

Debt: Feeding the fire

When the world's mounting pyre of debt is lit, will anyone be able to put out the flames?

In early 20th-century America, wildfires seemed virtually untameable. If lightning sparked a sizable one near a village, there was little residents could do but pray it didn’t torch their entire community. That was an alarmingly likely proposition, because the early 1900s witnessed huge conflagrations. But then came the age of modern fire management. The U.S. Forest Service embarked on an effort to tame both man-made and natural infernos. By the 1950s, major fires seemed a thing of the past. That might seem an unequivocally good thing, but more than 100 years of fire management has revealed a paradox: forests that have been vigilantly protected from periodic big fires gradually change. They tend to grow more fuel — in effect becoming tinderboxes. The phenomenon, coupled with warmer and drier conditions associated with climate change, has been cited in explaining recent fires in the western United States that have consumed more than 100,000 acres each. They’re known as “mega-fires,” and they defy efforts to quench them. They were seldom seen in years past, but many fire ecologists believe they mark the shape of things to come. Some have gone so far as to predict that half the forests of the American West will be consumed by holocaust in the coming decades.

America’s forests might well provide a good analogy for the future of its economy and its capital markets — and a theory promulgated by Montreal’s BCA Research, an independent investment research firm, explains why. When Martin Barnes, managing editor of BCA’s popular Bank Credit Analyst publication, joined the firm two decades ago, he was introduced to its debt supercycle theory. It links many memorable asset bubbles since the Second World War against a backdrop of mounting debt. It’s something that informs Barnes’s long-term thinking about the U.S. economy even today — and if it holds true, America’s capital markets are doomed to burn.

Economies have always been subject to booms and busts. What’s changed is how we deal with them. Like the fires that rocked America a century ago, economic conflagrations used to be largely unmanageable — and more severe. The Great Depression, with its rampant unemployment and poverty, is the most vivid example. According to BCA Research, though, there was a hidden benefit to such disasters. As a research report published last September explained, “The silver lining was the financial excesses built up during booms were completely purged during the downturns, so that the next expansion could begin with healthy balance sheets and low levels of debt.” Or, as the then treasury secretary Andrew Mellon famously advised President Herbert Hoover during the Depression: “Liquidate labour, liquidate stocks, liquidate the farmers, liquidate real estate….It will purge the rottenness out of the system.”

In the Depression’s wake, however, few were in a mood to endure such draconian remedies. New automatic stabilizers, such as unemployment benefits and deposit insurance, were introduced to cushion against economic downturns. The theories of John Maynard Keynes offered policy-makers new tools — not to mention philosophical justification — for smoothing out the swings, encouraging increases in government spending and tax cuts to deal with emerging crises. Then, during the late 1960s and early 1970s, the U.S. gradually abandoned its policy of pegging the dollar to gold. “That was the first sign that authorities were prepared to abandon the traditional concepts of financial conservatism, just to allow the economy to grow more rapidly,” Barnes says.

The debt supercycle theory posits that just as fire-suppression policy changed the nature of forests, so has increased mastery of the economy robbed economic busts of much of their purgative effect. “A side effect of these safety mechanisms is that you never get the cleansing of financial excesses that build up during the booms,” says Barnes. “So, over time, the underlying financial structure of the economy gradually deteriorates. Leverage and debt levels build up.” The best evidence: U.S. non-federal debt has edged up from about 100% of GDP in the mid-1960s to nearly 180% in recent years.

Periodic asset bubbles form. Sometimes they’re heralded by daily announcements of blockbuster mergers and acquisitions. Or technology stocks surging to improbable prices. Or banks bending over backward to offer credit to homebuyers of dubious means. Such bubbles inevitably pop, threatening to bring the debt-laden system crashing down.

Fed chairman Ben Bernanke and outgoing Bank of Canada governor David Dodge may lack the heroic status of firefighters (hopefully they will refrain from appearing bare-chested in calendars), but, crudely stated, their job is to put out flames of the economic variety before they burn out of control. That job is, arguably, getting tougher. As a result of the ever-increasing excesses created by the debt supercycle, Barnes says, “it becomes even more imperative to prevent a cleansing of these excesses. Because if a highly indebted society goes into a downturn, it can be devastating.”

So when bubbles burst, policy-makers use every tool at their disposal to reflate the economy and avoid catastrophe. Barnes continues: “You did see the Fed push interest rates down to 1%, for example, after the tech bubble burst. That’s remarkably low by historical standards. You have seen the government throw massive tax cuts if necessary, even if it means big budget deficits. They’ll let the dollar go down. They’ll just do whatever it takes.” In doing so, he adds, policy-makers set the stage for further excesses down the road. So the low interest rates introduced to weather the tech bust set the stage for the housing bubble, for example. “You’re always building up problems for the future to put out today’s fires,” Barnes says.

Surely, knowing this, policy-makers can devise a plan to avoid this looming catastrophe? Well, if the fire analogy holds, don’t count on it. Fire professionals have long known the drawbacks of putting out every fire. But imagine telling a homeowner that her woodlot home must burn in the name of forest health. And prescribed burns often meet with public outcry. Politics interferes. For his part, Barnes believes political realities and human nature preclude policy-makers from taking steps to defuse the debt supercycle in an orderly fashion. Electoral cycles are short. And attempts to unwind the excesses could spark a deflationary crisis.

The good news is that Barnes does not see the U.S. economy going up in flames anytime soon. The credit crisis — which Barnes sees as another “inflection point” in the supercycle — can and will be managed, he says, because plenty of fiscal and monetary options remain. A recession may occur, but that’s a far cry from saying the debt supercycle is about to end.

And the bad news? Debt cannot grow faster than income forever, Barnes says. At some point, policy-makers may have no more room to manoeuvre. Slashing interest rates, lowering taxes and other reinflationary tactics simply won’t work. If and when that happens, it’s going to be nasty. Very nasty.

Japan’s economic implosion in the 1990s provides a vivid example of what can happen. In attempts to moderate surging prices in land and other assets resulting from overinvestment during the late 1980s, the government tightened its monetary policies. That popped Japan’s “bubble economy,” sending stocks and land prices into a tailspin. Subsequent reduction in interest rates failed to prevent a long recession. (The example is imperfect. Barnes, like other critics, blames Japanese policy-makers for not cutting aggressively enough.)

So how might America’s day of reckoning arrive? Barnes thinks it might come if and when foreign investors and governments lose faith in the U.S. dollar. “It wouldn’t just be a case of the dollar being weak,” he says. “We’ve had that. It would be capital flight from the dollar. You’d see a complete collapse in the currency.”

However disquieting this news of impending doom is, Barnes is not stockpiling water and ammunition. He doesn’t think his clients should, either. For investors, the lesson is that policy-makers will do whatever it takes to avoid catastrophe, and it’s best not to underestimate their tenacity. “Don’t get sucked into an Armageddon view of the world, thinking there’s nothing the authorities can do to prevent a major economic meltdown here,” Barnes says. He believes interest rates will go lower — a lot lower. More public spending and tax cuts may follow, in spite of America’s yawning budget deficits.

If disaster is once again averted, the question for investors becomes: Where will the next bubble appear? “Things that were contaminated during the last bust will not be the beneficiaries of the next bubble,” Barnes predicts. “We’ve been saying for a while that emerging markets and resource areas would be the big beneficiaries — things to do with China — because those things are seen as far removed from U.S. housing.”

And until the debt supercycle reaches its fiery, spectacular conclusion, the financial forests will keep growing tinder.