The Next "Tipping Point"

Back in January of this year, I wrote this post concerning the issues of capital creation and private versus public money used as leverage in the economy. I referred to it recently when I wrote this post about Doug Dachille's recent confirmation of my observations.

The question of how excessive leverage enters an economic system was of interest to me. It seems to be something that everyone takes for granted, but few probably can explain.

After tracing the evolution of economics from barter to modern global finance using a multiplicity of fiat currencies, I wrote,

"Somehow, through the centuries, capital creation became increasingly dependent not upon hard assets or saved money, but some analyst's or banker's estimation of the forward earnings power of an entity issuing debt or offering equity subscriptions.

Culminating in events including the famed technology equity 'bubble' of the late 1990s and the recent real estate bubble of the late 2000s, the financial community's allowance of increased leverage, via lending on ever-smaller equity bases, resulted in economic expansion which has to have been secularly due to that higher leverage."

It's no secret that a government's printing of money or issuing of debt creates money which can be used as capital. If that monetary base creation isn't related to some sort of tangible value, then that is a source of excess leverage. In effect, a government's creation of money out of nothing has the same effect as bringing forward years, perhaps decades of value not yet created, and putting it into circulation as if it were already in existence.

There is a secondary manner in which newly-created or existing money can be the basis for excessive capital creation. That would be a market demand for some asset, usually equities or "hard" assets, which simply spirals upwards as a function of bidding on the assets.

A capital-creating phenomenon which occurs here which is so insidious because of the nature of open markets. When you or I bid up the price of the marginal share of a company's equity, we only have to pay for the accepted, higher value of those few shares. But everyone owning those shares feels wealthier by the amount per share which we have bid up the price.

If, in that instant, all those other shareholders borrowed against the new, higher value, then capital is magically created, less the 50% margin withheld by brokers, in an amount directly related to the price rise from just our trade for a fraction of the company's equity.

My point is, markets for privately-held assets can, by generally positive sentiment, cause rises in apparent value which can also serve as bases for capital base expansion.

Thus, we have to take as a given that, at times, the global sum of capital available may vastly exceed the actual, tangible savings.

From such events are financial bubbles born. Today, we have the Dubai World debt problem. A decade ago, the US technology equity bubble was about to burst. After September, 2001, Fed chairman Alan Greenspan touched off a decade-long real estate finance bubble by holding benchmark US interest rates too low for far too long, effectively creating too much capital in advance of its actual, tangible realization.

As I discussed these topics with a business colleagues yesterday morning, I was struck by how, somewhere in the past forty years, from about the time of Reagan's election to the Presidency, we moved from a largely prudent capital creation environment to one which could be more aptly described as 'borrow it forward.'

In a bi-partisan manner, US presidential administrations and the Congress joined the party, running continual deficits. The so-called "peace dividend" of the Clinton years was spent. Congress went further, simply borrowing from the world via Treasury-issued debt, rather than ever even attempt to balance the total federal budget, both on- and off-balance sheet, including Medicare and Social Security.

Since FDR began his first term in 1932, the US lost a sense of fiscal rectitude, and became comfortable with, then addicted to, running deficits, both in wartime and peacetime. It seems to me that this unbridled borrowing binge by the US for the past 80 years is about to come to an end.

Until perhaps 20 years ago, when no other major country had substantial economic power, and the dollar was the undisputed reserve currency in a world which included the hostile, communist Soviet Union and China, such deficits were disguised as Western world capital seeking safety in the greenback.

Now, with other major countries having evolved economically to the point of having substantial trade surpluses, and a lack of such imminent danger from communistic countries, other asset classes are seen as viable, and the excess dollars now have resulted in deprecation of the currency.

It seems to me that, with this background, the US is very near to an economic "tipping point."

Most uses of the phrase these days are political. They refer to the point at which poor voters in the US will use their numbers to vote in lush, perpetual welfare-state programs, overwhelming the votes of productive, working taxpayers.

However, I believe that this latter phenomenon won't actually occur, because the former, economic tipping point, will be reached first. And that will preclude the latter one.

How? Why?

Somewhere in the midst of my colleague's and my discussion on Sunday morning, I remembered a little vignette from a television program I happened to see for about 5 minutes while channel surfing on Saturday.

One of those "Real Housewives of" programs happened to be on, and I saw a recap of a prior episode, and the trailer for the one about to air. What I recall was this Orange County couple sitting with a realtor and agreeing to list their OC McMansion for something like $1.4MM. The husband bemoaned having "seen this coming" two years earlier, when the market-fueled mania priced the same home at around $2.1MM. The wife sobbed as they confessed that the proposed sale price would put them underwater when paying off the mortgage on the home in question.

For some reason, my first reaction was to recall the apocryphal story from 1929 involving JP Morgan and his shoeshine man. The story goes that when Morgan- or perhaps a Vanderbilt or some other wealthy financial luminary- heard his lowly shoeshiner presuming to give him stock tips, the market was dangerously overbought. According to the tale, the financier went to his office and immediately sold all of his equities, putting the proceeds into cash.

The Orange County McMansion tale calls that apocryphal tale to mind, I suppose, because it suggests that excessive leverage has become so woven into the fabric of the US society that some who appear to be wealthy have, in fact, been living on 'borrowed forward' money after all.

From unfunded federal Social Security promises to proposed, bloated health care bills, to essentially bankrupt states such as California, Michigan and, soon, Illinois and New Jersey, our government has become a profligate spender of other people's money in a manner that just got Bernard Madoff a life sentence in prison.

The only times in recent memory that the US dollar has risen in value relative to other currencies has been when global economic doom seemed imminent. If that's what it takes to save the dollar, I doubt those will be economic conditions conducive to the US enjoying healthy growth in the private sector.

No, I suspect that, though the exact timing is unknown, the US dollar and the debt obligations of its government will soon experience significant shunning. I discussed some of the implications of Lawrence Kadish's recent Wall Street Journal editorial on the size of the current interest expense of the federal government in this post, writing,

"You can see the awful mathematical conclusion, can't you? If rates move up, as they most certainly will as liquidity is drained globally, and too many dollars require ever-higher rates on US Treasuries, the current nearly $400B interest tab could easily swell by a factor of at least 5- twice for the larger debt level, and 2.5 times for the interest rate effect.

Imagine explaining to the average taxpayer that his annual tax liability is nearly half-consumed for just interest on our borrowing to pay for our lush social programs. And we're adding more, by the way.

And that, in a few more years, that figure will be easily more than half. So Washington will continue to try to borrow abroad to pay for promises it is increasingly unlikely to be able to keep to all parties- citizens, investors, and other countries."

For the record, the current administration's budget assumes an interest rate on US debt of half of the average of the past decade! That's simply not credible.

This is all simply unsustainable. Too much imaginary capital has been borrowed forward from decades in the future, and much of it has been invested in depreciating dollars or Treasuries denominated in the same depreciating currency.

My partner and I manage proprietary equity options investments, so we must be sensitive to actual, ongoing timing issues between calls and puts. It's not sufficient, for investment management purposes, to see a massive credit crunch returning sometime in the next two or three years.

But I do think that will happen. I don't think the Democrats in Congress and the administration will successfully remain in power for more than three more years if even one of the proposed deficit-increasing, budget-busting bills is passed into law. It is simply not believable that savers around the globe will willingly hand over their tangible, hard-earned capital to the US in order to see it spent on environmentally-popular programs in a currency that will continue to lose value.