It’s not just the dollar. Economies in the Eurozone and the UK have insufficient growth to support their colossal mountains of government debt. In this article I explain the mechanics of a debt trap. And how a combination of rising interest rates reflecting growing risk and stagnating economies bring on debt traps, leading to yet higher interest rates making the situation even worse.

My memory is of the sterling crisis in 1975/76, when the IMF bailed out the British government, and the Bank of England had to fund medium-term debt with gilt coupons of over 15%. The Labour government was forced to cut its spending to resolve the situation. So I have a question for today: who is going to bail out first the US Government, then the UK and Eurozone, and who is going to force them to cut spending on the edge of a recession?

Only the markets will do it: crisis first, and only if we are lucky the solution follows. Read on…

Introduction

There are signs that with respect to some jurisdictions these views are evolving with the outlook for government debt being examined more closely. There is also little confidence in economic prospects for all the major economies, including China, impacting government budgets. That the world’s exporter is faltering is a signal that consumer demand in her major markets is on the wane. Another major exporter, Germany, is certainly in trouble.

Given mounting government debts, debt is a problem no longer confined to private sectors which have suffered from the generally unexpected rise in interest rates over the last few years. And governments in the advanced economies appear to have little sense of the debt trap being sprung upon them too. As well as the rate of nominal GDP growth, the interest rate matters and a combination of slowing economies moving into recession together with high interest rates are a lethal combination for government finances.

More specifically than growth in GDP, what matters is the growth in tax revenue required to fund the pace at which the combination of debt and interest is being rolled over. In Europe and the UK, tax rates are already so high that attempts to obtain more revenue by increasing them will almost certainly lead to lower revenues due to the Laffer curve effect. The US is probably not at that point yet tax-wise, but economic stagnation has the same effect.

The following chart illustrates government indebtedness relative to GDP for the G7 nations and also relative to private sector GDP, which produces the revenue for governments upon which debt credibility depends.

Various papers have been written on this problem, all concluding that a debt trap occurs when the rate of GDP growth falls to below the rate at which the cost of funding the debt increases. But it is surely more correct to compare the rate of increase of tax revenues with the rate of increase of the debt: do tax revenues increase more rapidly than the debt, or does the compounding debt increase more rapidly than revenues?

How did governments cut the debt-to-GDP ratio following WW2?

The increase in gross Federal debt was 142%, but the increase in GDP was 483%. And the increase in revenue, which ultimately pays for the debt was slightly more than the increase in GDP. Therefore, revenue growth outpaced debt growth nearly three and a half times, leading to a significant reduction in debt to GDP. This was how the war debt relative to GDP was reduced, before the discipline of gold on government spending and interest rates was finally abandoned.

The common belief that debt reduction was due to financial repression, that is to say the cost of funding was suppressed by central bank interest rate policies and yield curve control, is incorrect. To understand why, we need to address another point. And that is what happened to prices. The dollar and through the dollar all other currencies were tied to gold at $35 for the whole 25 years, but the CPI for Urban Consumers rose from 22 to 40 — nearly doubling at an average annual rate of about 0.7%. Yet, measured in gold there should have been no inflation, because the expansion of economic activity under a gold standard is expected to lead to better manufacturing processes, product improvements, and a tendency towards falling prices.

The problems with a CPI measure are many. Logically, there is no such thing as a statistical measure of price inflation, the subjectivity of which has been clearly demonstrated in more recent decades by wildly differing estimates. Government intervention in the economy distorts outcomes, and the savings rate fluctuated but not enough to explain the disparity between a steady gold standard and a statistical outcome.

A cleaner price comparison is found in commodity prices. Oil was pegged at $2.57 per barrel increasing to $3.56 which held until 1973: that’s a 38% increase compared with a near doubling of US consumer prices. Copper was similarly more stable priced in gold, as the next chart demonstrates.

That both copper and oil did increase in price by either measure in the post war years can be explained by demand increasing for these commodities more rapidly than supply. But this does not get round the fact that with the dollar supposedly acting as a gold substitute at a fixed value of $35 per ounce there is an unexplained disparity in consumer price performance. The answer is that the Bretton Woods system ended up suppressing the value of gold, evidenced by the selling down of US gold reserves from 21,828.2 tonnes in 1949 representing over 70% of global official reserves and 45% of total above-ground stocks, to 9,069.7 tonnes, less than 25% of global official reserves and only 12% of above-ground stocks in 1971.

The suspension of the Bretton Woods Agreement in August 1971, far from removing gold from the monetary system, had the effect of releasing gold from its increasing suppression by US economic policies in the post-war years. It is important to understand this relationship in its proper context, now that in this new millennium US Government debt is spiralling out of control.

This millennium is different from the post-war years

Here, we can see that gross debt is soaring at a far faster rate than GDP, and even more so measured in the Federal Government revenues which are behind the sustainability of the debt. With the increase of revenue only covering 37% of the debt increase, the US Treasury is in a classic debt trap; a fact which is increasingly recognised by foreign central bankers who are getting out of dollars and into gold.

The second element of the debt trap — soaring interest rates

Interest rate suppression is no longer true, at least not to the degree of recent years. The sharp rise in interest rates and bond yields over the last thirty months have only partially been corrected in the belief that inflation has been brought under control. This is an error, because the inflationary consequences of a $2+ trillion budget deficit and a decline in the savings rate continue to feed into a falling purchasing power for the currency. And geopolitical factors encourage members of the Shanghai Cooperation Organisation and BRICS, representing the majority of the world’s population, to reduce their dollar exposure as well.

Both these factors are feeding into an inevitable funding crisis for the US Government, as foreign buyers of US Treasury debt stay away, and in some cases are actually selling. And instead of interest rates and bond yields being under the control of the Fed, they will be exposed to the brutal consequences of falling market demand. A buyers’ strike by foreign investors at the margin is already forcing the US Treasury to fund itself in short-term T-bills with auctions for longer maturities being generally avoided. Increasingly, the $35.4 trillion debt mountain sees longer maturities being replaced by T-bills as well. The whole maturity structure of US Treasury debt is changing, and it is not for the good.

Realistically, the yield curve should change from being negative to pricing in maturity risk. But there is a further problem: in a debt trap the higher the funding cost the less attractive an investment proposition becomes because the compounding pace at which the debt rises accelerates.

The consequences of recession

Consequently, adjusted by the reality, which is closer to John Williams’ Shadowstats estimates of CPI at anything up to 12%, in real terms the US economy is indeed in recession, which will get even deeper as interest rates are forced higher, reversing foreign investor demand leading to a declining dollar. The next chart of the dollar’s trade-weighted index with a death cross on the moving averages confirms how confidence in the dollar is already eroding.

The consequences of recession for the US Government will be lower tax revenues and higher welfare costs, increasing the budget deficit even further. Driven by neo-Keynesian economic advice, the government’s instinct will be to reflate. In other words, to increase the deficit even further in an attempt to turn the economy round. But that would make the problem worse. In the absence of massive spending cuts, the US Government is trapped with no way out, other than to squeeze the private sector out of bank credit by its own credit demands, intensifying the recession and therefore the collapse in the currency’s purchasing power.

For now, US and global markets are concentrating on the US presidential election while ignoring these mounting dollar problems. By selling dollars in their reserves to buy gold, it would appear that foreign central banks are the principal category of holder which has been anticipating this looming crisis. But once the presidential election is over, the resetting of the debt ceiling is slated for 2 January. The debt ceiling farce can only serve to accentuate the funding crisis and warn of the debt trap in the minds of America’s foreign creditors, as well as for growing numbers of US investing institutions aware of global sentiment.

Therefore, all else being equal, after the election on 5 November we should expect the US Government’s funding outlook to come under increasing scrutiny, along with those of other G7 nations. We probably have only one month to get out of dollar credit before the outlook for it begins to deteriorate at an increasing pace. The interest rate and bond yield outlook will then look to be for them to be rising rather than falling as currently expected. The consequences for financial assets, especially overvalued equities, will be devastating.

The wisdom of prescient central bankers, who are already getting out of dollars and other fiat currencies and hoarding gold in their reserves will then be appreciated more widely. It is not gold going up, but the fiat dollar and all its dependent G7 currencies going down. Surely, we are seeing the early stages of the demise of the post-Bretton Woods fiat currency system.