When the Credit Cycle and Currency Cycle Converge

The February issue of the “You May Not Know Report”, my monthly communication to clients, digs into the idea of a pattern that has repeated itself many times historically.

This week, I wanted to give you a preview of what you’ll see in detail in this report; it’s very relevant to where we are presently economically.

To better understand the currency cycle, it’s also helpful to understand the credit cycle.  When these two cycles converge, the economic consequences can be downright ugly.

The credit cycle sees credit expand (borrowing occur) until the system reaches it’s capacity for debt.  When the system reaches its capacity for debt, the credit cycle reverses and debt is purged from the system.

A good example of the credit cycle occurred about 15 years ago in the US real estate market.  After the tech stock bubble unwound about two decades ago, the central bank, the Federal Reserve, dropped interest rates to create more money.

Low interest rates (I would argue artificially low interest rates) create demand and drive up prices.  Going back to the real estate example, there are many more people that will buy a house if they can put no money down and get a low interest rate to keep their payments low.

Here’s an example to make the point clear.  Assume a household is in the market for a $250,000 home.

In a normal environment,  a bank may require a 20% down payment and an interest rate of 6%.  To buy the home, this hypothetical household will need to pony up $50,000 and be prepared to make monthly mortgage payments of $1,199.10 in addition to paying their real estate taxes and insurance.

In an environment where interest rates are artificially low, perhaps this same household could get a no money down mortgage and an interest rate of 3%.  In this situation, the monthly mortgage payment is $1,054.01.

The monthly mortgage payment is actually lower and no down payment is required.  Obviously, buyers come out of the proverbial woodwork.  More demand is created and prices rise.

The point is this:  credit can only expand so far, there is a limit.

Once that limit is reached, the credit cycle reverses and credit contracts.  In this economic system, where money is loaned into existence and interest rates are manipulated to remain artificially low, the credit contraction is inevitable.

Bankers who made loans at low interest rates to marginal borrowers find themselves owning real estate that no longer fully collateralizes the loan.  They rack up losses and become more conservative lenders.

That’s what should have happened almost 15 years ago in my view.  Bankers should have been forced to live with the consequences of their bad lending practices.  But, as you know, that is not what happened.

The Federal Reserve engaged in a temporary, emergency measure called ‘quantitative easing’.  The Fed created new money out of thin air and began to buy these bad loans from banks.

Essentially, the Fed went to the bankers and said, “here’s some fresh money in exchange for your bad mortgage loans.  We’ll keep interest rates low so you can do it again.”

In the world of banking and economics, nothing happens quickly.  There is a time lag between cause and effect.

Since 2009, the Fed has been printing money and has given it to banks.  Interest rates have remained near zero and more recently we’ve seen helicopter money in the form of stimulus checks.

Instead of allowing the credit cycle to play out and have deflation, the Fed has doubled down and doubled down again to keep the credit cycle from reversing.

This credit cycle applies to both the private sector and governments.

Government spending is financed via tax receipts and borrowing.  In their infancy, governments often operate with a balanced budget; government spending is fully funded by tax receipts.  But that doesn’t take long to change.

In a financial system where money is loaned into existence, credit expansion (borrowing) leads to temporary prosperity.  I use the word temporary here in the context of decades not months or years.  As noted above, when discussing economics and monetary policy there is a significant time lag between cause and effect.

As credit expands, everything seems to be hitting on all cylinders economically speaking.  It seems prosperity is everywhere.  As credit expands so do tax revenues and as the prosperity illusion intensifies, political promises become more generous.  This pattern repeats itself time after time historically speaking.

Generous political promises are eventually funded in part by government borrowing when the politicians collectively overspend.  As time passes, more of this spending is funded by borrowing.

Governments are not insulated from the credit cycle.  Just like in the private sector where there is a limit on borrowing, there is also a limit on the amount of money a government can borrow.  As spending becomes more reckless, willing lenders begin to disappear.  No individual, no entity or government wants to loan money that they may not get back.  Like in the private sector where individuals and entities become credit risks, the same principle applies to governments; at a certain point, governments become a credit risk as well.

When that point is reached, when willing lenders cannot be found in sufficient quantity to loan a government money, there are two choices.

Choice one, the government defaults on the debt.  The government simply goes to its creditors and says “sorry, I can’t pay you”.

Choice two, the government begins to create currency to fund it’s reckless spending paying off prior creditors with newly created currency with a diminished purchasing power.

Here is the point to remember:  when governments reach the end of the credit cycle and begin to create money to fund spending, it accelerates the currency cycle.

In 1929, at the beginning of The Great Depression, the private sector had the credit cycle peak, deflation set in and the US Government implemented many different programs in an attempt to lessen the pain for the general population.

In 1929, the US Government was not at the end of the credit cycle.  In 1929, the US Government had debt that totaled 16% of GDP or Gross Domestic Product.  That means for every dollar the US had in production, there was 16 cents of national debt.

In 2021, the US Government has official debt approaching $28 trillion and a debt to GDP ratio of more than 146%.  That means for every dollar of economic output today, there is debt of nearly $1.50!

In 1929, when the policymakers decided to have the US Government make up for the lack of spending in the private sector, the US Government was not insolvent.  Frighteningly, that is not the case today.

In 1929, when the private sector reached the peak of the credit cycle, the US Government was early in the credit cycle.  And, the currency cycle was still in stage one, gold was circulating as currency.  One ounce gold coins were worth $20 as they had been for nearly 100 years with only a couple exceptions.

In 2008, the US Government and the private sector reached the peak of the credit cycle.  The currency cycle had been in stage three since 1971; the US Dollar was a fiat currency.

The brutal reality is that in 2008, the US Government was nearing the end of the credit cycle.  At that time, there were still lenders for the US Government as demand existed for US Government debt.

Last year, by my calculation, the US Government peaked on the credit cycle.  By a long shot the biggest buyer of US Government debt was the Federal Reserve. 

Where did the Fed get the money to buy these US Government bonds?

You already know the answer.

Here is where we now find ourselves.

The private sector has peaked on the credit cycle.

The US Government has peaked on the credit cycle.

The currency cycle is late stage three approaching stage four which is fiat currency failure unless drastic action relating to spending and money creation are taken.

That seems increasingly unlikely.

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