The Limits of Debt

One of my favorite games to play with myself is "how will it all end?" Obviously the fiscal profligacy of most developed countries cannot last forever, at least not without a substantial increase in the growth rate of the tax base. So what will ultimately bring governments' spending spree to an end?

Japan is an interesting case, because in many ways they represent a potential future. They have the highest debt to GDP ratio of any country in the world, developed or not, beating the next highest, Greece, by almost 30%. They also have worse age demographics than most other developed countries, being second only to Monaco in median age, though not far ahead of Germany. That means more retirees being supported by fewer workers. Even if retirees are drawing from their own savings instead of from a social insurance pyramid scheme, such a situation still means a shift from savings (a.k.a. investment) to consumption even in the best case scenario.

But Japan is special in one very important way: the vast majority of its government debt is held by its own people. That means the interest the taxpayers need to pay goes right back into the economy, largely to pay for those retirees. Which means the real issue facing the Japanese is a declining workforce coupled with a growing non-working population. There's the risk that young people will opt not to enter the workforce when faced with the prospect of most of their income going to people who don't work, but Japan's "NEET" (Not in Employment, Education, or Training) is declining, and their employment rate among young people is actually pretty high.

So the limit on Japan seems likely to be its own people's tolerance of a declining standard of living. And they still have plenty of low-hanging economic fruit: the availability of day care in Japan is abysmal, meaning women have to drop out of the workforce to have children (and thus often opt not to have kids), and they have very low immigration. Policies to increase the availability of child care and increase immigration should keep Japan going for a very long time.

If we can't look to Japan as a crystal ball, can we look anywhere else? I doubt it. I'm not even sure how much of a guide history is to where things are headed, unless we're headed for war. I suspect WWIII would look a lot more like WWI than WWII. But trade constitutes a larger fraction of global GDP than it ever has before, 60% vs less than 25% in 1960. Even though Russia and the US don't trade that much directly, they share many of the same largest trading partners: China, Germany, Japan. This tells me that if a big war happens, it's likely to be a result of, not a cause of, a collapse in trade.

In other words, our biggest threat comes from economic nationalism, for which "self-sufficiency" is merely a euphemism. It's almost inconceivable that the US would intentionally shut down a significant portion of its trade in either direction, Trump notwithstanding, but minor protectionist actions by the US can cause big consequences for other countries, with the result that nationalists in those countries could gain even more power than they already have. The result could be a long-term decline in trade and trust and eventually war.

If there's no world war, then what? Well, in the US at least, the housing crisis has never really been resolved. The major difference is that now a much larger fraction of US mortgages are owned by the government rather than private banks and investors. The government seems unlikely to engage in mass foreclosures if there's another mortgage crisis, which means there will be continual wealth transfers from taxpayers, a decreasing fraction of whom will own their home, to homeowners. It seems likely there will be growing dissatisfaction with the decline of home ownership, and the government will respond by continuing to make it easier to get a mortgage, because the US Federal government can have little influence on the actual construction of housing.

The S&P 500 PE ratio is at around 25.5 right now. The most recent times it's been at or above this level were 2009 and 1999. Sound familiar? The yield curve is flatter than it's been since the 2009 financial crisis. I think the Fed is likely to have trouble raising interest rates without causing the stock market to falter. That doesn't necessarily mean they won't be able to rein in inflation when it comes, though, because they now pay banks interest on excess reserves, meaning they can prevent money from getting to consumers without also keeping it out of the stock and real estate markets.

But shifting money into finance dampens economic growth, because only those who own stocks (and have some investment savvy) get new money to spend on consumption. It also leads to increasing income and wealth inequality, which causes social unrest and the election of populists. We are seeing the rise of populist nationalists to power all over the developed world. It's possible that continued fiscal irresponsibility by governments, by reducing standards of living and increasing inequality, will only accelerate this trend. Which means war really could be the end result.

Cryptocurrency and blockchain developers need to focus on the democratization of investment and funding and not on making a few people rich. To the extent that crypto and blockchain are coopted by already-powerful players to increase their power, it is not a net good in the world. We need to make sure crypto spreads power rather than consolidating it. If crypto ends up consolidating power on net, we will have done the world no favors by developing it. But the squandering of crypto's potential to give power back to individuals will be the even larger tragedy in that case.