The Ponzi Economy 

John P. Hussman, Ph.D.

The standard of living of a country is measured by the amount of output that individuals are able to consume as a result of their work. The productivity of a country is measured by the amount that individuals are able to produce as a result of their work. Over time, growth in the standard of living is chained to and limited by growth in productivity. Productivity, in turn, rests on two factors: a productive capital base, and an active pool of productive domestic labor. The accumulation of productive factors is what drives long-term growth. When the most persistent, most aggressive, and most sizeable actions of policymakers are those that discourage saving, promote debt-financed consumption, and encourage the diversion of scarce savings to yield-seeking financial speculation rather than productive investment, the backbone that supports a rising standard of living is broken.

Meanwhile, financial repression by the Federal Reserve has held interest rates at zero, discouraging savings while encouraging and enabling households to go more deeply into debt. Various forms of deficit-financed government assistance and unemployment compensation have also been used to make up the shortfall, allowing consumption, and by extension, corporate revenues and profits, to be sustained. As long-term economic prospects have deteriorated, the illusion of prosperity has been maintained through soaring indebtedness, coupled with yield-seeking speculation in risky assets that has repeatedly (albeit not always immediately) been followed by crashes throughout history.

Wall Street At Work Aggravating Risk—-Would You Like Some Leverage On Them Junk Bonds!

After more than a decade of financial repression by the Fed and other major central banks, however, junk bond yields have fallen to the 5-6% range. Such rock-bottom yields, of course, are completely uneconomic and barely cover the risk of loss—-let alone inflation, taxes and the rest.  So you would think that bond fund managers would go on strike, forcing yields back into at least a minimum zone of rationality. 

Needless to say, you would be wrong. As highlighted in the Bloomberg piece below, fund managers are still insisting on a 10%+ return, but not by buying fewer over-valued junk bonds. No, they are just buying them on leverage in order to goose the yield on their own capital at risk. 

It goes without saying that the central banks have not eliminated the business cycle—-their pretensions to the contrary notwithstanding. Indeed, we are already in month 62 of this so-called recovery cycle—compared to an average expansion of about 55 months in the 10 cycles since 1948. 

So when the next economic contraction finally hits and there is an investor run on the junk bond funds, look out below. The evaporation of liquidity will result in soaring yields as desperate fund managers scramble to generate cash and are forced to sell into a bidless market. And then the gamblers who followed Citi’s advice and leveraged up their holdings by 2-3X will face margin calls and be forced to join the selling stampede, too.

Pundits are trying to bring subprime mortgages back. Don't let them

Pundits and think tanks are trying to bring back subprime lending, spinning it as a virtuous move for the economy. Nothing could be more obviously a terrible idea

 To see where a return to deregulation can take us, look merely at the fast-decaying market in subprime auto loans, not coincidentally the only lending sector not monitored by the Consumer Financial Protection Bureau, thanks to a legislative carve-out. 

Lenders have encountered higher-than-expected defaults, in what could be the beginning of a wider crash. These subprime loans have driven a temporary resurgence in auto production and boosted the economy, but if the market washes out, nobody will say it was worth it. 

Banks destroyed the housing market when they were allowed to ignore lending standards and sell whatever loans they wanted with impunity. They’re not exactly disinterested observers when they talk about regulation. Considering that they’re asking for the keys to the sports car they just wrecked, we might want to take their claims with a mountain of salt.

Stressed Borrowers Rattle Resurgent Subprime Lending Industry

The fate of subprime auto lending may have a wider impact. The lending has fueled car production, which has in turn buoyed the economy. “Automobile production and subsequent sales have become a leading barometer of growth in this part of the economic cycle,” Jim Vogel, an interest rates strategist at FTN Financial, said. “It used to be housing, and now it’s autos.” 

But history shows that a splurge on subprime lending nearly always leads to a crippling cascade of problems. While credit analysts do not yet see signs of an imminent marketwide disaster, they say that fissures are appearing in certain parts of the subprime sector.

DYI