In 2007 Wall Street’s risk models were horribly flawed. They severely underestimated the chances of house prices falling. And they gave everyone a false sense of security. The result: a debt crisis!
In 2018, the problem is the same again, just larger. The chaos is inevitable. Our financial affairs are in a sorry state. Since the last crisis, debt has surged at the consumer, corporate and, especially, governmental levels. We came through a debt crisis by producing a lot of more debt. The U.S. government will pay more than USD 300 billion in interest on its debt this year. And rising interest rates will only increase those payments as the government does not pay back but just rolls over its debt. The United States Treasury is on track to issue USD 1 trillion of debt just this year alone. The already bloated deficit grew by 17% in the last fiscal year.
The system is very simple but there is no free lunch: you have to borrow more and more to pay just your interest but you never pay back the principle amount borrowed. We could also call it a Ponzi scheme. It’s an ugly situation created by out-of-control government spending and corruption.
Real estate could be the starter of this crisis again. Also real estate is vulnerable to higher interest rates.
Inflation could be a solution but sustained inflation is never pleasant. Despite the Fed´s plan to hike rates eventually the Fed will need to send interest rates lower, possibly to negative territory. Nobody wants a housing downturn or falling stocks. If the Fed keeps hiking rates as it has been and is planning to do in the short term future, that’s almost certain to happen. The pressure on it to lower rates will come sooner rather than later.
If equity and real estate markets get hit hard everyone will be begging the Fed to lower rates and eventually restart quantitative easing.
At some point, inflation will be welcomed by the Fed. Sustained inflation would start to erase the debt by devaluing the currency. Inflation may be viewed as the least bad option. The eventual solution will involve a lot of money printing, debt monetization and, ultimately, inflation.
Sven Franssen