“What is a debt, anyway? A debt is just the perversion of a promise. It is a promise corrupted by both math and violence. If freedom (real freedom) is the ability to make friends, then it is also, necessarily, the ability to make real promises. What sorts of promises might genuinely free men and women make to one another? At this point we can’t even say. It’s more a question of how we can get to a place that will allow us to find out. And the first step in that journey, in turn, is to accept that in the largest scheme of things, just as no one has the right to tell us our true value, no one has the right to tell us what we truly owe.”
– David Graeber, Debt: The First 5000 Years (2011, p. 391)
In Hamlet, Polonius advises his son Laertes as he sends him off to school: “Neither a borrower nor a lender be,/For loan oft loses both itself and friend,/And borrowing dulls the edge of husbandry.” Borrowers and lenders have conducted themselves over the ensuing centuries in ways that would not have surprised Shakespeare, who understood human nature all too well. Later in the play, Marcellus, a soldier, warns Hamlet that “Something is rotten in the Kingdom of Denmark” after they are spooked by the ghost of Hamlet’s father. This is a reference not only to the murder of Hamlet’s father, the King of Denmark, but speaks to the fouling of the relationships that govern the kingdom. Those relationships are ones of blood and obligation; in one form or another, they are different forms of debt. Debt is not merely a contract between two parties; it is a solemn pact of trust. When it is sundered, not only is money lost but husbandry – the management of society’s resources – is corrupted. We learn from Shakespeare’s great drama that a world ruled by debt is extremely fragile.
February 13th marked the 25 anniversary of the bankruptcy of Drexel Burnham Lambert. I remember driving to work at Drexel’s Beverly Hills office that morning having no idea what was about to happen. My years at Drexel in the late 1980s and those I spent managing the firm’s private equity holdings in the 1990s were an intensive education in credit and human nature. Twenty-five years after Drexel’s demise and seven years after a crisis that pushed the global economy to the brink of collapse, the world is drowning in debt and derivatives. As a point of reference, when Drexel filed for bankruptcy, it had a balance sheet of $3 billion. When Lehman Brothers filed for bankruptcy in 2008, its balance sheet was two hundred times larger at $600 billion. As Figure 1 below illustrates, debt has grown exponentially while the global economy has crept along at a petty pace. Six years after the financial crisis, interest rates have been driven below zero in much of the developed world,2 a sign that policy makers have failed to create sustainable economic growth. (The latest tally is that $1.9 trillion of European sovereign debt is trading with negative yields.) They have managed to inflate financial assets but left the real economy behind. For example, U.S. equity prices have gained 122% since 2009 while U.S. nominal growth has grown by only 18% over the same period. Having exhausted their ability to employ interest rates as a policy tool, policy makers are now shifting their sights to currencies to stimulate growth. But currencies are themselves nothing more than a form of debt, a promise by a sovereign. And those promises are being actively debauched in a series of currency wars that are certain to end badly for those who depend on fiat money for their daily bread.
Figure 1
Unsustainable
Drexel and its aftermath taught me many lessons. The most important is that the world of finance is the world of human nature in all its terrible beauty. And that world is driven by incessant change. Drexel was thought to be the most powerful firm on Wall Street, yet it collapsed overnight. That taught all of us working there not only a lesson in humility but a lesson in the fragility of all financial structures, especially those built on leverage. Those who fail to acknowledge and adapt to change are always flirting with failure. Today’s investment landscape is filled with investors, strategists and media pundits who refuse to admit that we no longer live in a world that can pay its debts or respond to monetary stimulus as it did in the years before the financial crisis. Acknowledging these realities doesn’t mean one has to stop investing or stop taking risk. But it does mean one better do so with one’s eyes wide open.
U.S. economy
Contrary to what the Federal Reserve, Wall Street and much of the financial media are telling people, U.S. economic growth is not robust. Uncritical focus on doctored economic data leads to the conclusion that growth is self-sustaining and accelerating. In fact, growth is sluggish and evidence that it can be sustained if interest rates ever normalize does not exist. Normalized interest rates still lie far in the future, however, so equity investors feel empowered to ignore these concerns and bid up stocks ‘til Kingdom come. But just as they did 15 years ago during the Internet Bubble and 7 years ago during the housing bubble, when Kingdom comes it will come with the Devil.
Figure 2 below, borrowed from Societe Generale’s Andrew Lapthorne, shows that downgrades in U.S. earnings forecasts in February were the worst since the 2009 financial crisis. Mr. Lapthorne writes: “we believe that despite the many equity indices hitting post crisis highs, the message from within the equity market, and indeed from the strong performance of the sovereign bond market, is that investors are positioning themselves for an economic slowdown. For example, the relative and strong outperformance of higher quality stocks within the equity market has been highly positively correlated with the equally strong performance of sovereign bonds, both of which have rallied on the back of weakening earnings momentum. To simply disregard this economically consistent message as being simply a function of low oil prices, low inflation and central bank actions may be misguided to say the least.” (Andrew Lapthorne, Societe Generale Cross Asset Research, “Global Earnings Estimates Analysis: Is the U.S. heading back into recession?” February 24, 2015.) While Mr. Lapthorne may be placing too much emphasis on the performance of sovereign bonds, whose yields are artificially suppressed by massive central bank monetization programs, his point is well taken: earnings momentum is fading and doing so beyond the energy sector. It appears increasingly likely that S&P 500 revenues will experience their first year-over-year decline since the financial crisis and earnings may follow. The sharp drop in oil prices is a symptom rather than a cause of a global economic slowdown that is showing up in a broad array of data.
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