Perennial Asset Management

The Tinderbox of Debt and Deficits

A Spark on the Forest Floor

Intervention’s Unintended Consequences

In his book “Ubiquity: Why Catastrophes Happen,39 author Mark Buchanan discusses the concept of a “critical state,” which analyzes the stress created on a system, and how the system readjusts. Buchanan looks at earthquakes, forest fires, traffic jams and mass extinctions, but the concept also applies to capital markets. While it’s almost impossible to predict when the stress will be relieved, or how substantial the adjustment will be, it’s clear that something will happen to relieve the stress.

Buchanan addresses an interesting phenomenon in assessing forest fires. He postulates that because man became proficient at containing small forest fires, the normal cleansing process was disrupted. The flammable material on the forest floor therefore built up so that when a fire occurred, it became larger and more damaging than what was normal in the past. Buchanan’s thesis is that small fires are nature’s way of keeping the system in balance, and while man is trying to help, the intervention has serious unintended consequences.

Today, the Fed believes its raison d’être is to keep the economy growing and to avoid recessions at all costs. In effect, the Fed has been fighting every small forest fire. The Fed’s easy-money policies have prevented the economy from experiencing normal economic slowdowns, which facilitate a natural cleaning process that make way for the next economic cycle. Short-term interest rates are now almost 0% and the Fed’s balance sheet grew from $900 billion in 2008 to $3.7 trillion today, yet the U.S. economy remains weak with few signs of real improvement. This leaves the Fed with fewer tools to control, what could become, a much bigger fire.

Since the recession supposedly ended in 2009, we should be at a point in the cycle of strong economic growth, where governments are running balanced budgets, not significant deficits. Since economies are cyclical, it would be normal soon to experience another slowdown. Yet, every budget projection currently shows a balanced budget being achieved through stronger economic growth. But what happens if we experience another economic slowdown with the normal revenue decline?

The Firefighters are Exhausted … and May Leave the Forest

In this paper, we show that government debt and annual deficits have increased significantly in Ontario, Japan and the U.S. with limited, if any payback in terms of stronger economic growth. Each of these economies is experiencing the negative effects of carrying large and growing debt loads. While we highlight the problems in three jurisdictions, debt addiction is a major problem among almost all of the developed economies. Indeed, history has shown that these long debt super-cycles eventually come to an end, and they generally do not end well. We should not assume that the government will be there for us; rather, it’s now essential that we rely on ourselves to protect our future.

We should not casually accept the headlines and gloss over the real issues, as politicians provide a positive spin on their latest strategy. Governments’ well-intentioned policies have caused serious unintended consequences, and the flammable materials on the floor of the economic system are building up.40 The tinderbox of debt and deficits may soon find a spark.


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