People like me have been warning for years that the response of the Federal Reserve and the federal government to the 2007-2008 Great Financial Crisis (GFC) fixed nothing, and a worse financial crisis is in the offing. In the meantime, stock indexes are near their all-time highs; unemployment is low; the loss of depositors’ money from bank failures has been contained; corporate profits seem robust; and, fears of recession have proven unfounded. Investor sentiment seems perky. For example, a recent Wall Street Journal headline announced, “America’s Economy Slowed – It Probably Won’t Stumble (2/16/24).” The reporter asserts, “The real surprise is just how resilient the economy has been to the Fed’s tightening…. A slower but steady U.S. economy is nothing to be afraid of.”

I have good reason to feel foolish and discredited. Are super bears like me wrong, and even if we aren’t, is an inevitable day of financial reckoning so far in the future that it can be safely ignored for the time being?

Herein lies the case that the financial foundations of the economy are rotten, and sooner or later a significant  portion of our financial wealth could evaporate. Stopgap measures, mainly the creation of money by the Federal Reserve (backed by nothing) have shored up stock and debt markets far longer than seemed possible, but the chances are high that sooner or later, something will break. It therefore behooves anyone with financial investments to be clear about why they think what they think.

The one thing no one should do is pay attention to what the authorities say. Their incentives are to provide bland assurances that  everything is ok no matter what. Some of them may even be foolish enough to think that they, rather than the bond markets, ultimately control financial events. They will never level with the American people because unsettling truths are a threat to the preservation of what is most important to them, their own personal power. There are clever spin masters in the seats of power but no truth tellers.

Rather than official pronouncements, you should heed arithmetic and history. Here is some arithmetic every investor should keep in mind:

• Total U.S. debt (government, corporate, consumer) has risen 53X since 1971 from $1.7 T (trillion) to $90T in 2022.
• U.S. GDP ( gross domestic product) has risen 22X from $1.1T to $24T.
• None of these debt numbers includes unfunded liabilities for Medicare and Social Security.
• Federal government debt alone is $34 T, 120% of GDP. The Congressional Budget Office, whose estimates are chronically too optimistic, in its latest  10-year “Budget and Economic Outlook” stated that the additional deficit in the ten-year period 2023-2033 would be $20T.
• In 2024, the federal government’s interest payments will exceed defense sending.

Meanwhile, The Federal Reserve has fostered a “What, Me worry” mindset among the power elites and the relatively wealthy. By promiscuous money creation to keep interest rates low, the Federal Reserve has triggered a boom in financial assets. This has benefited the top 10% of the population but has done nothing for the bottom 90%. Even more insidious, it has reinforced investor behavior that is profitable in the short term, but disastrous long-term: buy when you expect the Fed to cut interest rates and sell when you think it is going to raise them. Investment success looks easy and people begin to feel that markets only go up.

The toxic mix of too much debt and too little worry sooner or later has to spawn some combination of market panics, inflation, and possibly social unrest. I know of no exceptions to the dynamic that develops when a central government becomes grossly over-indebted. Examples: France when John Law served as Controller of Finances in the early 18^th century, Weimar, various Latin American and African countries with regularity. High debt leads to higher debt, an eventual financial market crisis, currency collapse, and contempt for government.

The federal government has two ways of financing its gargantuan debt. It can borrow from the private sector or borrow from the Fed. If the former, interest rates go up and overleveraged businesses and consumers go broke. Recession ensues; market values of all kinds of assets drop. If the latter, the Fed “prints” money from nothing and uses it to buy federal debt. Eventually there is inflation of goods and services. I have oversimplified for clarity, but the basic point is not invalidated by details. The debt is so large relative to the economy’s productive capacity that no productivity miracle will save the day. There is no painless way out. The issue investors must ask themselves is not “whether” but “when”.

People who are retired or nearing retirement must worry about the when” question because if a market avalanche occurs during this phase of their lives, they do not have time to recover. Market losses mean a permanent decline in their living standards or worse. No one can tell whether a specific event will trigger an avalanche or have no effect. The actual precipitating event always seems to “come out of nowhere”, confounding the experts. Prediction is futile. Then, when markets do take a tumble, it happens so fast that very few can get out in time; bids disappear. One day everything is nice and quiet; the next there is shock, especially if, as is the case today, investors have been rewarded time and again by betting that the Federal Reserve “has things under control” and will be able to flood markets with new money if need be to keep asset values from serious decline.

Why can’t this benign pattern continue indefinitely? The gambit of creating money from nothing  gambit can work well for a long time, but ultimately it is self-destroying.  The federal government can spend as much as it wants, provided the Federal Reserve is willing to buy its debt by creating new money. Assertions of Fed independence notwithstanding, the Fed will never say, “No”. Eventually, more segments of the public will notice that the government is buying goods and services in exchange for debt that can never be repaid from cash flow (tax receipts). Consequently, they will refuse to buy newly issued debt without receiving a much higher interest rate to compensate them for the risk that as more money is created, its purchasing power declines. A vicious cycle is set in motion. To suppress interest rates, the Fed issues more money; the more money created, the less inclined private investors are to buy additional debt unless they are paid more for the use of their money. Interest rates spike or investors start exchanging their money for real assets, thus increasing their prices. The public finds itself in a world of high interest rates and/or high inflation.

It seems obvious that America is in the early stage of a financial graveyard spiral. Why then do markets seem unworried? What makes this dyspeptic view wrong?

1. Markets usually are pretty good at gauging the likely implications of new information. In the winter of 2024 investors are in a generally buoyant mood, given recent experience; the problems that worry the Chicken Little crowd are not considered serious threats, at least not for the moment. True, but markets are not always prescient. If they were, crashes would not happen. Market fluctuations arise from the action of humans who are susceptible to mass delusion and unresponsive to uncomfortable facts. It is nonsensical to infer from a lack of fear that there is no reason for fear. Reality sooner or later always wins.

1. Productivity improvements will save the day. The promise of a foundational innovation such as artificial intelligence (AI) is huge, but the current hype way overstates its impact in the near term. It usually takes decades for big innovations to percolate throughout the economy enough to improve productivity per capita. The innovations of the 1920’s, for example, were groundbreaking, transformative, and widely applauded, but that did not stop the Great Depression from occurring.

If no one knows when the malign effects of grotesque over-indebtedness will manifest themselves, or how, what should an investor do? It all depends on one’s circumstances. I am happy to describe what I am doing upon request, but otherwise am not comfortable giving investment advice. I do, however, offer the following matrix that might help you organize your own thinking. It lays out the implications of a decision, given the condition of a financial market and what you decided to do.   

Meltdown no meltdown

Sell you are ok lose market return

Do nothing wipeout earn market return

Are you willing to lose market return to protect yourself?

Are you willing to accept a serious decline in the market value of your portfolio in order to maintain your exposure to long-term capital appreciation and/or income generation potential?   

The questions are simple, but the answers are complicated. How much time do you have before you need the money from your investments? The less time you have, the less volatility you can accept. What is your judgment as to whether stocks are cheap or expensive relative to what a smart, knowledgeable businessman would pay? How can you be wrong? One sure danger signal is that you and others start to think that building and keeping your wealth is easy.