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The Long term debt cycle and The Euro area trilemma

The Long term debt cycle

Like the British empire that fell when the signs of its permanent crisis became evident the same will eventually happen to US to the advantage of China. What are these signs? The ups and downs of a leading modern empires seem to follow the Long Term Debt Cycle (100 years circa) with Empires that go from low debt to high/unsustainable debt levels. Overall It is a cycle of building debt and writing it off. This cycle goes from the initial part (the RISE) to the intermediate part (the TOP) and ends with the final DECLINE.

At the beginning of each cycle (RISE) there is a lot of buying power for borrowers because of low debt levels. High productivity, high levels of competitiveness and good resorce allocation create an environment for profitable trade between people and Countries. Work ethic and a capital market that funds innovation (technology) make the rest making the currency of the Nation the reserve currency of the World.

At the TOP of the cycle Debt levels in the Society become much larger.The Nation becomes relatively less productive and competitive because its citizen are better off and because others start copying their success. At this stage wealth gaps grow and Society becomes more selfish but there are still no relevant social conflits until living standard are OK. However from a save and invest attitude we move in this phase to a borrow and spend attitude also because being the reserve curreny of the world gives the privilege to borrow endlless. The cost of mantaining the Empire keeps growing until it becomes unprofitable and the power start to shifts. Overconsumption is the characteristic of this type of Society.

The cycle ends with the DECLINE phase. Because of high debt levels and frequent economic downturns there is a little buying power for borrowers left. When we approach the end of the Debt cycle Central Banks cannot stimulate efficiently the Economy as they usually did during the minor cycles of the booming phase (slashing Interest rates to stimulate the Economy) because Interest rates are at 0 already and negative in real terms (considering inflation).Promises (debt) are too big to repay and Public Institutions prefer defaulting on their debt by printing money (currency devaluation throught inflation) to make debt cheaper.

This is the most effective, subdle and less painful way to reduce debt levels in the Sociery and to redestribute wealth and power from creditors to debtors. This causes of course Internal conflicts between rich and poor, creditors and debtors due to a widened wealth gap that erupts in some form of extremism and populism. Democracy is challenged and some form of autoritarism /revolution /cvil war happens.

In this final phase international conflict with the rising power emerges (trade war, techology war, geopolitical war) until there is a test of power (fighting ar receding). The loss of faith marks the end of the cycle and the decline of the established Empire that is replaced by the emerging one. The most evident sign of this is the emergence of the new world currency that replaces the old one .

The Long term Debt cycle in action

The current long term debt cycle that is now in the late -cycle phase was born in 1944 with the Bretton Wood agreement when World War II ended and the Dollar/US dominated world order began.The Dollar became the World Reserve currency linked to hard money(Gold) and the US the leading Empire replacing the UK Empire. During the years that followed US abused its reserve currency Status and the quantity of claims on the money (debt assets) rised relative to the amount of actual goods to buy. When this happens the link to hard money is sooner or later broken.

In fact, this happened in the 1971. Debt notes were no longer convertible in tangible assets(gold) at a fixed rate and the age of the "fiat money" had begun which led to the debasement of money because central banks wanted to stretch the money and credit cycle to make it last for as long as possible (because this is better than the alterantive).

It is a constant of history that when the system on hard money and its claims(paper money) becomes too painful governemts abandon it in favour of what is called fiat money. Central banks can now create more money and debt assets and liabilities in relation to the amount of good produced without restriction.

But the time comes when also the Fiat money system reach their limit because credit created is too much and Interest rates reach 0 and cannot be used anymore as a tool to stimulate the economy. When that times comes debt defaults and devaluation of money come. With the crisis of the 2008 monetary authorities started buying financial assets directly from the market to buy financial assets (bonds) with the purpose to inject liquidity (QE) and hold interest rates down and stimulate borrowing again.This was the birth of Financial Capitalism. The consequence of that was however an increased Wealth Gap in the population because the majority did not understand that to save purchasing power you had to buy financial assets.

Finally during pandemic /covid 2019 crisis it was the turn of Governments to intervene directly in the economy by enlarging its budget deficits (monetization of the debt). Usually when this happens the inflation genie is back in the system and Competitive devaluation are around the corner. It is after all a deliberate policy and their last resource: create inflation to devalue national debts that have reached unsustainable levels.The alternative would be a Sovereign debt crisis with the Bankrupcy of the States and potential wars/revolutions or civl wars.

Central Banks and Governments policies of the last decade have created a huge and increasing wealth gap in the Society and now social and political conflicts are exploding. We have extremist from the left (extreme multiculturalism/woke, cancel culture and environmentalists) and from the right (nationalistic populists). This social polarity plus Geopolitical instability due to the rise of China and the end phase of the US debt cycle are creating a CW2, a new Cold War with technology being the battleground.

In the coming years both fiscal and monetary policies will be implemented to help spenders instead of the investors(as they did before) and we will have significant negative real cash rates and bond rates and interest rates below nominal GDP growth (inflation + real growth). Under this environment you would rather own a piece of the economy(stocks) and tangible assets than those linked to interest rates (bond).The risk is that if/when the velocity of Money explodes inflation goes out of control. A monetary crisis will erupt at some point and this will be the last step before capital moves from West to the East (capital outflow).

States can no longer borrow endless to meet their promise of different forms of socialism. They need a monetary system reset to create a new digital currency that will make easier for them to collect taxes. This risks creating a decade of Autoritarism and a period of instability. When confidence in Governments collapses Capital usually flies to Dollar (the currency of the Empire) and equities and Gold.

The Next Decade in a nutshell

Human Productivity and Debt Cycles will determine the next 10 years. This decade began in April 2020 with the largest dose on fiscal and monetary stimulation ever. Debt is now growing too fast in Society to be repayed in hard money and the COVID -pandemic has worsened the situation. Governments have taken the root to print even more money to cover these debt promises and the additional debt growth(and deciding where the money will go). This means, in practice, devaluing the Value of money. Interest rates will also grow smaller than inflation and this is the equivalent to say that wealth will be redistributed from creditors to debtors,This has to be done because historically when wealth, income and values gaps become too large the risk of internal conflicts /civil wars are high. The other important point to highlight is that the combined monetary and fiscal policies implemented mark the moment when esternal conflits also emerge between the establish world leader (USA) and the emerging one(CHINA). This is enough information to say that the period ahead will be characterised by huge volatility, lower return and the definition of risk will change too.Constructing a well balanced portfolio will be fundamental to survive in the challenging period ahead.

The Euro area trilemma

The economic theory states that a Country or Region cannot have at the same time all the 3:

1) A fixed exchange rate; 2) an Independent monetary policy; 3) Free capital flow .

This is the problem in Europe since the beginning of the EU. Greece, Italy, and Spain were accustomed to paying their past debts with a cheaper currency (by devaluing their national currencies). When they converted all their debts in Euro and the Euro doubled in value against the Dollar (their main export area) at the beginning of the Century suddenly they went into deflation and unable to pay their debts and prosper. This process accellerated with the political decisions that were taken by EU after the 2008 financial crisis (every Country was responsible of its own Public Debt). The path of history in cases like this clearly says that this is the road to economic and financial ruin.

The currency risk they tried to eliminate with the creation of a single currency was simply transformed in a credit risk (the bond spreads between members).The consequence of that was a loss of competitiveness. Internal devaluations (unemployment and deflation of wages later) and a decrease of productivity were the obvious consequence of deciding to remain in the Euro area at all costs. After 20 years this decision is creating a Sovereign debt crisis in the Region because Governments deficits boomed during the Pandemic crisis. The time when EU will be unable to continue borrowing endlessly it is approaching.

Modern History tells us that these Nations to finally restore competitiveness and go back to the old path of economic growth will have to default on their debts by inflation instead of deflation (as it happened until now). However, it seems probable that external devaluation will be needed as well and this can only happen with a monetary crisis that could break the Euro. The Multilateralism dream to unite different Nations with a single fixed exchange rate mechanism valid for all Countries could end badly.

Italy is the biggest example of that. Italy’s economic stagnation of the last 25 year began with its decision to be part of the EU project. In the 70s and 80s Italy had the strongest communist party of the West risking of being emarginated in Europe and trapped into an inflationist spiral out of control. In this situation the political class of the time decided to build the so called “ vincolo esterno” and force the Country to remain loyal and anchored to the Western block. The cost to sustain to achieve that task was to be part of the EU area and the mechanism invented to achieve that was the creation of a fixed exchange rate (EURO) ,a check and balance mechanism that had to force some Countries to be disciplined.

This did not come without costs for Italy because since then it has run 25 years of primary budget surplus to stay in the euro zone(it means that the State gives less to its citizens of what it takes from them).This has created stagnation and deflation(cost of labour) because of the decrease of purchasing power. During these years the system in place benefited only the few (creditors who were able to link their asset to a stronger currency) but not the whole Country.

Getting out of the EURO(which means going back to the national currency and devaluing it) is now politically challenging because the political class has bet everything on the EURO and today needs the support of the BCE to avoid total implosion.

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