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On liquidity and debt

January 23, 2012

Why do I write and talk about liquidity so much?  When I speak of liquidity I am really referring to the creation of new money, particularly as it relates to stimulating financial markets or economic activity. Whether it is liquidity from the Fed’s printing press, or from our government’s growing debt, or from easing interest rates, it is an artificial manipulation and stimulus that has both short-term and long-term ramifications.

My favorite saying is that we have borrowed our prosperity. The sad truth is that for decades, our economic activity has been underwritten by increasing debt. This is leverage and we now must experience deleveraging to right the ship. But that is not what has been allowed to happen. Instead, we are doubling down our leveraged bet. We are increasing debt at a faster rate than we ever have in our history. Historically, a nation—or any entity for that matter—is limited to the amount of debt a borrower is willing to buy. As we have seen in Europe, sovereign nations are being forced to pay a premium to borrow new money; hence the cost of issuing new bonds is increasing (look at Greece, Italy, Ireland, Spain and others as evidence.)

I think one of the reasons the interest on United States treasuries have not gone up as fast they should have, is because we have replaced traditional lenders, such as China, with the Federal Reserve, who at one point became the largest purchasers of our own debt. As I have mentioned before, it should be alarming that we have resorted to “offing” our debt to none other than the entity that prints our currency. Think about this, we are buying our own debt with newly printed money. Doesn’t it seem that we have just moved from policy that puts our debt in question to policy that puts our entire currency in question?

The second reason for the U.S. being able to keep interest rates low and still attract buyers of our treasuries is explained in the earlier submission, “The best-looking horse.” Our action—leveraging up over the last three decades—has a natural reaction, and that is deleveraging.

We must understand that the interrelation of liquidity/debt causes leverage and risk, which eventually exhausts itself and causes deleverage. It is unfortunate that we have failed to learn that more debt is never the solution to a debt problem. In fact, in the end, it will only compound our problems.

Charles Hugh Smith does a great job explaining this same sentiment in his article, You Can’t Fool Mother Nature For Long: The Substitution of Debt for Productivity.

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