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A bleak roadmap regarding QE/Debt/Sovereign Bonds/USD. Looking for feedback

Hello all,

I am writting in this board and not the Ask Me Anything one because I figured Cullen is a busy guy and others may be inclined to chip in the conversation as well. This all started because I have had an idea in my head for the past year about certain macroeconomic trends that I see, and their effects, but I have not been able to find anyone with enough level of expertise or at least real world understanding to explain if my thought process is correct or if I'm missing some key concepts. There is also a lot of alarmist content about the collapse of the economic system on-line, which makes it harder to find reliable information.
While I am excited to learn more about the world of finance and economics, these are all areas very outside my traditional natural sciences background, so I suspect I may be misunderstanding things more often than not.
I am sorry in advance for the long post but since this is still a fresh topic for me I am trying to explain it as best I can. Below, and attached, you can find a flowchart where I have tried to summarize the points I'm about to write to make it easier for you to follow.
My thought-process starts with QE, which was started as a response to the 2008 financial panic. Now that there have been zero to negative real interest rates on government bonds as well as savings for a few years, I found a potentially troubling connection between pension funds and government bonds. Pension funds usually own some government bonds since they traditionally have had a decent yield, are "safe" (lower risk of default), and in many cases are actually forced by law to hold a substantial percentage.

Given these very low interest rates in the last 8 years, this has affected pension funds tremendously since they need the yield to be able to pay the pensions. See the following news articles and opinion pieces for supporting evidence, especially in regards to Europe:
Now after realizing this, I thought that there would be more or less three options left:
  1. Governments are forced to cut pensions and benefits
  2. Pension funds are forced to diversify into other riskier financial assets
  3. Pension funds force the QE + zero/negative interest rate policy to end
Concerning point 1, I would wager that it's actually very politically difficult if not impossible to cut these benefits when most of the hurt economies by the crisis (in particular Europe) have not recovered. Doing so would lead to less spending, an even greater tendency to save money, lower investments, and general slow or zero growth, or even a contraction and recession, without the ability for a central bank to lower the interest rates further as they did in the past.
Concerning point 2, I thought how not only is it difficult for pensions to diversify since they are forced by law to hold some bonds, but in doing so they would be underfunding governments since there would be less demand for their bonds and debt. With less bid, it is possible that the debt issue could threaten other aspects of government operation, leading governments to seek an increase in taxes, further leading to a contraction or recession since the economy hasn't really recovered yet, as in point 1.
Concerning point 3, since the overwhelming majority of government bond purchase has been done by the ECB, if they were to suddenly stop doing so, it is very unlikely that the private sector would "pick up the slack" and buy as much as the ECB was purchasing, leading to a skyrocketing of interest rates since there would be little to no bid. As in point 2, this would lead to less funding for governments, and the debt problem becoming worse, potentially leading to an increase in taxes as the only solution, and thus prolonging or worsening the recovery, especially in Europe.
So if we assume the premises above are correct (which they may not be, which is why I sharing this here for feedback), then I could see some consequences happening:
  1. If the debt issue becomes a problem, and the alternatives are potentially counter-productive (raising taxes), then governments may seek an international debt negotiation or pardon
  2. The lack of a single european debt policy, or an incentive to start one at this stage, could lead to the collapse of the euro
Concerning point 1, there is certainly historic precedent in the past, however seeking an international debt negotiation or pardon would lower the confidence in the european institutions and governments, leading to increased lending interest rates due to a decreased rating, and further making it harder for governments to fund themselves despite the lower debt, which could further result in a recession.
Concerning point 2, I think I can refer back to the middle of the decade when Greece was having its serious issues and most investors were concerned about systemic risk. Since the debt was not unified in Europe like it was in the United States, it would be hard to maintain a single currency when the individual countries are cornered into a difficult position like in Greece.
A further consequence of point 2 and the potential collapse of the Euro, would be that previous money that was parked in the Euro would move to the US Dollar as it still stands as the world's reserve currency, and EUR/USD still is the most liquid trading pair in the market. Alternatively, a lesser % of money could flow to other assets such as Commodities, Equities, and alternatives (such as collectibles and cryptocurrencies), which could lead to localized or generalized unsustainable price rises.
The biggest consequence of the money moving from the Euro to the USD would be the huge valorization of the dollar, which would further drive two main consequences:
  1. Many countries have contracted debt in USD at a time when the USD was cheaper. If the USD rises, let alone substantially rises, then they will find themselves unable to meet the debt obligations, potentially leading to a worldwide cascade effect of sovereign debt related issues and implosions.
  2. A side effect of this would be that a strong dollar would hurt USA's exports substantially, leading to a slowing down of the economy and potentially triggering a recession. I believe the latest data is that exports represent around 12% of the USA's GDP as of 2017.
From these points we start getting even more into the speculative realm. All of these events have the potential to trigger extreme social unrest, conflict, and even war. Additionally, they could trigger or speed up the economic/monetary shift from the West to China and Asia, further promoting the decline of the West in terms of past prosperity and influence. This could also lead to a new monetary fund organization with different goals and lessons learned from the events that had unfolded.
I have written all the points above in perfect knowledge that they paint a fairly "alarmist" picture of the future, though I am very open to being proven wrong. This is why I would be interested in discussing these ideas with Cullen and others that follow this blog, as Cullen at least for me has proven to be among the few that are able to take a step back and try and look at data objectively without a political bias or agenda. I really appreciate everyone's time reading this and I look forward to hearing your thoughts on it.
Uploaded files:
  • QE_ECB_USD_CN.jpg


That is covering quite A LOT of ground. 🙂 Good for you for thinking this thru and trying to connect the dots.

Honestly, there's too much there for me to touch on so I'll touch on the main point (about pensions) and we can take it from there.

My general view is that pensions basically put together their budgets and return estimates based on totally flawed approaches. In essence, they looked at the historical returns of the last 30 years and assumed that those high returns would continue. Many pension plans were built with 10% return estimates and are now discovering that reality is probably closer to 6-7%. This will not be fixed with the Fed raising rates to historical levels because inflation doesn't justify the curve being that high. You can see this in the long end of the curve where rates are low and the essentially limiting how much the Fed can raise rates. In other words, the economy literally can't afford 6% overnight interest rates right now.

So, the two main options are:

1) Take more risk.

2) Reduce necessary returns.

My guess is some mix of both will occur with 2 eventually being the main answer. We're seeing 1) happen already. I believe it was CALPERS that just announced a big increase in private equity allocations. But ultimately 2) will come home to roost. The pensions just made bigger promises than they could fulfill and they're going to need to restructure their promises. I think it's that simple.

And yes, all of this will exacerbate the social unrest we're seeing which, IMO, stems mainly from the fact that inequality is very high and people don't view the USA as being a very meritocratic economy anymore....

"Pragmatic Capitalism is the best website on the Internet. Just trust me. Please?" - Cullen Roche

I note the "IMO", but it just sounds like prevalance induced concept change to me.  Which is a disease of affluent Westerners that have nothing better to do with their free time!


Sticking to CalPERS for a moment, there was a restructuring in 2013 called PEPRA that created a tiered system where new employees had a later full retirement age (62) and lower rate (2%). Public safety numbers are slightly higher. This reduced long term underfunding a little, but they also reduced their expected return to 7% which increased the burden on public agencies to pay more into the fund now. How this all works out in the long run is unknown, but many states are in much worse shape (Illinois, Kentucky, New Jersey). Those states are the ones to watch for early signs of distress.

Europe has unique problems because of the structure of the Euro. They need a defined transfer mechanism like the US does to that richer states support the poorer ones. That's a political problem I don't think is easy to solve.

It looks like the US after our housing bust is following in the footsteps of Japan after their housing bust. The Fed has been propping up the economy with a giant balance sheet just like Japan. The Fed hasn't started buying up corporate stocks and bonds, yet, but the BoJ is now a major shareholder in 40% of Nikkei stocks! Japan might be the canary in the coal mine regarding advanced economies and sovereign debt. Just my crazy opinions.

Thank you all for your contributions. I thought I would present the steelman for the best counter-arguments that I've found against my position and to see what you make of it.

I have received criticism that worrying about this topic is really worrying about a subsection of a larger topic.

"Will current private and public pension forms survive in their current state?" is a separate question to "will there be a catastrophic pension crisis?", and one cannot address the latter without addressing the underlying capacity of sovereign states to maintain and divert GDP.

I've also been told it's a form of extension neglect, like people freaking out about debt default without looking at who the debts are owed to. Current pension funds not being able to cope with economic shocks, slowing growth and growing demand isn't catastrophic if the state can just divert more GDP or change the rules of funding to make them more robust.

I've also been criticized by my assumption that higher taxes don't automatically cause recession, although they can sometimes. If one looks at nations ranked by tax revenue as percentage of GDP one doesn't find a particularly strong correlation. Denmark, Sweden, Norway Finland are nearly double the GDP percentage revenue of Switzerland, USA and Australia for example.

One could also divert existing GDP spending, such as from military spending. Current US GDP spending on social security is only 5%, its not immediately obvious they couldn't raise GDP tax ratio from 27% to 32% without causing some kind of economic collapse (and that would double existing social security capacity). Maybe it would cause slower economic growth but thats a long way from doomsday.

Most relevantly, what is being taxed and what its being spent on is more important than the raw numbers. Someone also suggested that one could get big gains from taxing things with high externalities, for example taxing alcohol, since alcohol causes dementia which increases social care bills, it also increases load on hospitals from alcohol related violence and accidents. So a higher tax would result in people drinking less, and the money they would have spent on more alcohol than is good for them goes to help pay for the costs of alcohol to society. Same thing with taxing sugar or polluting vehicles.

One could make the libertarian argument that people should be free to poison themselves if they want, but even if we ignore other people getting hurt, it would require people be willing to commit suicide in old age rather than become a burden on the state. And we could have physiocratic spend and non-physiocratic spend. For example, we could subsidize farmers to just leave fields empty or we could subsidize them to plant trees. On paper that is all just "GDP spend" but one generates wealth and reduces externalities the other doesn't.