Four mutually reinforcing systemic risks are clearly visible on the horizon. Unless we focus on them soon, we may end up in a financial crisis. Yet discussions of them are rare. I’m reminded of Nat King Cole’s 1953 hit, “Pretend.”
Government debt soon will be substantially higher than GDP. The debt-to-GDP ratio will continue to rise beyond that dangerous level, and within a few years (certainly less than a decade) the Treasury will have to resort to selling debt to the Fed, which will print money to buy it. By my calculations, the resulting steady-state rate of inflation will be at least 10%, even if we do what countries do when spending gets out of control – cripple our banking system with a “reserve tax” that imposes a high reserve requirement against deposits and zero interest payments on reserves.
The spending cuts needed to avoid that are substantial. You might say, “DOGE is on it!” – except DOGE is complicit in fiscal pretending. The new Administration says it won’t allow cuts in Social Security or Medicare, but touts perhaps $2 trillion in annual expenditure cuts. Cuts of $1.5 trillion likely prevent rising inflation, but as David Stockman’s recent calculations show, that would require significant cuts to Medicare and Social Security. The good news is that moderate, phased-in cuts to these programs (e.g., correcting inflation indexing errors, increasing retirement age, reduced benefits for high-income recipients) would do the job. But rather than employ instructive arithmetic, our leaders on both sides of the aisle seem to prefer another option: “Anyone can dream... The little things you haven’t got, could be a lot if you pretend.”
Second, Fed leaders act as if current monetary policy (including the recent rate cut) makes sense, even though inflation is running at about 3% and inflation expectations over the horizon of the next five years remain stuck above 3% -- both above the Fed’s stated target of 2%. The Fed says that the neutral level of real short-term interest rates will remain substantially below its historical average, implying that the current level of the policy rate is contractionary. But there is contrary evidence that global long-term real interest rates are reverting toward their long-term average of about 2%, which explains why current monetary policy is proving not to be contractionary enough to bring inflation down to the Fed’s target.
Third, there’s bank accounting pretending – a favorite means of avoiding action by regulators for many decades. Remember the banking crisis of 2023 and the disruptive failures of banks employing “hold-till-maturity” accounting to disguise asset losses? That accounting is still permitted, and high long-term interest rates are still shrinking asset values. Accrual accounting of bank earnings is another bank accounting trick, one that allows banks to pretend they are earning loan interest. Bank revenues of $100 billion in 2024 are considered good as paid under accrual accounting even though banks have not received them. Those accrued but not received revenues, as Christopher Whalen emphasizes, have risen dramatically since 2021.
Bank accounting pretending has a third component. Banks lend most of their money to commercial real estate (CRE) borrowers, but banks have not been forced to reserve adequately for the loan losses they likely will face from CRE defaults. Academic studies by Stanford’s Amit Seru and coauthors estimate that about 600 banks were already on the brink of insolvency in 2023 as the result of rising interest rates and CRE troubles, and both of those influences have worsened. Whalen cites an MSCI forecast that 14% of CRE loans maturing this year (especially those backed by offices and multifamily buildings) will exceed the value of the properties that support them. Pretending about bank risks apparently “isn’t very hard to do,” given that recognizing reality would put developers, bankers, and their somnambulant regulators in the hot seat. The three groups of pretenders have found “a love they can share.”
These four understudied risks – excessive government debt, rising real interest rates, bank system weakness, and CRE’s declining prospects – compound one another. The inflation risk from fiscal profligacy and the lack of Fed seriousness about targeting inflation will raise long-term rates as the bond vigilantes awaken. Rising interest rates will make it harder to fund government debt and further erode the value of bank bond holdings. CRE distress will be bad news for bank health, and consequent bank troubles will produce contractions in credit supply, which will further worsen the CRE default problem.
There’s an uglier word than pretending to explain what politicians and regulators are up to. The EU’s Jean-Claude Junker famously explained when facing the Greek crisis: “When it becomes serious, you have to lie.” From that perspective you’d be forgiven for thinking that this might be a good time to start amassing gold holdings in a Swiss safe deposit box.
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