PREVIEW： Brokenomics ｜ Breaking points
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Summary
In this episode of Brokonomics, I discuss the 12 numbers that I think are crucial to the world operating in a sort of functional way. These are: 1. What are the Breaking Points? 2. What is the tipping point where the economic system breaks down 3. What do they mean and how can we get there 4. Why they matter 5. How important are they 6. What will they be 7. Why are they important and why should we care about them?
Transcript
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Hello and welcome to Brokonomics. Now, this episode I thought I might call Breaking Points,
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which i think is an excellent name for a podcast actually i don't know if anyone's got that already
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um but what i wanted to do is i was um i'm gonna go on um ferrari's channel soon and because he
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came on mine and i talked about you know what are the what are the sort of breaking conditions
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in the whole iran situation from a geopolitical point of view on the various actors in it and
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that's going to be what you should have seen that episode by now and he said well why don't you go
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and mine and talk about the economic side of things as well so i've been putting together
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some notes and i ended up getting quite into it so i i managed to find 12 numbers that i think
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are pretty crucial to the world operating in a sort of functional way any and it's well i'll go
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i'll go through it but what it's all dependent on is that you see systems such as that we are in
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they don't fail at extremes you can't just say okay well there's a you know there's a there's
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a threshold and you get beyond that and you'll see that all the time on twitter you'll say you
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know if if if if rates go to whatever it is six percent everything collapses it doesn't it doesn't
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quite work like that but there are thresholds where behavior is is forced to be changed and
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what i wanted to do is identify where those thresholds are and as long as we recognize that
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it's sort of gradual stress um leading to sort of instability then we can we can sort of see well
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okay, well, that's going to lead then to constraints and forced actions and cascades.
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Because you have to remember, right, modern economies, they're not really free systems
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in the way that they might promote themselves as. They are basically range-bound control systems.
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And they're built on a whole number of assumptions about cost of capital being within certain bounds
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and energy availability being a good thing and currency stability and social tolerance.
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tolerance we don't mean that's fraying at the edges but really um most actors within this system
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they're not they're not really trying to well they would like to optimize but what they're
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really trying to do is is manage the set of constraints that they've got to work with
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so government debt has got to be enrolled we talked about that a lot on brokernomics
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central banks have to manage expectations um not really the reality but expectations
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it matters more um you know corporate price um we you know around benchmarks that they don't
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control you know and households react late unfortunately in all of this so essentially
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what i'm saying is stability is is an illusion and and it's an illusion created by suppressing
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volatilities and political backstops um lagging indicators and all of this sort of creates a sort
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stored fragility, which at a moment of crisis can be a problem. So I'm not going to talk about
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these breaking points as a, well, I will talk about them as a single number, but I'm not trying
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to frame them as a sort of crisis headline. What I'm really saying is this is the point
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where key people in the economy basically lose optionality and are bound in by a set of
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constraints that will lead them to worse constraints. And that's why I'm describing
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them as breaking points you know these systems aren't going to break everywhere at once it will
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break asymmetrically it'll be weak balance sheets i mean we're already there it's going to be
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leveraged institutions and then it's going to be sovereignty and in fact a version of that is what
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we'll what we've already had i mean the weak balance sheets break first that was that was
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the sort of dot-com bubble wasn't it leveraged institutions failing that was 2008 and the next
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time we get a proper proper crash situation it's going to be the sovereigns these numbers that i
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picked the thresholds for them are more or less known i don't think i'm going to be controversial
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in anything i say and they're watched closely but all of them are politically denied you'll hear
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commentators talking about them and you often see threads or people pop up on the news talking about
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them but i wanted to kind of pull them all together and talk about the set of conditions
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around them if any one of these goes it's going to cause a bit of a crisis somewhere
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if they all go the system is going to be replaced by something else something perhaps radically
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different they all force market uh you know they in all cases the markets will force policy
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and then that policy will distort the markets and then those distortions will create further
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stresses what have i got for you i'm going to talk about cost of capital and uh for that i've picked
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the u.s 10-year treasury the uk 10-year guilt the japanese um um the japanese 10-year and the u.s
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interest expense that governs at least in my world the price of basically all assets you know
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government solvency is really based on rolling debts not repaying them and the whole system
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kind of assumes that these rates are going to be below nominal growth and if it's not
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then the debt is compounding faster than the economy is growing then i want to get into energy
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price of oil brent i've picked um european gas feed into everything i mean it's not this is not
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just like a cost as as the other things were cost of capital it's a throughput of capacity through
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the whole thing and you go above a certain threshold on these prices and you're not just
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repricing you're actively destroying capacity then i want to do a bit on liquidity of course
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but the basket of goods compared against the dollar.
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And then let's talk about the real economy side of things.
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Either a dollar shock or an energy shock feeds into liquidity,
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which then feeds back into greater difficulties.
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So if you want to really boil it down, it's pricing time, time plus risk for the state.
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And it anchors all asset pricing because why would I invest in something that has risk
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if I can invest in something which is perceived as being a riskless asset?
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And it probably is to the extent that at least you get your nominal back
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because the government will do anything to pay its bonds back.
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so every other asset is going to be that plus the risk premium for given for however risky the thing
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is so if you can get large yields from that so it is the basis of which all assets are priced
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if it breaks everything else reprices you know yields go up deficits go up yields go up deficits
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go up you get the pattern the issue with the us 10 year i i think my break point for this is going
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be 5%. And this one is a bit bigger than just the risk-free rate for the US. It's effectively
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the global benchmark for discount rates. If I can get 5% here, why would I invest in anything else
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that's going to give me anything you wouldn't? Anything offering, say, 8% returns must be worth
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at least 5% plus with 3% risk. Now, above 5%, most of the equity housing and private equity
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models kind of break. And it would force a Fed versus Treasury slowdown. I mean, it would be a
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conflict between the two. One is going for, I need to roll out more debt in order to keep things
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ticking. And the other one is going to be, there is a fundamental threat to the system. You need
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to stop spending so much. And a lot of investors would be trapped, especially in leveraged assets.
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It's a real problem. UK gilts, 6%. Now that's not because the UK is a stronger system and
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therefore we can tolerate six where the US can only tolerate five. It's actually because they
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they have less ability to generate cheap capital and therefore the system has not become dependent
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on rates that's still quite so low but i mean it's still low you go over six percent and i mean you
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saw a bit of this with the list of trust thing pensions um the pension assumptions break which
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is a huge investor in the uk you get currency pressure and it kind of effectively forces a
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bank of england's intervention but that can only go so far so you then get into um spending less
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fiscal tightening uh the government's hands will be forced it'll be that or i mean we literally
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can't pay we can't afford to borrow as much money at this rate but we've still got the outgoings
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and we can't get the money in and we can't raise tax revenues we have to start cutting something
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something is getting turned off um i mean they try taxes first of course and it won't work
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because they're at the upper ends of how much they can raise in revenue.
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They can try printing it, but then you get a currency pressure
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Their break rate, their break point is probably only 2%.
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Again, because they have structured on the assumption of extremely low rates.
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you go above two percent and the bank of japan basically has to cap at that level
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or allow major currency disorder so they have to choose between
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going back to a harder form of yield curve control which will just end up transferring
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even more debt onto the japanese system where it's absurd that it's surviving anyway or you
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get a currency collapse so they are trapped u.s interest expense that's got to stay below 25
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you go beyond that you're getting into a sort of fiscal event horizon because at that point
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debt servicing costs are crowding out core spending and by core spending i mean i mean the real core
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is um medicare medicaid military all the infrastructure stuff that's getting pushed
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out if you go over by 25 25 of your expense is just interest and it's heading towards that you
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have to print which they probably would and they probably got the flexibility to do it but then
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you get into the problems we talked about the currency they've got to cut or find some other
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mechanism for debasement and they're trapped because actually so much of u.s spending is not
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discretionary it's been written into law you know the welfare commitments of various kinds
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i don't believe the military stuff has been written into law but if you start cutting on
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that then you you can't do the hegemony project projection core mechanism i'm trying to describe
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yields go up debt servicing goes up deficits go up means you have to issue more because you're
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running at a deficit and you're crowding stuff out yields then go up debt servicing goes up
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repeat and repeat repeat and it's not exactly a linear process you get you get feedbacks once
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you cross a certain threshold which i picked at five percent which sounds about right and we are
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already at the point of structural instability with this stuff because the debt stock whatever
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it is 32 33 trillion at this point it's it's too large for the market clearing rates
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so a small moving yield is going to have pretty outsized fiscal impact at this point
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to be fair i should also mention the duration matters on this right in the uk a lot of our
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debt is short dated and also a lot of it is index linked so that means that the pain hits fairly
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fast. With the U.S. and Japan, a lot of their stuff is quite long duration, which means that
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the impact hits them slower, but when it does, they're more locked into it if they have to roll
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over debt on very unfavorable rates, rates that the U.S. government and Japan can't withstand.
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So the policy trap is essentially, if you let yields rise, you can restore market pricing,
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but you'll blow out the deficit, you'll be forced into basically austerity and very limited
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room to move and over on all that, or you get into default risk, which they can never
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I want to circle back to that when we get to the S&P.
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you can cap yields you can do your yield curve control or maybe even a form of qe
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to mitigate this to an extent but then you're going to get currency weakness you're going to
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get inflation risk which is a political nightmare or capital just for japan and the uk capital
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flees in the us capital stops arriving and then model is built on capital arriving three you could
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try and inflate the debt away but it that really does require negative real rates which gets more
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difficult as the rates are going up and up and up you're going to destroy people's savings and
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you know the boomer generation they do vote and they would feel this hardest because a lot of
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them are now on savings income so it's hugely politically destabilizing so essentially what
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i'm saying is there is no there's there's no clear path of any of this stuff it's merely a question
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of what combination do you do and how do you distribute the pain that's the pain where this
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kind of break actually occurs is it's not at yields get too high it's at the point where the
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markets stop passively funding the rollover of the debts at your five percent your six percent
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and the central bank is kind of forced into the position of being the marginal buyer
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and at that point the regime has shifted it it becomes appreciated that this is not a market
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operation anymore this is a it's a state system that is operating unsustainably and artificially
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at which point you kind of destroy belief so who's forced to act first well the treasury
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be it to welfare checks, military pay, military equipment,
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And so they're going to be putting enormous pressure on the Fed
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The Fed, however, they've got to try and protect the system as a whole
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you know they will show up in initially in extreme speculative volatility well
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in the past few weeks um with the middle east situation you've certainly been seeing that
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they'll start pivoting towards shorter term capital in the hope that it's going to turn
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around in the future and you're going to get your your main inflation channel coming initially
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through the sort of commodity exporters pension funds are trapped in this because they've got
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such a duration mismatch i'll come back and talk about that more governments because they've got
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their fixed spending commitments are trapped and households because they're tied to an asset price
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their home their equities i mean some people are going to be perhaps income rich and asset poor
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and they do relatively well out of this um but a lot of people don't especially the the the older
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and higher voting population will really suffer from it.
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You'll get the break, you've got the need for that external funding,
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And Japan can delay because they can absorb some of this domestically,
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The yield curve control either breaks or it holds.
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And the US will almost certainly be the last to break.
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But when it does, you're looking at global repricing
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because there's no external anchor to the dollar.
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I'm just saying, what are the break points if it comes to it?
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If things start to get back, if there is a global loss of confidence,
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if things like these thresholds start getting crossed,
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I mean, equities would have to come down considerably.
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properties either wouldn't sell or would come down be severely depressed the fiscal situation
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would get crowded out very difficult for the americans to do because they've written so much
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into law and the policy shifts from any pretense of having a growth policy to just outright survival
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policy and the other thing to think about okay let's say these thresholds are crossed what about
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the duration i mean if if it lasts weeks to months and you get a volatility spike and liquidity will
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deteriorate you'll get some um auctions of debt fail but that that's survivable if it goes on i
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don't know six months plus you're gonna get forced into a situation where either that spending has
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to be cut or they do what is probably more likely which is the printer has come quantitative easing
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we're probably into the realm of financial repression.
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You will be forced, if you have assets, to invest in bonds.
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Well, I mean, they already are, but they'll be mandated.
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um corporates will be mandated to buy bonds they will force you into the system by threat
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basically beating up and jailing you if you don't you know the system does not
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you know merely tolerate these sort of neutral rates it basically has it is got into a situation
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where it requires rates that are low relative to the debt load and actually the real breaking
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point is when that illusion has failed. Those, I would say, the hard constraints from a purely
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economic point of view, how do we get there? What are the real constraints that lead into that?
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Well, that's why I want to talk about energy, right? Because energy isn't just filling up the
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tank. You can think of it as the physical throughput of the entire economy. If you enjoyed
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