BOND WAVE MAPPING: CASE STUDY 3
Private Debt Cycle Along the Bond Wave
Originally published July 23, 2016
Last edited July 17, 2017
by Michio Suginoo
Sidney Homer, in his chart of the centennial best credit frontier or “Homer’s Saucer,” left us a notion that the state of money has something to do with the evolution of the Western civilization. Homer’s notion extends to a life cycle of civilization. In studying the bond wave, I intend to contemplate Homer’s notion in a shorter horizon, say secular time frame. Using the bond wave, by observing a long-term transformation in the relationship between bond yields and other metrics for an extended period of time, my attempt is to capture a notion that the state of money mirrors a broader socio, political, and economic reality.
Bond wave mapping provides a heuristic approach to apply historical analogy to make inferences about our present and future based on our past.
This section reviews the private debt cycle along the bond wave.
Overview: Secular Rhythm of Private Debt-Money
During the most recent bull bond wave, the Globalization Wave, private sector in the United States observed a cycle of finance-fed financial crisis. It can be simplified in the following chain of events:
Of course, besides these events, this period was accompanied with other trend—hollow-out, outsourcing of manufacturing functions to developing economies—amplifying the structural shift of economy.
In this chain of events, the role of money was significant. Changes in the supply of money transformed the structure of economy. This period observed the non-neutrality of money. This reading reviews the non-neutrality of money through private debt cycle along the bond wave.
Two recent bull bond waves demonstrated remarkable synchronization with private debt cycles. In this section, we project the secular rhythm of private debt activities over the bond wave by applying “bond wave mapping” with four metrics:
As a reminder, the recent five bond waves are defined as follows:
A more detailed definition of the bond wave is described in Secular Rhythm of Bond Wave.
In brief, two recent bull bond waves have mirrored historical rhythms in their private debt cycles: the private debt level peaked during these bull waves and, thereafter, manifested destructive, systemic financial crises thereafter: the Great Depression during the Vacuum Wave, and the Global Financial Crisis during the Globalization Wave.
Briefly, the two bull bond waves－the Vacuum Wave and the Globalization Wave－demonstrate two similarities below.
These systemic financial crises distinguish themselves from other types of economic distress in the following aspects.
The creation, destruction, and evaporation of modern money
Modern money is primarily created (or destroyed) through two major dynamics: debt creation (repayment) through commercial lending in the private sector; and monetary policy adopted by central banks (McLeay, Radia, & Ryland, 2014, p. 16).
Commercial lending is a private sector’s money creation activity: debt money increases by lending and decreases by repayment, and even evaporates through defaults in the system. More importantly, money is not neutral, since it affects real economy in the long term.
According to Hyman P. Minsky (1985), the state of the economy influences the psychologies of economic actors—savers, lenders, and borrowers—transforming their profit expectations (income expectation and expenditure preferences) and liquidity preferences and, ultimately, their economic behaviours; then changes in their behaviour feed back into the state of the economy. The period of economic stability induces the psychologies of these economic actors to expand the leverage in the system:
Then, it triggers transformations from stability to instability in the following order:
Consequential deleveraging becomes destructive to the economic system. If it involves corporate sector, it would compel business to mobilise new innovations to cut labour cost. A dire job expectation destroys consumptions, consequentially, the aggregate demand. It would annihilate the money multiplier in the long run. As Hyman Minsky noted, “stability is destabilising,” and money affects real economic activities: therefore, money is non-neutral. And real economy transforms from one state of disequilibrium to another, proving that economic forecasts based on equilibrium are nothing but fallacy.
Private debt cycle metrics
To capture the rhythm of the private sector’s debt money along the bond wave (i.e., expansion, destruction, and evaporation), this readings applies bond wave mapping on the following metrics:
Private Debt Cycle during the Vacuum Wave
The following three charts—Chart 3.3.1.a, Chart 3.3.1.b, and Chart 3.3.1.c—cover the period 1916 to 1950 to illustrate the evolution of US private debt around the Great Depression. While the first chart measures the level of private debt and GDP in dollar terms, the second chart traces the relative ratio of private debt to GDP. The third gauges the money multiplier, the driver of money creation in the private sector.
In Chart 3.3.1.a:
Now we shift our attention to the private debt in relative terms. In Chart 3.3.1.b, along with the time horizon of the Vacuum Wave (bull), the total private debt-to-GDP ratio captures one debt cycle. The proportion of leverage in the system measured as relative to GDP starts expanding from the early bottom at 122% in 1920, the start of the bull bond wave; peaks around its middle at 233% in 1933; then bottoms at its end, at 63% in 1945. This timeline demonstrates a remarkable synchronization between the private debt-to-GDP ratio and the Vacuum Wave. Caution is needed in this interpretation. This notion of synchronization is not with regards to the oscillations between these measurements. The feature described here as the synchronization is that one private debt cycle (a pair of rising and declining waves) fits into one single bull wave.
The peak in the debt-to-GDP ratio lags that of the debt level. During this lag, the ratio continues to increase, it is because the denominator, GDP, declines more drastically than the numerator, debt level, from Black Thursday to the beginning of the New Deal program. Therefore, the debt-to-GDP ratio’s surge (in the absence of a rise in debt level) is a manifestation of the destructive impact of the Great Depression on the GDP. This destruction is expressed in the rapid decline in the velocity of money in the same chart.
How money affects GDP
Next, we briefly overview the transformation of the non-neutrality of money—in other words, how money affected GDP—by tracing the velocity of money: GDP divided by M1 or M1 Equivalent. Although the velocity of money might not be considered the measurement of the non-neutrality of money, it illustrates the impact of money on GDP in its trajectory.
M1 is a measurement of money in circulation. Since the Federal Reserve Bank did not release M1 statistics before 1959, for the period prior to 1959 we must employ a proxy for M1 to construct the chart approximating the velocity of M1 money stock: Friedman & Schwartz’s M1 series before 1946; Rasche’s M1 series for 1947 to 1958. (Carter et al., 2006, pp. Vol 3: 604-607) We call these proxies collectively “M1 Equivalent” for our discussion purposes. We measure the velocity by dividing GDP by M1 Equivalent. Chart 3.3.1.b illustrates the trajectory of the velocity of M1 Equivalent from 1916 to 1952.
The velocity measure, after increasing from 3.04 to 3.67 during the period 1916 to 1920, remains high, with the exception of a dip from 1921 to 1922, peaking at 3.89 in 1929, the year of Black Thursday. Thereafter, it reverses direction downward to the end of WWII, although it demonstrates some stability during the New Deal era and some rebound in the mid–WWII period. In brief, until the beginning of the Reconstruction Wave, the velocity of money fails to demonstrate a sustainable recovery.
In principle, the velocity of money collapses significantly throughout the post-crisis period—from Black Thursday until the end of WWII. The post-crisis deleveraging process impairs the velocity of money. Overall, the large-scale fiscal expansion of the New Deal and the WWII special war demand did not reverse the post-crisis collapse in the velocity of money. It took another massive fiscal expansion, the post-war reconstruction effort, to restore the velocity of money: it required a series of unconventional fiscal expansions and possibly the destruction of war. Here as well, the rhythm in the non-neutrality of money and the bond wave demonstrate a remarkable synchronization.
Finally, Chart 3.3.1.c demonstrates “bond wave mapping” over the historical chart of the money multiplier. The M1 money multiplier—M1 or M1 equivalent divided by the money base—gauges the effectiveness of the monetary base in promoting the private sector’s ability to create money.
The monetary authorities can directly influence the monetary base; nevertheless, they can only indirectly induce the money multiplier. The latter is the work of the private sector’s debt money creation through commercial lending: this mechanism drives the circulation of money in the private sector. This chart shows that the monetary authority’s influence over the circulation of money is indirect and uncertain.
In 1929, the year of Black Thursday, the money multiplier (M1 multiplier in the chart) reached its high of 4.4, remaining relatively stable for one year, then plunged to 2.72 in 1934. Along with the progression of the New Deal program, it made a momentary recovery until 1937 to 3.25, then collapsed again until the year before the US participation in WWII. This suggests that while the New Deal boosted the money multiplier for a short term, it did not fully restore its sustainable mechanism. It took WWII—another massive fiscal expansion and the destruction of war—for the money multiplier to restore itself.
Now, in order to take a closer look at the interaction between the monetary base and M1 equivalent, Chart 3.3.1.d tracks the year-over-year (YoY) change in both the monetary base and M1. Overall, this chart reveals that the change in M1 equivalent tends to lag the change in the monetary base.
The one-year stability observed earlier in the money multiplier from 1929 to 1930 is because both metrics, M1 and the money base, declined moderately at comparable rates. Then, despite an increase in the YoY rate of change in monetary base up to 6% from 1930 to 1932, the YoY change in M1 made a remarkable decline. It requires an even stronger rate of increase in the monetary base—from 6.4% to 18.4% from 1933 to 1935 to boost the YoY change in M1 money. This coincides with the early stage of FDR’s administration and the New Deal programs (fiscal expansion).
Thereafter, for the rest of the New Deal era, the YoY rate of change in the monetary base again plunges from its peak of 18.4% in 1935 to –7.2% in 1937. Accordingly, M1 demonstrates a drop in its YoY rate of change. This implies that the absence of an increase in the monetary base might be associated with the plunge in M1 in the aftermath of the financial crisis.
Then, WWII reverses the course of events. From its onset, the YoY rate of change in M1 increases to 30.5% in 1943, lagging behind the drastic increase in the monetary base that has taken place since 1938. Thereafter, despite a drop in its level, the YoY rate of change in M1 remains above the zero line, with a minor breach from 1948 to 49. This illustrates the background behind the remarkable recovery in the money multiplier after 1940.
So far, we have observed one historical debt-cycle case along with the Vacuum Wave. Next, we move to another case in the Globalization Wave.
Private Debt Cycle
During the Reconstruction and Globalization Waves
Chart 3.3.2.a tracks the level of private non-financial debt and GDP during two bond waves—the Reconstruction Wave and the Globalization Wave. The private non-financial debt level and GDP rise gradually at roughly the same rates during the Reconstruction Wave. Entering the Globalization Wave, the private non-financial debt level accelerated faster than the GDP and made its near-term peak at USD 24,741 billion in 2008 at the onset of the Global Financial Crisis. However, unlike the case of the Great Depression, it did not collapse afterwards. Instead, after a temporary setback, it kept rising. From this dollar term chart, the debt level does not form one cycle—a pair of a rising and a declining trends—in contrast to the case of the Great Depression.
When we measure the debt in relative to GDP, the relative ratio of private non-financial debt to GDP in Chart 3.3.2.b demonstrates a declining trend during the aftermath of the Global Financial Crisis.. In 2008, the ratio peaked at 1.68, then declined notably for some time to 1.46 in 2014 before stabilizing briefly.
Now when we trace the velocity of money the impact of money on GDP, the presence of one cycle appear more clearly. In terms of the velocity of M1, it peaked at the outset of the crisis and collapsed near the end of the Vacuum Wave. This is in line with the Great Depression case.
Now we turn to the money multiplier for this period in Chart 3.3.2.c. Like the previous case of the Great Depression, the money multiplier plunged rapidly after the outbreak of the Global Financial Crisis in 2007. Its level collapsed from 1.61 in 2007 to the historical low of 0.71 in 2014. The chief contrast is the trajectories of the monetary base between the Great Depression and the Global Financial Crisis (dark blue lines in Chart 3.3.1.c and Chart 3.3.2.c, respectively). In the former case, the monetary base did decline in the aftermath of the crisis; in the latter case, it made a historic surge. Despite the historic boost in the monetary base by the monetary authority, the money multiplier collapsed. This shows us that the increase in the monetary base was not effective in restoring the private sector’s ability to drive the circulation of money.
It also suggests that the historic surge in the liquidity expansion supported the persistence in the level of private non-financial debt after the crisis (Chart 3.3.3.a). The deleveraging process, an automatic adjustment mechanism to liquidate excess leverage in the aftermath of the systemic financial bubble, may have been compromised by the liquidity expansion. On the other hand, it failed to boost the money multiplier. This translates into the lack of demand. This is a reflection of the failure of the policy response in restoring a primary driver of the economy, income expectation and employment. This implies the need for a demand side measure.
Since quantitative easing (QE) allowed the monetary authority to purchase private securities directly, the QE process does not necessarily involve an adjustment of the monetary base in its passage. The monetary authority, through its direct involvement in private securities, has impaired the auto-correcting demand-supply mechanism—or the price discovery mechanism, if you like—of the market, and may have failed to allow the money multiplier mechanism (the private sector’s economic driver) to be overhauled.
Resemblances and Differences
in Two Private Debt Cycles
These “bond wave mappings” revealed recurrences and the evolution of the debt cycle by expressing resemblances and differences in two systemic financial crises: the Great Depression and the Global Financial Crisis. Here is a brief recap of the recurrences and evolutions in the debt cycle over the bond wave.
Resemblances: Recurrent Features
Together with our observation of two immediate negative impacts of the systemic financial crises on GDP, we can confirm the long-term impact of money on the economy.