Three possible routes to US economic collapse in the near future

Abstract (Summary)

This post provides an overview of the current situation in US financial markets, examining the impact of quantitative easing (QE.) It hypothesises that sustained QE has led to high levels of asset price inflation. This asset price inflation, along with lingering issues from the COVID-19 pandemic, is then linked to present cost-push inflation in the broader US economy. Finally, three speculative outcomes from this situation are presented: hyperinflation, in which the money tied up in assets eventually reaches the rest of the economy; ossification, in which economic divides become even more severe, leading to political collapse into authoritarianism; and depression, in which the financial system collapses in a manner akin to the Great Recession of 2007-2008 or even the Great Depression of the 1930s. Readers are invited to discuss which outcome is most likely.

How does money get its value? (It gives protection from the government)

The primary reason that money has value, is that it provides you protection from the government. This can be demonstrated with a thought experiment: imagine that, tomorrow, all people in the USA agreed to stop using USD and instead use a given decentralised cryptocurrency for buying and selling all goods and services, also assuming that everyone has an amount of that cryptocurrency equivalent to the USD they have today. In this experiment, nothing would change for the regular economy. However, the US government would still demand for all taxes to be paid in USD, under threat of violence (imprisonment) if you don't comply. Hence, even though USD would have no value for acquiring goods and services - no value for day-to-day living - all people would still need to have USD so that they don't go to jail - this is encompassed by the term 'legal tender.' (For more on this topic, see this video.)

All other value that money has, is derived from this primary source. Individuals need USD to pay their personal income taxes, property taxes, consumption taxes, etc., and therefore demand to be paid in USD. Corporations need USD to pay their employees (for the reasons above) and to pay corporate taxes. International companies and need USD to pay for goods, services and assets (including financial assets) from the USA, because people and companies in the USA demand to be paid in USD.

Furthermore, while the US Federal government doesn't need USD (because it can create it - see the above video) US Federal government members do need USD, for all the reasons noted above. This gives a complimentary source of value to USD: it allows individuals and companies to influence US government members, and thus influence US government policy - another way that money protects people from the government.

How does money lose its value? (Lower taxes, or greater supply of money)

From the above, it naturally follows that money can lose its value if the government reduces taxes. This means that the same amount of USD provides more protection than previously, or that less USD is required to provide the same protection as previously. Hence, with lower taxes, people will be more willing to part with their USD (exchange it for goods and services), driving up aggregate demand, spurring economic growth and inflation.

Another way to money to lose its value is for the total amount of money to increase, without a change in taxes. This can occur through increased government spending. It can also occur through a reduction in official interest rates: the government purchasing T-bills transfers money from the government to the financial system, allowing and encouraging financial institutions to offer more credit (individuals and companies to take on more debt) increasing money in the economy. This can also occur with quantitative easing (QE), in which the government buys other financial instruments to inject money into the financial system.

What is happening to the money supply? (It's exploding)

The broadest measure of money in the economy (money which hasn't been taken up in assets, see below) is the M2 money supply. The M2 money supply has increased from $15.4T in February 2020 to $20.1T in April 2021, a +30.0% increase. To put it another way, 23.1% of all USD ever put into the money supply, has been created in the last 14 months - $4.6T of it.

We can see that this increase is mainly driven by QE. During QE, the Federal Reserve purchases financial assets from the market, increasing the money supply and increasing the assets on their balance sheet. The total assets on the balance sheet of the Federal Reserve has increased by $3.6T from the end of February 2020 to the end of April 2021.

Where is the money going? (Financial assets)

As explained above, increases in money supply should lead to decreases in the value of money - i.e. inflation. Thus far, inflation of the prices for consumer goods (as measured by the CPI) is +4.2% year-on-year in April. This is the highest since 2008, but still far short of the increases that might be expected given the increase in the money supply. The price of real property has also increased by +7.2% from 2020 Q1 to 2021 Q1 - which is high, but still not as high as the increase in money supply.

What has increased in price, are financial assets. The S&P 500 increased by +23.7% from its highest point pre-pandemic to the end of April 2021 (measuring from the lowest point during the pandemic to today, the increase would be +83.4%.) Total market capitalization of US public companies (total value of all shares of all publicly-traded US companies) increased +30.3% from the end of 2019 to March 2021. Similar numbers are seen across any broad-based measure of financial assets. Even cryptocurrencies, until recently, had seen spectacular increases in price, despite these lacking the fundamental value of legal tender as explained above, and lacking the cashflow that comes from share dividends.

Financial assets' prices increase if there is an increase in demand for those assets; this demand would be driven by an expectation of increased return on investment. Investment return for shares can come from dividends (which, by law, must be paid out of the company's retained earnings), from share buybacks (funded by the company's cash reserves, or credit) and from selling the shares to someone else at a profit (because the buyer of those shares expects a return from one of these routes in the future.) The Buffet Indicator compares total market capitalization of US public companies, to US GDP; in doing so, it is a proxy for how much aggregate investment return can be expected to come from corporate profit growth in the long run. According to this indicator, the stock market is significantly overvalued, showing that investors' valuation of company shares is tied more to their expectation of being able to on-sell those shares for a profit, than to the underlying profitability of those companies.

All these are strongly suggestive of the following:

1. Quantitative easing has pushed more money into financial institutions
2. This money was then lent out to those who could access it (i.e. the already-wealthy)
3. The wealthy used this additional credit, to purchase financial assets, driving up their price.
4. Expectations of future increases in asset prices are themselves pushing up the prices of assets (a speculative bubble), creating a cycle that further enriches (on paper) the already-wealthy.

What's the impact of asset price inflation? (Increasing economic inequality; regulatory capture; general inflation, eventually?)

Financial assets are overwhelmingly held by the wealthiest members of society: the wealthiest 10% held 84% of the US stock market in 2019. Hence, we see that the US billionaires increased their wealth by 44% during the pandemic. The increase in money supply has overwhelmingly been to the benefit of the upper class. This furthers economic inequality. The Gini coefficient is a measure of the concentration of income in a society (0 indicating all members of society receive equal income; 1 indicating that all income in a society is received by a single individual.) The US' Gini coefficient was 0.48 in 2019 and, given that wealth can be leveraged to generate income under capitalism, we can expect the Gini coefficient to have worsened (risen) in 2021. The US' Gini coefficient is therefore worse than the Roman and Byzantine empires, worse than medieval England and Wales, worse than late Qing dynasty China, and on par with or worse than India under the British Raj (interesting to note that every single one of those societies went through violent collapse.)

Furthermore, concentrating control of money among the already wealthy causes the value of money held by the rest of society to erode: not only have many of the working class lost income and wealth due to the pandemic, but what money they do have is now worth less, in terms of the value it provides (as defined above.) This further enables regulatory capture by the owner class - which is itself widely suspected to be the reason that major action has not been taken against the corporations most responsible for climate change.

Asset price inflation is commonly assumed by economists to eventually lead to consumer price inflation (i.e. inflation in broader society.) Under neoliberalism/neo-classical economics, this assumption commonly rests on the idea that the wealthy have to spend their money at some point, which will increase aggregate demand, create jobs and cause the wealth to 'trickle down.' I myself am skeptical of this assumption, because of the assumption that the wealthy must spend their wealth. A 2019 study found that the wealthiest 20% spend one-tenth as much of incremental income as the bottom 20%, and that if the top 1% of people were given $1.0T, this would generate only $0.2T increase in economic growth.

More likely, asset price inflation will lead to consumer price inflation via the cost of capital: As share prices increase, return on investment decreases. Wealthy investors will demand that companies increase their returns, so that the wealthy can continue to increase their wealth, as previously. This increases the cost of new capital (financing from investors) for companies. Companies therefore must raise the prices for their products and services in order to generate the profits demanded by their investors. (I am already seeing this behavior at the company at which I work.) This impacts companies whose products are used by others in production, exacerbating the impact - e.g. publicly-listed mining and lumber companies are pressured to raise their prices, increasing the costs of construction materials, increasing the costs of company buildings, increasing the costs of the products made by the companies in those buildings. This impact is compounded by continued disruptions to global supply chains, triggered by COVID-19 but due to improper implementation of just-in-time manufacturing, which also are driving up the cost of production; see this video for further details.

This link between asset price inflation and consumer price inflation occurs at a slower pace than the link proposed under neo-classical economics, this helps to explain why, after a +30% increase in the money supply, we have seen only +4% consumer price inflation so far. This, however, may soon change, as outlined below.

Possible outcome 1: Hyperinflation

Michael Burry, the man behind 'The Big Short', who predicted the 2007-2008 market crash, has famously recently predicted that the US will face hyperinflation in the near future. Hyperinflation describes a sharp, out-of-control increase in consumer prices. Any combination of the below factors could, if severe enough, lead to hyperinflation:

• The holders of financial assets do, in fact, decide to sell those assets and use the proceeds to increase their consumption, driving up prices.
• Irked by growing inequality, the public pressures governments to significantly raise wages for the working class. These wages in turn get spent on consumer goods.
• Governments spend large amounts on infrastructure, employing many working-class people. These people then spend the money they received from the government.
• Governments are pressured to provide further financial assistance to working-class people, such as rent or student loan forgiveness.
• Working-class people, en masse, refuse to return to low-paying jobs, forcing the owner class to provide higher wages.
• Prices begin rising due to cost-push factors like the cost of capital, commodities or supply chains, or due to demand-pull factors as listed above. Seeing this, consumers react by bringing-forward their planned purchases: buying things now, in expectation that prices will increase in the future. This in itself drives up demand, and therefore prices, creating a vicious cycle wherein inflationary expectations create inflation.

It should be said that many of the above things would probably be good if they did happen. In a normal economy with a competent and functioning government, the inflationary effect of these things would be offset by increasing taxation (especially on the upper class) and increasing interest rates. However, neither of these are politically expedient in the current, toxic US political climate. The 2013 taper tantrum revealed that the government is already beholden to the whims of high finance (who want interest rates to remain low) and the Federal Reserve chair has indicated he has no plans to reduce QE in the short term, and that interest rate rises are even further off.

Hyperinflation will have severe impacts for anyone whose wealth and income are not tied up in inflating assets. That is, hyperinflation will severely hurt the working class, while the owner class will be mostly insulated by the assets they control. The working class rapidly will find their savings become worthless. They will become even more enslaved to whatever jobs they can find and hold, forced to perform in the hope of receiving pay rises to mitigate the value of their salaries lost to inflation. The increased economic precariousness of the working class has, in many historical examples of hyperinflation, led to sustained decrease in quality of life and population as a whole, via food shortages, economic stagnation, illness, reduced birth rates, increased death rates, etc.

Possible outcome 2: Ossification

In biology, ossification refers to soft tissue being transformed into hard bone. Here, it is used to refer to the hardening of socioeconomic strata.

The concentration of wealth and power among the upper class has already led to a degree of regulatory capture; further concentration could lead to the wealthy gaining even more control over the government. The wealthy would then use that control to solidify themselves in their position, and harden their social stratum against new entrants. Examples of this behavior are already commonplace, from governments tripping over one another to offer subsidies to Amazon, the fourth-largest company in the world to Uber successfully getting prop 22 to pass in California, to the detriment of their workers, despite the company starting as an illegal taxi service.

The first speculated outcome was based on the assumption that something would cause the share of new money supply and financial assets to shift from the near-exclusive domain of the wealthy. However, it could also be that the wealthy use their new (and old) wealth to ensure this doesn't happen - after all, no-one is forcing them to spend their money, and they can lobby the government (or pay for 'news' articles, if r/Superstonk is to be believed) to ensure that it doesn't get taken away. Hence, economic inequality in the USA becomes ever more severe and entrenched.

As highlighted before, there are many examples of societies that had extremely high economic inequality. All of them collapsed into some kind of violence, normally with some kind of authoritarianism. Some flavors of socio-political collapse brought about by ossified economic inequality include:

• 'Proletarian' revolution with increasingly indiscriminate violence. e.g. French revolution; Mao's China; Pol Pot's Cambodia under the Khmer Rouge; Stalinist Russia
• 'Populist' revolution leading to fascism. e.g. Weimar republic collapsing into Nazi Germany; arguably what was attempted with the Jan 6 insurrection

Revolution is not a necessity for violence and precipitous decline. Seeing the treat posed by the masses, the ruling class may instead opt to leverage state-enacted violence at an increasing rate, to keep the people in check - another route to authoritarianism, but without a revolution. Recent examples include China and especially Hong Kong under the CCP, modern-day Russia, Myanmar, and any present-day dictatorship. With the continued development of sophisticated surveillance and repression technologies, and disinformation campaigns leveraging the internet, this kind of authoritarianism is looking increasingly invulnerable.

Possible outcome 3: Depression

We have seen that the government can create money, and then that money gets pumped into financial markets to inflate asset prices. How can that money then be destroyed? It could be destroyed through taxation, but we have already argued that this is unlikely in the current environment. However, the early-2000s Dot-Com crash and 2008 Global Financial Crisis (GFC) were two recent times when an enormous amount of on-paper value was simply erased from financial markets. This could happen again, and there are a few reasons to think a crash in the prices of financial assets is on the horizon.

Already, we have seen that the Buffet Indicator shows that stock markets are probably overvalued. This is caused by record-low interest rates and easy access to credit for wealthy investors. When investors can take on additional debt cheaply, they will be willing to put that debt into riskier investments (as the downside risk is smaller.) Cheap access to debt is, in fact, one of the main drivers of the housing market bubble that created the mortgage-backed securities bubble, that led to the GFC. And we have several recent examples of venture capital investing in companies that became (or are on the way to becoming) spectacular failures: Theranos, Quibi, WeWork, Nikola, etc.

An increase in risky investments across the market, increases the risk of loss (and magnitude of loss) in the event of a sudden, negative change in broad market conditions. I have elsewhere argued that the US could see a resurgence of COVID-19 due to the Delta variant; in fact, exactly this is already happening in the UK. Even if this does not occur, the US looks poised to enter the worst fire season in history. And if r/Superstonk is to be believed, there could be a massive sell-off of financial assets, as hedge funds and their banks scramble to get the funds they need to protect themselves, after having made the wrong bet on GameStop going out of business.

Regardless, Federal Reserve reverse repo agreements have hit their highest level ever, which indicates unprecedented demand for US treasuries, to the point that financial institutions were willing to lose cash (via negative rates) in order to hold them. This would only make sense if financial institutions are expecting interest rates to rise, and have heavily (and potentially nakedly) short-sold the treasury market in order to make a profit on the rise in interest rates. That is, these indicators point to the "smart money" making large bets on interest rates rising (Michael Burry, mentioned earlier, is also short treasuries, the same bet.)

We saw in the 2013 Taper Tantrum that financial markets do not like the idea of rising interest rates. It seems that many market participants recognize that the current market valuations only make sense in the low-risk environment afforded by cheap debt. But now, market participants are betting on interest rates rising (probably to stave off hyperinflation, as above.) If that does occur, we can expect to see many speculative investments fail as less-profitable businesses collapse. This, in turn, could lead to a contagion effect as we saw in the GFC, where investors fear that other businesses are going to collapse, and withhold their money (or increase the cost of capital.)

As the cost of finance rises for companies, they would choose to cut costs, by cutting headcount or reducing pay rises. Hence, the interest rate rise leads to a decrease in employment and income for the working class. If the malinvestment problem is widespread (it probably is, given all the above data) then we can expect significant job and pay losses across the whole economy. These would, in turn, reduce the amount that people can spend on goods and services, driving more companies out of business - the vicious cycle that starts recessions.

Given that the state of the real economy is already worse than it was in the last recession, and financial markets are already inflated far in excess of what they were in 2007, being hit with another recession would lead to even more severe consequences - perhaps equivalent to the Great Depression.

Conclusion

I have discussed at length various indications that the US economy could be heading towards collapse, attempting to show the relationships between these indicators to how collapse might play out. I've also outlined three possible scenarios for what this collapse might look like. I invite you, the reader, to debate any points I may have wrong, add to them, and share what scenario you think most likely.