As much fun as it is predicting the market and risk-free rates based on the economic cycle, the level of US national debt creates a large, worldwide uncertainty that the economic cycle can be understood based on past market data at all. Of course, acting on long-term expectations of the economic cycle should tend to even it out, so the uncertainty I’m mentioning also helps contribute to the cycle in the first place.

Its no secret that the Fed actively manages the yield curve to set ‘risk-free’ interest rates. Although conspiracy theorists disagree, the Fed sets its policy to try and prevent long-term financial crises, so the uncertainty I am talking about here is whether or not the Fed will be successful in its efforts.

From Sept. 2008 to Dec. 2014, the amount of the US national debt increased dramatically as we began ‘quantitative easing,’ which is more or less printing money to cover our government’s spending. That is why we, as a country, have been able to run post losses in the neighborhood $800 Billion per year for the past 10 years.

What is strange is that the rest of the world has continually been encouraging us to overspend. In 1971, President Nixon decided to let that happen by ending the gold standard. The gold standard was an international understanding that the one ounce of gold should be worth about $35 USD. Since people are naturally ingeneous, innovations and technology keep growing at an exponential pace. That means there will usually by many more goods on the market next year than this year, and we will either have to inflate the money supply or else see the price of common goods fall every year.

Psychologically, it’s hard to see sales and wages fall, so we needed inflation. That was impossible under the gold standard, so we ended it. Developing economies, however, tend to make their first steps toward growth by producing goods at low wages for export to developed nations. As their own economies develop, however, their wages go up and it becomes increasingly hard to sell to the US. Enter inflation. As long as our money supply inflates, the government can hand out money in military spending (including overseas aid), retirement and health programs (and interest paid to US banks). Those folks can then spread the money around and eventually all our prices go up. This presents foreign markets with a choice – either raise prices and see slowed economic growth and job loss or else continue working at low wages to sell to the US. They seem to choose to continue selling. Their prices and wages rise too (so they still inflate) but with a lag. Effectively, it is a tax imposed by established economies on every country that wants to use exports for growth. It is the same ‘inflation’ tax we pay at home.

Unfortunately, it creates a mounting problem for us. The accumulated debt acts like a reservoir for possible future inflation. In the beginning of our republic, we had the option to monetize all our debts. Since its start in 1913, the Federal Reserve (a union of banks) appropriated the power to create money as too dangerous for politicians to control, leaving the federal government with only the rights to create new debt instead. However, the idea that new debts will one day be paid in full has become unfashionable even in the business world, where the usual expectation is that all debts will be rolled over, forever. Why give up money when you already have it and things are going well?

Like those businesses, we are continually growing our money supply on one side, while growing our interest payments on the other. If gross domestic production keeps up, then we will grow our capacity to pay, and we can make the system balance out by growing mostly in sync. Yes, we will still have inflation internally, but hopefully inflation plus income taxes can remain tolerable. If, however, we issue too many new debts, then it will become hard to keep up – as anyone considering bankruptcy knows.

Since 2014, the percent of debt owned by foreign countries has been steadily decreasing, presenting a conundrum. The developing world is catching up and is beginning to tolerate slower economic growth in exchange for higher wages. This should be good news.

However, as early as 2014, warning lights started blinking when we awoke to discover that the Federal Reserve system itself owned 64% more US government debt than China. The rapid pace of quantitative easing pushed us higher in debt much faster than we had hoped, making us grey-haired before our time.

So, the big question staring us down is, “How do we remove all this play money from the Fed.’s balance sheet?” I think we need some real financial hocus pocus here, since we can’t afford to keep paying interest on it, while market movements at the end of 2018 showed that we can’t try to pay it off either (since then deflation would happen). I’m not an economist, but I can’t see why other countries would care whether we make interest payments to ourselves or not. So, ideally, the portion of debt held by The Fed itself would disappear. The market is acting as if this were the case.

What the Fed was trying to do (and what markets fear most) is to demand payment of the debt from US taxpayers. If that happens, the US markets will deflate and make it harder to buy imports again. The rest of the world seems to be willing to tolerate some of that. However, the deflation that results will lower stock market prices and cause a Wall St. generated recession. Two things are for sure, we will be squeezed as much as possible on every side and markets will go wherever the Fed wants them to. In that light, it’s interesting to note that Goldman Sachs says there’s a 25% chance of increase and 20% chance of decrease in 2019, some traders have bet big that losses won’t be larger than 22% over 2 years, while Morgan Stanley thinks GDP will decline, forcing a short-term 7% drop.