Sam Altman, from the Valley, posted this question, which I know a lot of people have been asking:

What are we currently missing but is going to seem obvious in retrospect about the implications/significance of negative interest rates? — Sam Altman (@sama) January 10, 2020

Here’s what I replied:

Negative interest rates are fueling the largest debt bubble in history. When rates bounce back up, some big sovereigns will default. https://t.co/hyKem1vPBt — Preston Byrne (@prestonjbyrne) January 10, 2020

I am a child of the global financial crisis (GFC).

I’m not an economist, but I spent the first half of my professional life working out the consequences of the last debt crisis, the existence of which most economists missed until it was far, far too late to stop. Any securitization lawyer who still had a job in the wake of the GFC – between New York and London there were probably a few hundred of us – will know exactly what broke in these transactions, what modifications needed to be made to fix them, and who needed to take a haircut as these fixes were implemented.

If you don’t know what securitizations are, those are the structured debt transactions which nearly brought down the economies of the Western world in 2008, an event that was stopped only by massive government and central bank intervention.

As a paralegal in a big city law firm’s securitization team in 2007, I remember reading about the gradual ticking up of default rates in the outer boroughs of New York City and asset writedowns by big banks. I was living in the City of London when Lehman went down. I remember the images of bankers clearing out their desks. I remember the long faces worn by all of the other bankers who remained employed, that week. I remember Bear Stearns going down earlier that year, and friends from university losing their first jobs. I remember the conference room on the top floor of the shipping company’s headquarters across the street from my shoebox-sized (25m square) apartment on Charterhouse Square in which I lived in my final year of law school, ablaze with light at midnight as its officers tried to position the company for the coming storm.

I remember it being overcast, drab, and gray, just like the boring, too-small suits British professionals tend to wear. I remember reading about how the overnight lending markets froze up – completely. I remember, months later, hearing how the United Kingdom was less than twelve hours away from ATM machines being switched off.

It was the end of the world. I will never forget any of this as long as I live.

I started by first job as a junior lawyer in 2009, at the same firm where I had worked as a paralegal. I spent the next five years of my career being principally concerned with securitizations. Specifically, I worked on teams that took these transactions apart, and personally spent most of my billable hours drafting documents or doing diligence for transactions that restructured or unwound deals that had gone, or were on their way to going, south. The bonds in these deals failed because they were backed by cheap debt, which itself was backed by worthless assets, the prices of which had been vastly inflated by the availability of cheap debt. What many of them shared is that the cheap debt never had any chance of being repaid on schedule, if at all.

This cheap debt therefore had no business ever being originated. Yet it was.

NIRP and the potential for an associated out of control “NIRP Bubble” gives me the willies because it is the ultimate creator of cheap debt. It creates systemically cheap debt. Cheap debt looks like a great deal at the time for happy borrowers. NIRP reduces the price of money itself – it makes low rates systemic across virtually every category of borrowing (unlike, say, mortgage securitizations, which confined the cheapest debt to secured loans – although the attendant boom also loosened credit conditions generally). It turns every man, woman, and child in the Western world into happy borrowers whenever we borrow. But, as with the subprime crisis, debt cannot stay cheap forever. Cheap debt eventually becomes expensive debt. And when that happens, if the debt load is too high, you get a debt crisis.

NIRP is very possibly laying the groundwork for a massive debt crisis which will be as obvious to our children, in hindsight, as the subprime bubble seems to us. “Well of COURSE people shouldn’t have overstated their income and taken out ARMs they couldn’t afford.” Well of course we shouldn’t have funded state entitlement programs with trillions in low-interest debt and ensured our governments and, by extension, our societies were addicted to low interest rate revolving credit facilities writ large.

Central bank rate setting is basically an adjustable rate mortgage for states and their entire economic systems.

The problem is that here the central banks, though nominally independent, are in fact subject to the whims of the political apparatus, and NIRP/cheap debt solves a lot of short term political problems. Not only does it juice the economy (longest bull run in history!) but it prevents governments from needing to make what Habermas identified in Legitimation Crisis as their most fundamental choice in resource allocation – between the demand for welfare by the populace and a low tax burden by enterprise – and putting that risk off for the future in the form of debt, which accumulates as and is quantified by the annual budget deficit and accumulated debt balance.

Habermas understood that this is a very dangerous game. States are, when they do this, creating expectations of satisfaction of what he termed “programmatic demands.” i.e. “stuff the population expects will get done, otherwise they’ll revolt.” The title of the book, Legitimation Crisis, refers to Habermas’ description of what happens when a state is ‘no longer able to satisfy the programmatic demands it has set for itself.’ The risk breaks out into the open, leading to the untethering of institutions and political expectations, upheaval, and revolutionary change. Accumulating debt is the process of deferring making hard choices between certain programmatic demands. When a state does this it reduces political risk in the present by increasing political risk in the future.

NIRP is the ultimate expression of state-sponsored entities kicking the can down the road.

We see this happening in places like Venezuela or Zimbabwe, but we think that it cannot possibly happen in the United States. We’re smarter than that. We’re bigger than that. We’re better than that, we think.

But the thing is, we’re really not.

I’m sure Leonid Brezhnev once said something similar. The Soviet Union posted some solid growth numbers and was the center of half the world too, once upon a time. — Preston Byrne (@prestonjbyrne) January 10, 2020

The subprime crisis got its start when hitherto-illiquid markets for real estate got access to global capital markets and cheap debt. Cheap debt appeals to the eternal human proclivity towards high time preferences. So when we flood the world in it, this financing is going to be taken up and used. With gusto.

Increasing central bank balance sheets and budget deficits across the Western world indicate this is exactly what’s happening. Yet central bank governors don’t see the monster they’re creating.

NIRP is fairly new, so I’m not saying that some debt disaster is going to happen now, or next year, or even the year after that. What I am saying is that where deficit hawks might have been wrong in the past, a stopped clock is right twice a day – and NIRP might be a critical element, a missing piece, the unforeseen development, that finally makes that narrative, which while logical has consistently been wrong, relevant.

There are a couple of critiques I’ve seen of this view, that NIRP will create a debt crisis.

“So they’ll never raise rates again. Easy.”

Then they’ll have inflation. Which is equivalent to default, is already here in asset prices, and is starting to bleed over into the rest of the economy. Some say the fact that Taco Bell managers are getting paid $100,000 a year is due to “tight labor conditions.” One could argue that the tight labor conditions are the result of a glut of cheap money. Time will tell.

“The Fed can always keep rates low by buying new notes.”

Do not need investors if Fed willing to keep rates low. Yes, unexpected inflation can be a "real" default. Or, it can be a state-contingent "haircut" that is implicitly agreed to. Everything depends on how wisely debt/expenditures are managed, not the debt per se. — David Andolfatto (@dandolfa) January 10, 2020

This is insane.

Debt hawks like Ron Paul are widely disbelieved these days, I think, because central bankers got away with QE without hyperinflation. As a result, they think they can get away with anything.

This critique works now. It does not work when there’s a crisis. As with all crises, the next one cannot be foreseen with absolute certainty, so folks usually assume that things will continue as they are and venerable institutions like the Federal Reserve will always have clever enough boffins with effective enough tooling to allow business as usual to continue.

It is not a stretch to assume that in a future crisis those tools will have long since run out of potency. This is widely acknowledged across the banking industry.

BI quotes the CEO of Deutsche in September of last year:

The likes of the European Central Bank and the U.S. Federal Reserve have “no conventional measures left to effectively cushion” the blow of a “real economic crisis,” Christian Sewing said at the Sibos banking conference in London.

Or Larry Summers in 2015:

Central bankers bravely assert that they can always use unconventional tools. But there may be less in the cupboard than they suppose. The efficacy of further quantitative easing in an environment of well-functioning markets and already very low medium-term rates is highly questionable. There are severe limits on how negative rates can become. A central bank forced back to the zero lower bound is not likely to have great credibility if it engages in forward guidance.

NIRP can’t work forever. Eventually rates will go up or something will break. That may take the form of inflation or hyperinflation. I query how long the Fed will be able to keep rates low while people use wheelbarrows of cash to buy bread, which is where helicopter money eventually ends. If Venezuela is an indication a central bank can engage in insane behavior for a very long long time, but I suspect the non-unitary nature of the American state and the sophistication of federal constitutional arrangements would prevent a bonkers monetary policy from holding sway for very long.

Also, this isn’t a U.S. problem but a global one. Saudi Arabia, for example, has a $12 billion dollar-denominated note out there. If it were to redenominate to Riyals, print the Riyals and use that to satisfy investor claims, that would be a default. The privileges attendant with being the backbone of the global financial system accrue to one country only, the United States, and at the moment we seem to be doing everything in our power to lose that position.

“How do you default on a negative rate note?”

You don’t necessarily have to default on that note to suffer the consequences of a default. You can effectively default by triggering runaway inflation and printing money. You can also default on some other obligation you can’t pay because you have an enormous debt load and can no longer issue new notes because the market won’t lend to you affordably or at all. That’s still a default and will affect your ability to tap capital markets.

The first things to freeze up during the global financial crisis were revolvers like ABCP and short term loans like the overnight market. The government debt sector is basically a huge RCF. Modern Western governments will cease to function if they can’t issue more debt. Freezing them out of the capital markets, even for a short amount of time, would be enough to cause an immediate political crisis.

So when will all this happen?

Who knows? This is not even a theory, more a hunch, a feeling that we’ve been here before and our leaders have failed to learn from their mistakes. This post is an introductory argument based on that hunch. I leave it to folks with advanced degrees in mathematics to model and quantify this hunch. 50-year lows in unemployment and all-time highs in the stock market don’t tell me that I should sit back and enjoy the ride. These things tell me something all-time extraordinary is happening.

I could be wrong, another debt crisis may never happen, and NIRP may herald the beginning of a glorious new era where debt is infinitely cheap and growth continues forever. My instincts tell me that forever growth will not be the end result of NIRP. I think the end result is that large debts will get accumulated, lenders will begin to lose confidence that these loans will ever be paid back, rates will go up, and debts accumulated will either no longer be capable of being serviced or revolving facilities will no longer have buyers.

Crises generally break out when there’s a shock.

I think the shock required to shake the world will need to be of global proportions. Who knows what it’ll be. A big war? An invasion of space groundhogs dropping out of warp in low Earth orbit, sent here by the Marmot Star Empire?

Maybe. But I think it’ll be something that initially looks small and contained, but which scares the hell out of investors due to its macro implications, which will set off the next big crash. And we’re not talking about a correction (which we’re overdue for anyway) but a really, really big crash that could be years off.

If Ghawar Field runs dry before our species cracks fusion, say, in the next decade, that might do it. Everyone’s growth projections would be revised down and it might become apparent that countries with huge debt loads can’t grow enough to repay them.

To conclude, all I know are two facts. First, that rates today are lower today than at any time in recorded history; second, that for all our technology and sophistication, we are nonetheless subject to the same laws of economics and thermodynamics as our ancestors.