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Archive for the ‘Credit’ Category

The carrot of self-sustaining recovery will remain out of reach, for the policies presented as the path to recovery preclude the “virtuous cycle” everyone desires.

The enduring myth of the post-2008 era is that central-planning money printing and deficit spending would soon spark a self-sustaining recovery. Once consumers and businesses stepped up their own borrowing and spending, the central bank and state would then pare back money printing and deficit spending, as the increase in private-sector spending would fuel further borrowing and spending, i.e. become self-sustaining.

The reality is the mythical self-sustaining recovery is the carrot dangled in front of a credulous public: though we’re constantly reassured “we’re almost there” (the promised land of self-sustaining recovery), the mythical recovery remains out of reach, no matter how much money is printed or borrowed and blown in fiscal stimulus.

There are several key reasons for this.

1. As noted yesterday, consumption is not investment, no matter how many times you call consumption “an investment.” Investment is planting one’s seed corn (capital) wisely. Consumption ($300 million fighter aircraft, $70,000 biopsies, McMansions in the middle of nowhere, endless subsidies of housing and banking, etc.) is turning the seed corn into sour mash and indulging in a drunken orgy of squandered debt that cannot and will not be paid back in dollars with today’s purchasing power.

2. Borrowing money (debt) yields diminishing return. There’s this funny little thing called interest that piles up in a borrowing spree that eventually siphons off much of the debtor’s income stream, effectively impoverishing the borrower.

There’s another funny thing called mal-investment or mis-allocation of capital: when the borrowed money is nearly free (low interest rates), then even poor quality bets (oops, I mean “investments”) get funded. This is especially true if the winnings are yours to keep but any losses you incur are covered by Big Brother–the Federal Reserve or the U.S. Treasury–and the taxpayers the government has indentured to the banking sector.

3. Debt that cannot be written down because that would impair the politically powerful financial sector remains a tightening noose around the throat of the economy. Capitalism requires creative destruction, which includes the liquidation of bad bets and unpayable debt. Since that is verboten in our State-managed crony-capitalism system, the impaired debt remains on the books, supported by endless government subsidies.

Both the phantom collateral and the subsidies derange and distort the markets, leading to further bad decisions as risk has been obscured.

4. As analyst Ramsey Su recently observed, It is obvious that the central banks of the world have printed too much money, (which) all went into the wrong hands and now has nowhere to go. In the oft-propagated myth of central bank intervention, helicopters drop cash into the economy to stimulate demand for goods and services, sparking the “virtuous cycle” of a self-reinforcing recovery.

But the money isn’t dropped into households or the real economy–it’s dropped into banks, which use it for speculation or funding cronies’ speculations and asset grabs. If the Federal Reserve had wanted to do a real helicopter drop of money, it could have sent $10,000 in cash to every taxpayer. Instead, it lavished at least $23 trillion in subsidies, backstops and guarantees on the Too Big To Fail banks and the mortgage industry.

This neofeudal distribution of $7 trillion in new Federal debt to taxpayers and the Fed’s trillions in “free money” to the parasitic financial sector has carved out a vicious cycle of lower real household incomes, higher interest payments and new asset bubbles in stocks, bonds and housing. These trillions of dollars in freshly issued money have flowed to financiers who have used it to chase yield in one asset class or another.

As a result of these neofeudal policies, the economy is now perched precariously on the edge of multiple asset bubbles and demographically impossible-to-fulfill promises of entitlements and other giveaways (such as mortgage/housing subsidies and a variety of corporate welfare scams).

The carrot of self-sustaining recovery will remain out of reach, for the policies presented as the path to recovery preclude the “virtuous cycle” everyone desires.

Charles Hugh Smith – Of Two Minds

An over-indebted, overcapacity economy cannot generate real expansion. It can only generate speculative asset bubbles that will implode, destroying the latest round of phantom collateral.

I have endeavored to lay out the global endgame in four recent entries:

Is This the Terminal Phase of Global Capitalism 1.0? (February 8, 2013)

Note to Fed: Giving the Banks Free Money Won’t Make Us Hire More Workers(February 11, 2013)

Cheap, Abundant Credit Creates a Low-Return, Bubble-Prone World (February 12, 2013)

Europe Is Not “Fixed”: Two Charts (February 13, 2013)

For those seeking a summary, here is the global endgame in fourteen points:

1. In the initial “boost phase” of credit expansion, credit-based capital ( i.e. debt-money) pours into expanding production and increasing productivity: new production facilities are built, new machine and software tools are purchased, etc. These investments greatly boost production of goods and services and are thus initially highly profitable.

2. As credit continues to expand, competitors can easily borrow the capital needed to push into every profitable sector. Expanding production leads to overcapacity, falling profit margins and stagnant wages across the entire economy.

Resources (oil, copper, etc.) may command higher prices, raising the input costs of production and the price the consumer pays. These higher prices are negative in that they reduce disposable income while creating no added value.

3. As investing in material production yields diminishing returns, capital flows into financial speculation, i.e. financialization, which generates profits from rapidly expanding credit and leverage that is backed by either phantom collateral or claims against risky counterparties or future productivity.

In other words, financialization is untethered from the real economy of producing goods and services.

4. Initially, financialization generates enormous profits as credit and leverage are extended first to the creditworthy borrowers and then to marginal borrowers.

5. The rapid expansion of credit and leverage far outpace the expansion of productive assets. Fast-expanding debt-money (i.e. borrowed money) must chase a limited pool of productive assets/income streams, inflating asset bubbles.

6. These asset bubbles create phantom collateral which is then leveraged into even greater credit expansion. The housing bubble and home-equity extraction are prime examples of theis dynamic.

7. The speculative credit-based bubble implodes, revealing the collateral as phantom and removing the foundation of future borrowing. Borrowers’ assets vanish but their debt remains to be paid.

8. Since financialization extended credit to marginal borrowers (households, enterprises, governments), much of the outstanding debt is impaired: it cannot and will not be paid back. That leaves the lenders and their enabling Central Banks/States three choices:

A. The debt must be paid with vastly depreciated currency to preserve the appearance that it has been paid back.

B. The debt must be refinanced to preserve the illusion that it can and will be paid back at some later date.

C. The debt must be renounced, written down or written off and any remaining collateral liquidated.

9. Since wages have long been stagnant and the bubble-era debt must still be serviced, there is little non-speculative surplus income to drive more consumption.

10. In a desperate attempt to rekindle another cycle of credit/collateral expansion, Central Banks lower the yield on cash capital (savings) to near-zero and unleash wave after wave of essentially “free money” credit into the banking sector.

11. Since wages remain stagnant and creditworthy borrowers are scarce, banks have few places to make safe loans. The lower-risk strategy is to use the central bank funds to speculate in “risk-on” assets such as stocks, corporate bonds and real estate.

12. In a low-growth economy burdened with overcapacity in virtually every sector, all this debt-money is once again chasing a limited pool of productive assets/income streams.

13. This drives returns to near-zero while at the same time increasing the risk that the resulting asset bubbles will once again implode.

14. As a result, total credit owed remain high even as wages remain stagnant, along with the rest of the real economy. Credit growth falls, along with the velocity of money, as the central bank-issued credit (and the gains from the latest central-bank inflated asset bubbles) pools up in investment banks, hedge funds and corporations.

The net result: an over-indebted, overcapacity economy cannot generate real expansion. It can only generate speculative asset bubbles that will implode, destroying the latest round of phantom collateral.

Here are three charts that illustrate #14:

Eurozone credit since the inception of the euro. This is roughly equivalent to TCMDO (Total Credit Market Debt Owed) in the U.S.

Eurozone credit growth:

Money velocity in the U.S.:

That is the endgame in three charts. Checkmate, game over.

Charles Hugh Smith – Of Two Minds

Debt.  There isn’t a day that passes as of late that the issue of debt doesn’t arise.  Federal debt and consumer debt (including mortgages) are of the most concern due to its impact on the domestic economy.   Debt is, by its very nature, a cancer on economic growth.  As debt levels rise it consumes more capital by diverting it from productive investments into debt service.  As debt levels spread through the system it consumes greater amounts of capital until it eventually kills the host.  The chart below shows the rise of credit market debt and its impact on both personal savings and economic growth.

From the 1950’s through the late 1970’s interest rates were in a generally rising trend with the Federal Funds rate at 0.8% in 1954 and rising to its peak of 19.1% in 1981.  Of course, during this time the U.S. was the manufacturing and production powerhouse of the entire global economy post the wide spread devastation of Europe, Germany and Japan during WWII.  The rebuilding of Europe and Japan, combined with the years of pent up demand for goods domestically, led to a strongly growing economy and increased personal savings.

However, beginning in 1980 the world changed.  The development of communications shrank the global marketplace while the rise of technology allowed the U.S. to embark upon a massive shift to export manufacturing to the lowest cost provider in order to import cheaper goods.  The deregulation of the financial industry led to new innovations in financial engineering, easy money and wealth creation through the use of leverage which led to a financial boom unlike any seen in history.  The 80-90′s was a period of unrivaled prosperity and the envy of every nation on earth.

Unfortunately – it was the greatest economic illusion ever witnessed.

The reality is that the majority of the aggregate growth in the economy was financed by deficit spending, credit creation and a reduction in savings.  In turn this reduced productive investment in the economy and the output of the economy slowed.   As the economy slowed, and wages fell, the consumer was forced to take on more leverage to maintain their standard of living which in turn decreased savings.   As a result of the increased leverage more of their income was needed to service the debt – and with that the ”debt cancer” engulfed the system.

The Austrian business cycle theory attempts to explain business cycles through a set of ideas. The theory views business cycles “as the inevitable consequence of excessive growth in bank credit, exacerbated by inherently damaging and ineffective central bank policies, which cause interest rates to remain too low for too long, resulting in excessive credit creation, speculative economic bubbles and lowered savings.”

In other words, the proponents of Austrian economics believe that a sustained period of low interest rates and excessive credit creation results in a volatile and unstable imbalance between saving and investment.   In other words, low interest rates tend to stimulate borrowing from the banking system which in turn leads, as one would expect, to the expansion of credit.   This expansion of credit then, in turn, creates an expansion of the supply of money.

Therefore, as one would ultimately expect, the credit-sourced boom becomes unsustainable as artificially stimulated borrowing seeks out diminishing investment opportunities. Finally, the credit-sourced boom results in widespread malinvestments. When the exponential credit creation can no longer be sustained a “credit contraction” occurs which ultimately shrinks the money supply and the markets finally “clear” which then causes resources to be reallocated back towards more efficient uses.

The chart below shows the increasing levels of money supply and debt versus the changes in economic and wage growth.  The impact of debt on the economy remains unrecognized by policy makers and central bankers who have failed to understand what the current downturn encompasses.  Therefore, these same individuals continue to chase economic theories based on a mistaken belief that the current recession is an ordinary period of falling aggregate demand.  However, the reality is something far different.

The reason that the policies which have been enacted by the current Administration up to this point have all but failed, be it “cash for clunkers”  to “Quantitative Easing”, is because they were designed to either drag future consumption forward or to slow the deleveraging process.  The Keynesian view that “more money in people’s pockets” will boost consumer spending, and ultimately grow GDP, has clearly been wrong.  It hasn’t happened in 30 years.   What is missed is that things like temporary tax cuts, or one time injections, don’t create economic growth but merely reschedules it.  While the average American will act on a near-term increase in their take home pay – any increased consumption in the present will be matched by a decrease later when the tax cut is revoked.

This is, of course, assuming the balance sheet at home hasn’t broken.  The problem today is that for only the second time in the history of the United States we are in the process of deleveraging the balance sheet of the U.S. economy.   As we saw during the period of the“Great Depression” most economists thought that the simple solution was just more stimulus.   Work programs, lower interest rates, government spending all didn’t work to stem the tide of the depression era.

The problem is that during a “balance sheet” recession the consumer is forced to pay off debt which detracts from their ability to consume.   This is the one facet that Keynesian economics doesn’t factor in. More importantly it also impacts the production side of the equation as well since no act of saving ever detracts from demand.  Consumption delayed is merely a shift of consumptive ability to other individuals, and even better, money saved is often capital supplied to entrepreneurs and businesses that will use it to expand, and hire new workers. 

So, while classical economics says that production comes first, the problem becomes that during a “balance sheet recession” the economy is put into a stranglehold for productive investment. The continued misuse of capital and continued erroneous monetary policies have instigated not only the recent downturn but actually 30 years of an insidious slow moving infection that has destroyed the American legacy.

This is why we need real reform in government that leads to a smaller government, more clarity for businesses through pro-growth policies, real regulation of Wall Street which separates banks and brokerages, as well as programs and subsidies for bringing back to America those jobs that require a little hard work and a little bit of sweat but create a whole lot of pride and prosperity along the way.

It’s time for our leaders to wake up and smell the burning of the dollar – we are at war with ourselves and the games being played out by Washington to maintain the status quo is slowing creating the next crisis that won’t be fixed with monetary bailout.

Lance Roberts – Street Talk Live