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Suppose that company
HN has been used to selling cars for cash at $10,000 apiece, but that
business has been a little slow lately.
Faced with the
imperative to re-energize the dealership, inspiration strikes some genius in
the marketing department. Shortly afterward, he emerges smiling from a lunch
with one of his buddies up in finance and makes straightaway to the CEO's
office suite.
The gist of his idea
is this: henceforth, HN will overcome sales resistance by offering a hot new
deal. It will sell its cars for a sticker price of $9,500 — an
ostensible 5% discount — and it will also allow the customer 5 years to
pay back the money at a monthly rate of "only" $192.625.
This financing
represents an interest rate of 8% monthly, or 8.30% compounded annually, and the
"discount" will, in fact, cost the owner a total of60 x $192.625 =
$11,557.54 by the time he has fully paid for the car.
The angle for the car
company is that it knows that, with the help of its favorite partner in the
Money Trust, it can now repackage the loan ("securitize" it) and
sell it on to the bank at an internal rate of return of 5.85% (net of
servicing fees accruable to HN), thus ensuring that it will receive its
original $10,000 as an upfront payment which it can book directly as income.
Thus, the car
company's profits will be unchanged, despite the lower selling price (in
fact, some of these profits may subsequently be used to help fund the loan
— whether directly extended to the buyer, or more indirectly by putting
them on deposit with the securitizing bank).
Conversely, unless
the customer can invest the $10,000 he would formerly have spent on the car
in an annuity at the same rate of 5.85% (which, as a retail customer, he is
highly unlikely to do), he is worse off under the financing deal than before,
despite the illusion of an initial saving.
But — hey!
— what does he care? By paying out less than $200 a month for his
wheels, he is now free to decide whether he should play the stockmarket with
the rest of his funds, or put it towards that second condo he wants to buy in
the hope of flipping it for a quick turn.
From HN's
perspective, of course, the additional benefit is that the new program will
allow lesser-quality, would-be customers who have not accumulated $10,000, or who could not previously
borrow for so long or so cheaply, to buy the car for the first time.
Therefore, the deal
could well result in even higher sales and hence profits for HN — and
all this despite the fact that car selling prices have declined by 5% as far
as those collecting data for official government indices are concerned.
Inflation (properly
defined as the securitizing bank's monetary creation which supplemented the
car company's circular diversion of profits towards this act of customer
finance) has thus seemed to reduce the kind of "inflation" that is
routinely misdefined as a rise in the consumer price level.
Lulled into false
security by this seemingly benign outcome, the central bank will now be happy
to keep interest rates lower for longer and so it will promote this very act
of monetary expansion in the future.
As interest rates
fall, the math means that lower dealer prices can be quoted, while generating
the same or higher accounting profits, in turn encouraging the central bank
to greater laxity, lower rates,and so on round again and again…
Here we should note
that this is in no sense an academic exercise since, in Canada and the United
States, the relatively low official CPI rates of recent years have
accompanied rising corporate profits, yet these same higher earnings are, in
good part, being used to finance increased consumer indebtedness and/or
outright household dissaving (the same is true, to some extent, of New
Zealand, Australia, and the United Kingdom).
But we must not stop
there, for there is a deeper and more ironic inference to be drawn from all
this.
As Bob Woodward never
fails to mention in his gushing hagiography of our lately departed
"Maestro," in the late 1990s, Alan Greenspan became so puffed up
with his idea that productivity gains in the United States were being
drastically understated that he ludicrously likened his bathtub insight to
Einstein's theory of General Relativity.
However, Greenspan's
sole support for this flimsy thesis came from the rather tautological identity
that profits = selling prices - labor costs - non-labor costs.
Apart from the
fallacy inherent in maintaining that, in a rapidly changing world, the last
term could be regarded as a constant (when, as Roger Garrison has pointed
out, the cost of capital is a key component that Greenspan himself could help
lower by keeping policy too easy), this led the Chairman to argue that the
higher profits that were seemingly being delivered against barely changed
prices could only mean labor productivity was higher than estimated.
Eureka! No need to raise
rates or slow the growth of credit!
With hindsight, we
now know of course just how reliable the profits of WorldComs, Enrons,
Nortels, and Fannie Maes really were as a measure of increasing prosperity,
but as the above exercise in the arithmetic of securitization shows, the
whole darn thing may have been little more than an artifact of financial
engineering, even barring bad accounting or outright fraud.
In other words, in
seeking to boost sales by exploiting the possibilities of modern finance (in
a perfectly legal manner), GMAC and Ford Motor Credit, GE and John Deere
(among countless others) may have misled our preening, erstwhile Maestro into
financing the whole wasteful bubble of the late 1990s!
If so, we might point
out to the irrationally exuberant Mr. Greenspan that his revelation was not
so much Einsteinian, but rather had its parallels in the theories of
cosmologist Alan Guth — a man whose popular treatment of his life's
work bears the highly apposite title: "The Inflationary Universe."
Sean Corrigan
Sean Corrigan is Chief
Investment Strategist at Diapason Commodities Management (Lausanne and
London)
Copyright © 2006 -
Copyright © Diapason Commodities Management - Sean Corrigan
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