Reader Mike wonders how interest can ever be repaid in a credit-based
economy.
Hi Mish,
I wonder if you would be able to comment on this from Bill Gross in For Wonks Only:
"A credit-based financial economy (as opposed to pure cash) depends
on an ever-expanding outstanding level of credit for its survival. Without
additional credit, interest on previously issued liabilities cannot be paid
absent the sale of existing assets, which in turn would lead to a vicious
cycle of debt deflation, recession and ultimately depression.
Put simply, if credit needs to expand at 4.5% per year, then the private and
public sectors in combination must create approximately $2.5 trillion of
additional debt per year to pay for outstanding interest."
This seems to correlate to reality 100% but the implications are stunning. It
means that assets must increase in value at the rate of the original loan
plus all interest payments ever made. It also means there will be a very
major reversal at some point as there will be a moment when the last loan
that someone will actually pay gets written and the system will not be able
to expand. I always assumed that debt levels would just reach a very high
plateau and stay there but Gross is saying that is not possible.
If the system we have requires the interest to be created every year (in the
form of new loans) to survive that seems like the very definition of a ponzi
scheme.
Do you know the mechanical reason why the interest payments need to be
created by issuing new debt? It is possible, of course, that you disagree
with Bill Gross but he probably knows more about how debt works than any man
alive so my assumption is that you agree with his viewpoint.
I'm sure you get endless requests for articles but this is such a fundamental
question I would be extremely grateful (as I'm sure would many other people)
if you are able to write a reply as an article.
Mike
Exponential Math
We are in this mess precisely because of fractional reserve lending and
never-ending policy of inflation by central banks that do not seem to
understand the long-term ramifications of exponential math.
I have covered the exponential math aspect before. For details, please see Money as Communication: A Purposely "Non-Educational"
Fallacious Video by the Atlanta Fed.
Credit in a Gold-Backed World
There is nothing wrong with credit expansion used for productive purposes. If
we had a 100% gold-backed dollar without FDIC, bad debts would be
extinguished automatically.
Interest rates would be low for low-risk ventures and high for high-risk
ventures, with lenders (depositors willing to lend money) taking the risk.
On high risk ventures, some projects would lose and some win, as it should
be.
Importantly, no money held for safe keeping (checking deposits), would ever
be at risk in 100% gold-backed system. Nor would there be any mathematical
need for credit to expand exponentially forever and ever without end.
30-year mortgages might not even exist, but that would not cause any problems.
Deflation (a natural state of affairs because of rising productivity) would
provide price stability central bankers now claim they want.
But that is not the world we live in.
Fiat World Math
Unfortunately, we live in a fiat world, not a 100% gold-backed dollar world.
We have fractional reserve lending, and a huge mismatch in duration. Banks
borrow short and lend long. It's a recipe for disaster.
Thanks to central bank encouragement and unnaturally low rates for a fiat
scheme, credit is out of hand. Loans that have been made cannot possibly be
paid back. Unproductive zombie companies survive only because they can roll
over debt while expanding it. Covenant-lite debt is now accounts for 50% of
new debt issuance.
Worse yet, real wages are falling because of central bank inflationary
policies in a productivity-driven world increasingly dependent on robots, not
human labor.
Minimum wage laws, Obamacare, Congressional fiscal policies, Fed interest
rate policies, public unions, and inflationary policies in every phase of
government make it likely that companies use robots at a far faster pace than
they would otherwise.
Something has to give and it will.
Debtberg Malinvestments and the Zero-Bound Problem
I asked my friend Pater Tenebrarum at the Acting Man blog to chime in on this situation. Pater
writes ...
Interest is basically nothing but the discount of future
goods vs. present goods. At its root, interest is actually a non-monetary
phenomenon. In the modern-day fractionally reserved fiat money system, it has
become possible to expand money and credit at immense rates. The reason why
the debtberg was able to grow to such immense proportions is that interest
rates fell for over 30 years. But now we have arrived at a critical juncture,
because interest rates can no longer go any lower. The possibility to
refinance existing debt again and again to lower its cost has come to an end.
The size of a debt is immaterial if the debt has been used for productive
purposes and is so to speak 'self-liquidating'. Imagine you are a company
that borrows $200 million at 3%. If you employ this money to produce goods
that have a net profit margin of 6%, the repayment of the debt plus interest
poses no problem.
But a lot of debt in the system today is a "dead weight" that will
produce nothing. All extant government debt is only a reflection of past
spending, and the funds have been 100% consumed. The same obviously holds for
consumer debt, but consumers at least have an income based on production
(i.e., their work will create value in the future). The government's income
relies on the production of others, which is coercively appropriated.
In the realm of corporate debt, which may be considered productive in
principle, there is the problem that many of the investments that have been
undertaken are really malinvestments, as economic calculation has been
falsified by monetary pumping. Debt that has funded capital malinvestment is
a dead weight as well, although this may only become obvious at a later
stage.
So the situation is now this: debt service will now grow with every new
addition to existing debt, as interest rates have arrived at their absolute
lows. Given total credit market debt of $60 trillion in the US alone, it will
become more and more difficult to actually produce the added value required
to service this debt. There is indeed an incentive for many to play a kind of
Ponzi scheme that is very similar to the government debt Ponzi. Many
companies, especially the junk credits, can only survive by rolling over
their debt when it comes due.
Nevertheless, Gross' calculation may be a bit too simplistic. After all, if
you are a creditor and get paid interest and principal, money is only moving
from A to B. It is still there, only its ownership has changed hands. The
problem is that central banks believe in inflating debt away and keeping
prices "stable".
In a free market economy, prices would not be stable, they would in fact
decline. Thus, interest would be quite low to begin with, and every dollar
would be doing more work over time (i.e., could be exchanged for more real
wealth/goods/services as time passes).
So we currently have a systemic bias toward more and more debt expansion.
Obviously, debt service costs in this system are slated to rise, while an
offsetting creation of wealth is no longer guaranteed. You can see this from
the fact that more and more new debt is added per dollar of GDP growth. So
Gross is quite correct that there is a problem - the problem is the ongoing
bubble. Such a bubble does indeed require a constant acceleration in debt and
money supply to keep going.
Seems to me that it is a system that is coming ever closer to a cliff.
On the Edge of a Cliff
- Japan is on the edge of a cliff
- Europe is on the edge of a cliff.
- China is approaching the cliff, if not already on the
edge.
- US is approaching the cliff.
No one can be sure when some country is going to fall off that cliff, but
exponential finance, Ponzi financing schemes, and zero-bound interest
limitations suggest the outcome is sooner rather than later. As I have stated
before, a global currency crisis awaits.
Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com