By Patrick Corby
Economic credit expansion, overindulged in by all Western nations for the last four decades, has had more of an effect than inflating prices. The easy-credit of inflationary policies has led to masses of household, company and bank debt with the average British adult having £28,704 outstanding in debt including their mortgages.
The Office for Budget Responsibility (OBR) has forecast that by 2017 household debt will reach the UK national output that year estimated at £2.04Trn.
In Western nations debt is no longer a taboo instead it is a cultural norm. Politicians keeping interest rates artificially low have allowed this indebted culture to form and churn along. But this has and will continue to reverse as the consequences of such policies untangle.
Expanding credit by pushing the interest rate low increases the demand for loans, giving individuals access to more credit than they could otherwise afford. This increase in credit then increases and bids up prices through the system of inflation. Prices can then inflate along in nominal value through the increased ‘future savings’ promised or debt instead of actual value associated with increased efficiency in production; hence the demand fuelled by credit expansion is artificial.
Demand Fuelled by Debt
This policy allows prices to be bid up as more future credit is allowed to be consumed off in the present therefore increasing prices along with the expansion of credit in the system. The higher climbing prices in certain sectors increase the amount of participation of entrepreneurs who decide to participate. These are typically the sectors where prices have risen with genuine investment that gain momentum through speculative participation; this is commonly called a bubble. All is well; until the music stops.
The example of Robert Brennan of First Jersey Securities will illustrate this idea. Brennan owned and operated a scam called ‘boiler shops’. The scam was to create artificial prices ‘inside’ then sell to those caught in the ‘outside’ hype leaving them with assets of artificial value and reaping the cash they paid.
Friends of Brennan, the ‘insiders’, bought into the shares of his firm and increased the price. Once momentum had gained telemarketing was used to sell the stocks to ‘outsiders’, mostly dentists and undertakers, who wanted in on the gaining shares.
When all shares were sold to ‘outsiders’ they were worth quite a bit. The telemarketing acted in the same way lowering the interest does, giving an artificial signal to the market that then builds on that signal. When the ‘outsiders’ tired to sell the shares for that price they found no buyers and realised the bubble the price was set in; demand was artificial and therefore so was the price. When the debt constrains participation and no more individuals can be found to pass on the higher prices the bubble is seen as just another speculative illusion fuelled by a façade of demand.
The price falls rapidly towards the real value of the shares as the ‘outsiders’ chaotically tried to sell at the best loss price they could get.
This same process can be seen as credit is expanded in the economy.
Once the debt stops, credit stops and with it the demand. Nominal inflationary prices will only increase with higher market participation which can only be sustained by lower interest rates fueling higher debt. But we cannot lower interest rates any more and the debt is unrealistically high by all standards. The music is slowly switching off and the overleveraging of debt on little capital is being seen as unsustainable.
Bad Debt Good Debt
Low interest rates allow healthy and unhealthy investments to be took out which then go on to be used to buy capital. The bad investments gain access to capital and their demand fuels artificial values through inflation, the good investments are strangled of capital as they fight with more competition of its rights. But because malinvestment is bad because its production is inefficient the demand is not real but sustained by debt. Revenue received is not able to pay the original debt off so we get a situation where business limp along paying continuous interest payments with no deleveraging and no production just a clogging of the economy.
But something happens when unsustainable businesses start to fail; their inventories are sold off. This has the effect of reversing the whole inflationary process and depressing price levels. Due to the depression of prices other firms in the industry have their capital base, and therefore the net worth, decrease.
This increases the leverage of the firms and decreases their borrowing opportunities. As the capital base they sought loans off decreases in price worth, the confidence of repayment of loans falls and banks start to ask for repayments instead of simply carrying over interest payments or offering further loans. The zombie households,companies and banks that rely on further debt become lit up.
As more and more firms fail from burdensome debt banks become increasingly tight lenders and refuse renewal on now riskier loans. Their profits now fall in line with failing firms and they suffer the same fate of a shrinking capital base disallowing them to leverage and bolsters them up.
In the above case, regardless of the policy sustaining the nominal interest rate, the real interest rate is high due to the declines in consumer price level and depressed investment. The BoE can keep interest rates close to 0% as possible. The real risk is there and will be reflected in the loans offered.
When the bubbles do start to show selling takes hold and then it all comes crashing down.
Lets get Indebted
There are those that believe that debt is necessary for growth; that debt is an integral part of development and growing out of poverty. This view stems from a Keynesian belief that consumption drives growth.
But not everybody can afford debt. That’s why governments have to push down the interest rate so low to create the incentive to those that cannot afford such leverage.
That’s why there was a category of individuals that were labelled ‘sub-prime’ in the mortgage industry before 2007. They were risky loans due to their ability to afford such levels of debt.
In fact part of the reason we saw sub-prime mortgages bundled into mortgage-backed securities (MBS) was because of the lack of interest able to be accumulated on normal loans. Governments, for better or for worse, have distorted normal practices in the market and left little ability to seek normal profits.
The situation is unsustainable.
In 2007, before the financial crash, the typical British bank demanded an average deposit of £12,700 for the average mortgage. In 2010 that had increased to £31,500 as banks start to clean out the masses of bad debt they had burdened themselves with, unable to be paid and just waiting to be written off, destabilising their capital base with it.
Roughly three in ten companies in the UK are zombie companies that are barely able to pay interest and wages. They are tolerated by banks because they still want to ‘crystallise’ on the debt.
HM Revenue & Customs is under political pressure not to pull the plug on these companies because debt will be written off and unemployment will rise as thousands of workers are thrown into the streets.
But these companies cannot expand, cannot grow, they do not produce as they barely sustain themselves. They clog the market and hold billions in capital that is being refused release, they have a workforce that can be used efficiently elsewhere and drag on healthy production that is badly needed to secure our economy.
Chris Giles, chief editor of the Financial Times, has stated that it is these “zombie” households, companies and banks are holding back the recovery.
Freddie George, analyst at Seymour Pierce, is quoted as stating there are still a lot of high street chains with too much debt which are on the edge of failing.
Sir Mervyn, head of the bank of England, made the point this year that “Obviously, this cannot continue indefinitely,” “Policy can only smooth, not prevent, the ultimate adjustment.”
As loans conditions tighten, limits on credit cards are cut and overdraft curbed, the available credit in the economy is deflating, dragging demand down with it to a healthy level, sustainable here and now instead of in an uncertain future.
Capital regulation is changing, banks’ business models are being forced to secure themselves, politicians are beginning to realise that the ‘get rich quick’ culture they so wish for is a facade and the culture is gradually readjusting. There is still along way to go down.