A Treatise on Unsound Money: Part 2
Written by Derryl Hermanutz
Day after day, day after day,
We stuck, nor breath nor motion;
As idle as a painted ship
Upon a painted ocean.
Water, water, every where,
And all the boards did shrink;
Water, water, every where,
Nor any drop to drink.
Samuel Taylor Coleridge, The Rime of the Ancyent Marinere
Asset price inflation is the first round effect of excessive bank credit creation. You can blame the borrowers if you like, but which one of these parties holds himself out as a “financial professional“, the banker or the rube asking for a loan? Bankers are supposed to “underwrite” the loans they make, which means doing some research to satisfy themselves that the borrower will be able to repay the loan. All the rube has to do is walk into the bank and ask for money. It’s the banker’s job to know whether to say yes or no (I’ve heard some outrageously funny rube stories from bankers who said “no”). Legislation has given the banker the power to create and allocate money. Regulation should ensure that he exercises that power responsibly.
Asset price inflation generates second round general CPI inflation, because all those folks who sold high priced assets to the rubes now have the money, and they spend some of it buying stuff for themselves. Another second round effect is investment goods inflation, as some people choose to invest their new riches to make even more money, rather than spend their earnings on consumption. Ultimately this proves to be the kind of hopeless money losing speculation Mill described, but as long as the credit-driven asset and CPI inflation continues, there are profits to be made investing in asset and goods production, and increased profitability combined with increased savings to invest drives up the price of investment goods.
But once the credit punchbowl is pulled out of the equation we get a reversal of all the inflationary trends, what Mill called a “commercial revulsion“. The price of the first round assets flattens as there is no new credit-fueled demand bidding up prices. During what Minsky called the “Ponzi finance” phase of the cycle, many people borrowed and bought assets with the expectation of flipping them for a quick capital gain, but now they can’t sell them because banks aren’t financing new buyers at inflated prices, and many flippers are not willing or able to service the debt they took on to buy these assets.
So they start dumping them, which adds supply into a reduced demand and collapses the formerly inflated asset prices. There are no more big incomes generated by producing and selling high priced assets, so general spending declines, which reduces or reverses CPI inflation. Reduced demand and reduced prices reduces profits of asset and goods’ producers, so all the new money that was invested in new production now earns a low or negative return.
Which brings us to our second misguided sentiment in the Ash article,
“Real rates of interest, after inflation, are likely to get worse below zero. Not least because, while failing to raise interest rates, central banks will continue to print money to buy government bonds – thereby pushing down the interest rate they offer to other investors (ie, you and the entire retirement savings industry).”
Who, pray tell, is going to borrow all your money and pay you high interest when the profitability of your popped bubble economy just evaporated? Remember this?
“By the time a few years have passed over without a crisis, so much additional capital has been accumulated, that it is no longer possible to invest it at the accustomed profit; all public securities rise to a high price, the rate of interest on the best mercantile security falls very low, and the complaint is general among persons in business that there is no money to be made.“
Déjà vu all over again.
Savers (including workers and capitalists/investors) saved the money they earned during the boom, and maybe earned some high interest while the punchbowl of new credit-money was still flowing into the economy. But now the spenders are trying to suck money OUT of the economy to repay their debts, not borrow “more” to spend in. There is a “negative demand” for new borrowing, which is expressed as a negative real interest rate. Too much money chasing too few profitable investments drives down the price of borrowed money, which is the interest rate. That’s where the world is at today – more and more money collecting less and less interest, which creates a bubble in prices for interest bearing vehicles like “public securities” and “the best mercantile securities” (i.e. government and corporate bonds).
But it is an eternal truth of sound money that the “market” interest rate must always be positive, even when there is no market for new loans because there are no willing borrowers who are actually able to “repay” their consumer loans and there are no productive investments that are “profitable” when final (consumer) demand collapses. Lenders suffer losses of principal in this environment, and loss of loan principal is equivalent to earning a negative rate of interest on the money you lend. But apparently sound money doesn’t believe in arithmetic, or history, or centuries of rational analysis, so moneylending must always yield positive interest rates. I suppose the government bailout of failed TBTF banks ‘proves’ that lenders always get their interest and never lose money, but I’ll leave the sound money guys to make that case.
Thus the collapse of a bubble is preceded by a time when the world is awash in credit for which demand has faded and the illusory wealth in the credit system is about to face a wave of defaults. This gives us a “Coleridge moment.“
The Five Parts of the Treatise on Unsound Money