End Of Credit Cycle Dynamics

August 9, 2018

There are differences from previous cycles, but they can be explained. Over the last thirty-five years, non-mortgage consumer debt has been an increasing factor, as has the general drift from manufacturing to the provision of services. To whom the banks owe deposit money has changed from almost entirely consumers with savings and small businesses’ cash balances to a greater proportion of purely financial businesses.

The absence, so far, of price inflation to match the expansion of US bank credit since the last credit crisis is in large measure explained by the ownership of cash. Of the institutions and businesses, we know from figures released by the Federal Reserve Bank of New York that of the $12.8 trillion of cash, deposits and checking accounts in the banking system, foreigners (overwhelmingly financial institutions) have cash deposits of $4.217 trillion.

This is hot money, created by bank credit, but not spent and therefore not driving up consumer prices. This is an example of why the evolution of bank customers on the liabilities side of the banks’ balance sheets affect how the credit cycle should be read, the likely duration of the final pre-crisis phase estimated, and how the crisis itself will unfold. Furthermore, having created the credit cycle through its suppression of interest rates, the Fed lacks the theoretical knowledge to understand the extent of the problem it has both created and oversees.

This article examines these dynamics and concludes that the duration of this final phase of the credit cycle may be considerably shorter than most people expect, and is likely to be driven more by financial than economic considerations.

Interest rates do not control credit demand

We start by looking at why central banks cannot control inflation by managing interest rates. Last week, the Bank of England raised its base lending rate by a quarter of a per cent to three-quarters of a per cent. In its statement, the Bank stated that its “Monetary Policy Committee sets monetary policy to meet the 2% inflation target and in a way that helps sustain growth and unemployment.” In this, the Bank’s monetary policy is little different from the other major central banks, particularly that of the American Fed.

There are multiple links in the supposed chain between changes in interest rates and the 2% inflation target, but essentially the Bank must be assuming that an interest rate is the price of borrowing money. If that was so, you would expect higher interest rates to reduce the growth of bank credit, and lower rates to stimulate it, and if you control the rate of monetary growth, then the quantity theory of money suggests you can influence the rate of price inflation. This is a common assumption in financial markets, which are necessarily in tune with central banks’ monetary policy.

The facts suggest otherwise. The following chart shows what happened in the US between 1970 and 1990, including the time when Paul Volcker, as Chairman of the Fed, jacked up the prime rate to 20% in the early 1980s. The reason for illustrating these decades is that volatility in interest rates were at their most violent, and the effects should be at their most obvious.

If interest rates were money’s “price”, one would expect to see higher rates at least slow down monetary growth, and even make it contract. Lower rates should make money supply growth accelerate. This plainly did not happen, and it has never happened since money became totally fiat. Nor did it happen in the days before money’s purchasing power sank year after year, when Gibson’s paradox clearly showed there was no correlation between interest rates and price inflation. This being the case, it is evident that the supposed link between interest rates and bank lending as a means of controlling price inflation has never existed.

Gibson’s paradox, whereby interest rates correlated with the general price level and not the rate of price inflation, appears to have altered since the 1970s, because the general price level has simply soared.  Measured in gold, the dollar has lost 96.5% of its purchasing power since it was last officially set at $42.22 per ounce. Obviously, a collapse in the purchasing power of money is bound to undermine long-established relationships between the general level of prices and interest rates. While that correlation may no longer be graphically illustrated, the lack of correlation between the rate of changes in the general level of prices (the inflation rate) and interest rates still persists.

Clearly, the basis of monetary policy, particularly the supposed link between the price of money as a means of managing price inflation, is fundamentally flawed. We also know from experience that central banks tinkering with interest rates have failed to prevent recurring credit crises. In other essays, I have demonstrated why this is so, and I won’t repeat the theory here. Instead, we need to ask ourselves, if an interest rate is not the price of borrowing money, what is it?

Interest rates reflect time preference

There are, essentially, two approaches to addressing the relationship between interest rates, money and prices. There is the Keynesian, mathematical approach, which is in the tradition of William Stanley Jevons (1835-82). Jevons was one of three economists who proposed a theory of marginal utility as the basis of value in the 1870s. To Jevon’s successors, concluding with Keynes, interest was the charge imposed by savers on borrowers. It therefore followed, as Keynes argued:

“Thus, the rate of interest at any time, being the reward for parting with liquidity, is a measure of the unwillingness of those who possess money to part with their liquid control over it.”

In other words, Keynes was saying interest is the price of money demanded by savers, but as we have seen in the chart above, changes in interest rates do not lead to changes in the quantity of money, so it cannot be right.

The other approach was that of Carl Menger, founder of the Austrian School, who argued that marginal prices were set subjectively by human action. Menger also noted that we all value actual possession more than a future possession of the same satisfaction. But the production of better and more desirable goods involves time and investment in the means of production. Therefore, as Menger pointed out, if a manufacturer wants money up front in order to be able to deliver a product in, say, six months’ time, he will only get it at a discounted value. This is because parting with money means we have to defer our own possession of goods. It is the deferment of ownership of goods that is the issue, not money itself.

The root of time preference is that if we are to forego the enjoyment of goods, we will only do so on in accordance with our assessment of their future value, allowing for the deferment of utility and the uncertainties of promised possession. We think of money as being fully fungible into all goods, and therefore representative of our desire for them. On this basis, we might be prepared to part with $98 today on the promise of $100 in six months’ time. This can be expressed in one of two ways. We can either say the present value of $100 in six-months’ time is $98, or we can say it represents an annualised rate of interest of 4.08%. The rate of interest is an expression of the time preference of the certainty of possessing money today, over only having it in six months’ time.

This is not the same as assuming interest is the price of money. Money is not goods, it is merely the bridge between our labour and our consumption. Parting with money for a period of time is actually deferring the benefit of the immediate possession of goods. Of course, there are some goods for which we will readily defer ownership, and there are some for which we will only reluctantly defer actual possession. Therefore, the time-preference of money is a catch-all general representation of what we can buy today but deferred for an agreed period of time, which will be differently assessed by each of us. It is rightfully set between individual savers and borrowers.

Obviously, time preference can only originate in the minds of lenders and borrowers of money, which makes it impossible for the state to intervene without unintended economic consequences. Time preference exists regardless of interest rate policy. Accordingly, the management of interest rates by policy makers, who believe they are managing the price of money, is rather like asking a blind man to drive you home from the party.

Time preference also evolves over the credit cycle to reflect expectations of the likely purchasing power of money over time. If the rate of price inflation picks up and there is a general expectation it will increase further, then this is the same as saying the purchasing power of money will decline. Therefore, the present value of future money will be less, which together with the loss of money’s utility will translate into yet higher interest rates. This is a late-cycle phenomenon, because the previously increased quantity of money will be progressively undermining its purchasing power, and expectations that the trend will continue and likely accelerate become more firmly entrenched in peoples’ assessment of their own personal time preferences.

Therefore, it is public perceptions embodied in time-preference which drive interest rates, not monetary policy, and this becomes increasingly apparent late in the credit cycle, when central banks always find themselves on the back foot.

The vested interests in monetary expansion is being rumbled

The intentions behind the management of interest rates appear inconsistent anyway, being aimed at controlling price inflation without ever contracting the growth in money supply. Under this policy, it is believed an even rate of price inflation at 2% can be broadly achieved. Even if this were true, it means that the purchasing power of money would decline by half in thirty-five years. Given that in the US, the sum of cash, checking and deposit accounts is currently $12.8 trillion and growing at five to seven per cent per annum over the long-term, this represents a huge transfer of wealth. Furthermore, wealth is being transferred as the same mechanism erodes the value of coupons on $40 trillion of US bonds, including $14 trillion issued by the US Government held in public hands.

This wealth transfer disadvantages savers and benefits borrowers. That much should be obvious. But it also disadvantages the poor in society, whose fixed wages and welfare payments always lag the rise in the cost of living. Retirees are hardest hit. Lower welfare payments inflated away by currency debasement are an immediate benefit to the government. The basic reason behind inflationism is it provides funding for governments and reducing their welfare costs, but it is also favoured by lobbying businessmen.

Businesses benefit by buying raw materials and capital equipment at the old prices, and, so long as trade unions are subdued, they pay wages at yesterday’s rates. They sell their products at today’s prices for an average profit boost over their operational costs equating to the rate of price inflation. Consumers end up earning yesterday’s salaries and paying inflated prices. And economists acting in the role of deceivers tell them that higher prices are necessary to secure their jobs.

Consumers have, if only subconsciously, twigged it. Instead of saving, they are now themselves borrowers, so the simpler world where borrowers were businesses, and consumers were savers is no longer the case. The change in consumer behaviour has a significant impact on prices, bringing the expansion of bank credit to bear on consumer demand more immediately.

However, the expansion of credit money still takes time to feed through to actual prices, not least because consumers can usually buy cheaper imported goods. Monetary expansion leads to trade deficits with other countries for this reason, and American consumers have benefitted hugely from access to cheaper foreign goods over this credit cycle. The Trump administration is naïvely trying to reduce foreign imports through tariffs, which will only impart a strong push towards higher consumer prices. So far as prices are concerned, the safety-valve of cheaper imports is being locked down.

At the same time as tariff policies are about to lead to higher consumer prices, the government’s budget deficit is being increased, providing an extra source of demand stimulus that can only drive up prices even further.

Despite the rise in American interest rates so far, the process of monetary expansion cannot stop. It will continue regardless to supply the credit to support higher prices, as the chart above implies. Interest rates will rise, reflecting the increasing discount of time preference already developing in the private sector, until the business models of the borrowers based on years of zero rates become wholly uneconomic. The wise ones will cut their malinvestments, but the majority will try to struggle on, with their banks becoming increasingly reluctant to support them. This is the conventional model of how a credit crisis develops, but as we shall see the next crisis is likely to be financial in origin, rather than economic.

How the pre-crisis stage of the credit cycle will evolve

There are significant errors in interest rate policy, which guarantee the next credit crisis will occur. By assuming an interest rate represents a price for money, monetary policy proceeds on the wrong basis from the start. But to admit this disparages all attempts to manage interest rates, and modern central banks are extremely unlikely to give up the most powerful reason for their existence.

Given an understanding of the fundamental error, which is a failure to recognise the role of time preference in the economy, we can forecast the evolution of monetary policy leading up to the next credit crisis. Besides the proven lack of any link between interest rates and bank lending, it is clear that throughout the cycle, interest rates are always held below the value of a market-determined time preference. This drives the expansion of debt and money, as both businesses and consumers are encouraged to borrow to support economic growth.

For the last few years many financial commentators have pointed out that the expansion of debt in the American economy has failed to boost economic growth as expected. You could argue that this is because much of the debt is not applied to expanding the provision of goods and services, and that is certainly true. Untangling the relationship between accelerating debt and GDP involves a variety of factors, and outstanding bank credit should be regarded differently from outstanding bond issues, the former being money and the latter assets in the hands of the public. A more pertinent analysis arises from understanding that the mirror image of bank credit is the creation of bank deposits. In other words, those commenting on debts should be commenting on the money that has been created instead.

The question arises as to how that money is distributed. To date, publicly owned cash, checking accounts and bank deposits have increased from $5.460 trillion just before the last credit crisis to $12.854 trillion today. That means about $7.394 trillion has been created since September 2009. As noted earlier in this article, we know that $4.217 trillion of that is owned by non-US corporations, overwhelmingly foreign banks and financial institutions. That leaves an increase of bank deposits totalling $3.177 trillion in the hands of US owners.

These numbers are central to how the credit cycle develops from here. Foreign-owned dollars are sitting in the banks, likely to be encashed for other currencies, gold, or even commodities. It is hot money that will never be spent in the US economy, so in that narrow sense is non-inflationary. However, if the dollar weakens, it will turn into flight money.

Of the US-owned dollar deposits totalling $7.394 trillion, a substantial portion is owned by financial institutions, not just accumulated as a result of inter-bank dealings, but as a result of extending credit to consumers. The preponderance of foreign and domestic financial institutions’ ownership of dollar balances at the banks explains why recorded price inflation since 2009 has been surprisingly subdued, despite almost unprecedented monetary expansion. Much of the effect on prices, if official CPI figures are to be accepted as representative, has yet to follow through. This means there is bottled-up potential for a fall in the dollar’s purchasing power to accelerate in the run-up to the next credit crisis. Quite simply, too much money is in unstable hands, some of which will exit by selling the dollar, and some of which is trapped in the system.

So far, we have focused on monetary considerations, but there are also fiscal policies and trade tariffs to consider. President Trump has, through tax cuts designed to protect domestic production, exacerbated the situation. Admittedly, where the benefits go to the wealthy, this is unlikely to increase direct consumption noticeably, but where it leads to added employment, we should bear in mind that the supply of employable labour is already very low. Trump’s tax cuts seem certain to help drive up manufacturing costs in the coming months.

Trump’s widespread introduction of tariffs, even discounting the possibility they are a temporary trade weapon, will also increase the costs of domestic production and raise consumer prices. It will therefore become obvious to a wider public that the rate of price increases will accelerate, probably relatively quickly.

That wider public will particularly include the holders of bank deposits, checking accounts and cash. Given the consumers’ recent proclivity for debt, we can no longer rely on the normal lag between currency debasement and public realisation of the effect on its savings to slow the loss of the dollar’s purchasing power. The proportion of institutional and financial holders of these accounts must be greater than on previous credit cycles, and they are inherently speculative holders. In other words, they are likely to want to pass on cash and near-cash to someone else as the rate of price inflation increases, more rapidly than if deposit holders were comprised of consumers.

This is where an understanding of time-preference is important. As the purchasing power of dollars on deposit declines, financial institutions will be quick to get rid of their dollars. Domestic financial institutions are likely to buy financial assets, but they all tend to be on the same side of the transaction. There is therefore a strong possibility that a rush to get rid of dollars for assets will develop, driving up equities and property prices. At the same time, yields on long maturity bonds will rise. These developments tell us one thing, and that is the present value of future money will be falling at an accelerating rate.

It will not be read that way by the Fed. The Fed will see signs of an overheating economy, and attempt to cool it, at first reluctantly, by raising “the price of money”.

Let us return to factors affecting foreign ownership of dollar deposits. President Trump is increasing the budget deficit, which assuming little change in the savings rate, will feed into an increasing trade deficit as described earlier in this article. Foreign owners of dollar deposits also own some $18.4 trillion of US securities as well as their bank deposits, totalling $22.6 trillion, exceeding the US’s GDP of $19.4 trillion by a significant margin. To these imbalances will be added an annual trade deficit of over $1 trillion dollars. Do the foreigners really want to continue increasing their dollar holdings over and above these record levels?

The answer is likely to be an emphatic no. They may briefly surf the wave of higher equity prices, but of their $18.4 trillion holdings of US securities, $11.2 trillion is recorded as bonds, which will be declining in price, as argued above. The sheer quantity of existing foreign-owned dollar exposure and the increasing trade deficit points to enormous selling pressure developing against the dollar in the foreign exchanges, as soon as the dollar loses its recovery momentum.

This gives us our timing. A flight out of cash dollars into equities, property and even fine art, combined with a rise in bond yields can only happen for a brief period of time. Price inflation, driven partly by the sheer quantity of dollars on deposit and partly by a combination of fiscal stimulus and tariffs on imported goods, will soon leave the Fed’s 2% inflation target far behind. It will be a case of a brief financial boom at best and then a dramatic bust. The Fed will be unable to keep up with the rapidly falling present value of future obligations, encapsulated in time preference values.

In summary, the next credit crisis will be driven by the monetary imbalances that have accumulated since the last credit crisis, triggered by President Trump’s fiscal and trade policies. The timing for the onset of the credit crisis looks like being any time from during the last quarter of 2018, only a few months away, to no later than mid-2019.

Alasdair Macleod

HEAD OF RESEARCH• GOLDMONEY

 Twitter: @MacleodFinance

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Alasdair became a stockbroker in 1970 and a Member of the London Stock Exchange in 1974. His experience encompasses equity and bond markets, fund management, corporate finance and investment strategy. After 27 years in the City, Alasdair moved to Guernsey. He worked as a consultant at many offshore institutions and was an Executive Director at an offshore bank in Guernsey and Jersey.

Fed has done all it can to fix US economy's non-structural issues, now it must hike rates