-- Published: Friday, 19 May 2017 | Print | Disqus
By Alasdair Macleod
The greatest strength of a truly free market economy, where money is sound and does not corrupt prices, is the absence of cyclical action. With sound money, and consumers deciding for themselves their wants and satisfactions, having to choose between this or that instead of deploying unbacked credit to have this and that, there can be no cycle of credit, and no credit-driven business cycles.
Central bank manipulation of money is intended to force everyone to act the same way at the same time. Central banks direct the quantity of money and credit to encourage us en masse to spend money we do not have, supplanting the randomness of Schumpeter’s “creative destruction” with a synchronised destruction, deferred to the end of the credit cycle.
The constructive and continually evolving process of reallocation of capital from uneconomic projects to more productive uses is ruined by unsound money. To this damage can be added extensive regulation, promoted by governments as being in the public interest, but more accurately, designed to protect established businesses from competition. You cannot sell ice cream without a license, and even then, its composition is regulated by the state.
Economic progress brought about by technology has always been despite government economic planning. Horse power was replaced by the internal combustion engine, but all the muck-shifters, coachmen and blacksmiths found re-employment in other trades. Drudgery in the home was replaced by labour-saving equipment, and domestic servants gained other employment and a higher level of personal freedom. Computers have automated all the things we want to automate.
These advances have been driven by enormous shifts in consumer demand, but the individual investments in new, up-and-coming industries still have their successes and failures, and in free markets these successes and failures are just as non-cyclical as in any other line of business. That is why we can describe economic activity in free markets with sound money as essentially non-cyclical and therefore random. But government bureaucrats don’t do random. It goes against their controlling nature. This is why repeating cycles in the economy have their origin in government intervention and will continue, as will unsound money, until the fiat money system collapses.
Even under the gold standard money was unsound, because banks were free to expand unbacked credit at will, formalised by the 1844 Bank Charter Act, which endorsed fractional reserve banking. Not long after the creation of the Federal Reserve Board, central banks colluded with each other to manipulate the quantity of money. Central banks have been generally free from criticism of their actions, arguing that evolution of monetary policy renders the past irrelevant. To combat this nonsense, the few critics left standing can only use reasoned theory, which given the general disinterest in monetary affairs, is an uphill struggle.
However, the logic that in a sound-money economy credit-driven cycles do not exist, is irrefutable, because it takes unbacked credit expansion to get economic actors to abandon random activity and act in concert. The question then to be answered is can there be any other source of cycles? The answer must address human behaviour itself, which is undoubtedly prone to being driven by fads and fashion. But in the absence of easy credit, a person buying into the latest fashion must divert funds from buying something else, or compromise personal cash liquidity. He or she cannot have both. We can therefore assume that while ephemeral shifts in the use of money and savings can take place in a sound money environment, they are bound to be more limited without the expansion of unbacked credit.
Booms and busts that have their origin in human behaviour rather than credit have occurred. The South Sea Bubble, which popped in 1720, could be cited as an example. The lure of easy profit tempted people living in London, or within a day or two’s coach ride, to divert their gold and silver from other uses into speculating in the stock market. The same had happened with the tulip mania in Holland in 1636. We cannot say these events were totally free of unbacked credit, debased or clipped coinage, but they were relatively so. In the absence of freely available unbacked credit, these speculative booms are too rare to be called cyclical. Rather, they are instances of the extraordinary popular delusions and madness of crowds that drive them, as Charles Mackay aptly described it.
The Mississippi bubble in France was different, because it’s architect, John Law, used a combination of money-printing and share issuance to fuel it. Eight decades later, France made the same error of debasing money by issuing assignats as a means of paying down the royal debts. This currency collapsed rapidly, as did the mandats currency that followed the revolution. Even this was not cyclical: true cyclicality only came with the validation of bank credit in the 1844 Bank Charter Act in England.
The origins of modern credit cycles
We must accept the possibility of mass speculation in an economy based on sound money, but any tendency towards regularly repeating human behaviour requires the rocket-fuel of unbacked money and credit. We are now addressing formalised bubbles: the 1844 Act led to a repeating cycle of bank credit increasing in good times, leading to speculative excess, banking crises, slumps, then recovery. This was the pure credit-driven business cycle. The Bank of England first developed the modern function of lender of last resort in the years following the 1844 Act, to rescue failing banks central to this cycle of credit.
After the Fed was established in 1913, a dialog with the BoE gradually developed, which in the 1920s grew into a close working relationship between Benjamin Strong, Chairman of the Fed, and Montague Norman, Governor of the BoE. Their cooperation over monetary policy, expanding credit while maintaining the gold standard, fuelled industrial production in the 1920s with restrained price inflation. This was followed by the greatest credit bust in history, apart, that is, from the Mississippi bubble. The legacy of global unemployment in the 1930s hung over politics until the 1980s, and changed mainstream economic thinking to this day.
The twenties boom and thirties bust were made more violent and prolonged by cooperation between the two central banks, which were the issuers of the most important currencies at the time. The natural randomness of the free markets of the two greatest nations had been fatally compromised.
Following WW2, a new cycle of intervention commenced, comprising greater government involvement in Britain and Europe, supported by monetary expansion. In the US, the government stimulated the economy through defence spending and the expansion of American corporations, paid for by exporting dollars, which were guaranteed under the Bretton Woods Agreement, as well as expanding domestic bank credit. A new super-cycle of US dollar credit was created, whereby it was expanded without the consequences of runaway price inflation, that is until the Bretton Woods Agreement failed in 1971. Subsequently, prices began to rise despite attempts to restrain them.
The Bank of England was forced to increase interest rates in November 1973 sufficiently to create a slump in the economy, though they didn’t peak until 1979. The Fed finally ended the dollar’s post-war credit cycle by raising the Fed funds rate to over 20% in 1981.
The 1945-1980 period was something of a super-cycle, where Keynesian intervention ameliorated end-of-cycle crises, leaving distortions to accumulate from one credit cycle to another. Since then, the world has embarked on a new super-cycle of credit, this time fuelling asset prices, while the production of goods in America entered a long-term decline. Commodity prices have been suppressed by the expansion of artificial supply through paper derivatives. Cheaper production in emerging markets and the suppression of raw material prices have kept price inflation below where it would otherwise be, allowing the creation of fiat currency and unbacked credit to continue for a prolonged period. The focus of credit expansion, particularly after the regulatory changes in the mid-eighties, has been debt-fuelled consumption and speculative investment.
But this cycle has its roots before 1981, in the post-war years.
The current super-cycle of speculative investment
It started with the cult of the equity in the 1950s, when the risk-reward of investment tipped away from bonds towards equities. This was justified by the prospect of mild price inflation. While modest at first, it threatened to get out of control after President Nixon abandoned the link between the dollar and gold in 1971. A growing consensus was developing, that buying equities gave investors greater financial security than a portfolio of bonds. But this was only true at certain stages of the credit-driven business cycle, when the central bank suppressed interest rates below their natural level and encouraged the expansion of bank credit. At other times, exposure to equities could and did lead to substantial portfolio losses.
The simplest way for a member of the public to benefit from the enhanced returns of equities without being tripped up by investment risk, cyclical or otherwise, was to hand over money to an expert. The investor is reassured. These so-called experts, fund managers, began to tout for business by comparing their returns with an appropriate index. Again, this works well during the initial stages of a central bank induced credit cycle, when even a fool can make money. All the fund manager must do is avoid the more obvious dogs and go for investments leveraged to the stimulus of credit. But when the credit cycle advances, and money begins to flow from financial instruments into the productive economy, the financial bubble is pricked. But few fund managers are concerned with these dynamics, because they have a greater interest in keeping assets under management growing, instead of paying attention to cyclically-changing risk factors.
Over time, even fund managers have become disillusioned with their inability to stock-pick. They regularly underperform the benchmarks they set themselves, and get stick for it. Since the technology bubble of 1997/2000, which was a major set-back for value investment, they have increasingly given up on active management and turned to index tracking, and more recently exchange-traded funds, or ETFs.
At first sight, ETFs are a good way to play investment cycles, or themes. They are available for all categories of investment, so a fund manager or even the individual investor can buy into baskets of commodities, bonds, currencies, foreign markets, inverse ETFs and leveraged ETFs. These ETFs, marketed as a means of controlling investment risk, instead add a potential risk to investment, which emanates from the manager, the structure, and the derivatives used. These risks are hard to quantify, are buried in the small print in the prospectus, and so are generally ignored.
The transition from bond diversification in the 1950s to the ETFs of today has encouraged everyone in capital markets to expose increasing quantities of their savings to trend risk. A savings super-cycle has developed, incorporating several credit cycles, ending up with investors disregarding risk assessment almost entirely.
There can be little doubt that in a sound-money economy, shorn of the distortions created by unbacked money and credit, investment opportunities would tend to be selected on their individual merits. This is because a bad investment cannot be bailed out by monetary expansion. Investment returns in sound money come from its increased purchasing power over time, the consequence of economic progress. A portfolio of ten stocks and bonds purchased for ten ounces of gold in ten years’ time might only be worth twelve or thirteen ounces, but those ounces would buy more than they did ten years before.
We have yet to see how this credit-driven investment super-cycle will end. But we can conjecture that the concealment of risk in modern portfolios comprised of index-trackers and ETFs, is a dangerous mirage, and could end badly. A parallel example is how banks convinced themselves that risky mortgages were not risky if packaged together in a securitisation. That miscalculation and the derivatives built upon it led to the great financial crisis of nine years ago, threatening a systemic collapse of the entire banking system.
The removal of apparent risk by synthetic financial engineering is always an illusion, and when the investing public begins to smell a rat, baskets of seemingly riskless portfolios could be rapidly liquidated, leading to indiscriminate selling of stocks.
In a properly functioning market, where investors are driven by perceptions of entrepreneurial and economic value, lower prices are an opportunity. Today, value considerations are overwhelmed by the trend-chasers and their utilitarian investment vehicles. All that the owners of equity ETFs understand is that prices always rise, so what could go wrong? The risk that is rising interest rates, or a final stalling of credit-fuelled consumption, will undermine the trend. There will be too few buyers to stop it.
If it hadn’t been for the emergence of sovereign wealth funds and quantitative easing (central banks supporting markets by buying bonds and even equities), markets would probably have crashed already. It is the last and most extreme form of market-rigging by governments and their central banks issuing unbacked money.
The cyclical accumulation of debt
The distortion of investment returns by credit cycles is reflected visibly in the prices of securities. Less obvious is the accumulation of debt, which in parallel with financial markets has evolved its own super-cycle. Gone are the days of bank credit being expanded initially for the benefit of large businesses, followed by other businesses, and then finally for consumers borrowing a modest mortgage to buy a house. Nowadays, debt has been securitised. Banks and their associated credit vehicles feel insulated from individual risks. Money is loaned to students, partially underwritten by state and local taxes. Automobiles are sold on credit. Credit card debt is securitised as well. Consequently, on every credit cycle the amount of debt facing liquidation accumulates, and more and more ordinary people are drawn into debt earlier in the credit cycle.
Since the great financial crisis in 2007/08, student debt in the US has more than doubled, up 132%. Total consumer credit (or debt, ex-mortgages) has increased by 46%, including car loans by 40%. So, despite the greatest financial shock ever faced by consumers less than ten years ago, they have continued to accumulate debt. The other side of this debt is the assets and consumption being financed. That new neighbour, who recently paid more than you did a few years ago for a house in your street, with two new cars in the drive and frequent foreign holidays, is likely to be deeply in debt, owning nothing outright. Wealth has become a middle-class illusion.
This illusion increases on every cycle, and every cycle the innocent consumer, egged on by the financial system, in turn egged on by the central bank, believes the threat of an economic bust has been banished for ever. And with salaries not keeping pace with price inflation, easy credit has been a lifeline for the average consumer. But like every fairy-tale, not only is there a beginning and a middle to the credit cycle, there is always an end, and it’s not “they lived happily ever after”.
The end of our tale always involves a greater rescue effort from widespread insolvency than the last time it was told. Last time, the Fed’s open cheque was estimated to be worth about $13tn, on a GDP of about $14.5tn when the crisis hit. This time GDP is over $19tn, and bank credit has risen from under $9tn to $12.5tn. The Fed’s open cheque to save the system will have to be larger accordingly. This time, if it’s ETFs and index trackers that need rescuing, the prevention of another Wall Street crash would require the Fed to buy massive quantities of stocks and bonds to save the system.
Randomness is banished from banking as well
Making this credit cycle even more dangerous are the G20 meetings of finance ministers and central banks, where it is formally agreed to coordinate monetary policy. Randomness has become completely subverted to the global coordination of the credit cycle through regular group-thinking sessions at the highest level. Furthermore, the imposition of common standards on the banks through Basel II and Basel III, means the banks are loaded up with the same asset classes. By holding the same assets, all the banks are gaming the system when it comes to capital ratios, so they can pass the stress tests. Consequently, stress tests are meaningless.
For example, the European Banking Commission in 2010 stress tested 91 of the largest European banks. All the Irish banks passed, only to be bailed out four months later. A stricter stress test was devised by the ECB in 2011, which passed Dexia and Spain’s Bankia as sound, as well as the whole Cypriot banking system. Dexia, based in the Low Countries, failed within three months, Bankia was so obviously insolvent it’s a mystery how they were ever passed, and the whole Cypriot banking system collapsed two years later.i
It’s not just the Europeans either. We should take note that the global banking system has not been fixed in the ten years since the onset of the great financial crisis. Professor Dowd’s extensive work on this subject (an example of which is referred to in the end-notes) is required reading for anyone who erroneously thinks that regulation of banks removes or lessens systemic risk.
The reason this is so important is the banks are the intermediaries between the continuing increase in private sector debt and the asset prices they hold as collateral. The banks have provided the credit for their customers to inflate assets, which they take on board as collateral against loans. If the odd bank behaved like this, we would draw parallels with banking at the time of John Law’s Mississippi bubble, withdraw our deposits and say good riddance when it collapses. But all banks are doing this at the same time in multiple jurisdictions, and the systemic protection afforded by variety in banking business models, typical of free markets, is gone. Worse still, banks are pressured to standardise risk management tools and procedures, so in a crisis they are likely to make things considerably worse by taking the same avoiding action by selling the same asset classes at the same time.ii
Gone is the protection of randomness. For the regulators, who are meant to be experts in assessing and controlling bank risk, it really is a case of see no evil, hear no evil, speak no evil. They all agree with each other that they are open minded, constantly reviewing the situation, but are instead trapped by political pressures, bank lobbying and their own groupthink, which incidentally, they are quick to deny.
For the investing public seeking to protect and preserve their assets, the onset of the crisis stage of the credit cycle is always a surprise. Let’s hope that for readers of this article it will be less so.
Summary and conclusion
It is hard for even experienced analysts to appreciate the accumulation of risks that result from central banks managing the credit cycle. This is partly because of a natural inclination to believe that the Jeremiahs have been discredited by the passage of time from the last crisis. But while we can all see some obvious threats, such as a dicky Eurozone banking system, the derivatives mountain or the bank lending bubble in China, no single threat jumps out as certain to cause the collapse the world’s financial and economic system.
The threat is in the credit cycle. Credit cycles always, without fail, end in a crisis. We can say this as certainly we expect the tide to continue its ebb and flow. How the next credit crisis is expected to manifest itself is a matter of judgement, as is its timing. This article has attempted to point the reader towards a greater understanding of the factors involved, so that he or she can better judge relevant developments. If consumer prices continue to rise (US producer prices are already rising at 2.5% year-on-year), interest rates will have to rise until they cause the crisis. Same ending, every time.
The following is a summary of the main points in this article, which individually are not necessarily cause for alarm, but most probably are when taken together.
- Central banking’s monetary policies have destroyed the randomness of economic activity that with sound money leads to economic progress without meaningful disruption.
- The overriding mistake is to believe that business cycles are endemic to free markets. The cycle is one of credit imposed on the economy. Central banks have put the cart before the horse.
- Successive credit cycles accumulate debt, until there is a crisis of larger magnitude. The current cycle has been of declining interest rates since 1981, generating a valuation boom that has driven bond yields to all-time lows, and equities to all-time highs. This cycle is unlikely to survive the current trend of rising consumer prices, because of the unprecedented accumulation of private sector debt.
- The evolution of equity investment has probably reached its end-point with the widespread use of ETFs. ETFs have convinced the investing public that investment is risk-free, for the same psychological reason banks thought that securitisation of mortgages banished lending risk.
- Successive credit cycles have seen the expansion of consumer debt earlier and earlier. The result is consumer wealth is apparent rather than real, adding to the general complacency.
- The banks are stuffed full of overvalued assets, which they have helped to puff up by lending money for further purchases of the same asset classes. Market purchases by central banks and sovereign wealth funds have made financial distortions even worse.
- Regulators have compounded systemic risk, not reduced it. Their focus has been directed by internal groupthink and the construction of artificial risk criteria such as Basel II and Basel III, which fail to address risk properly. On this and capital adequacy, banks both lobby and game the system, and are considerably more fragile than regulators would have us believe.
Monetary inflation transfers wealth from most ordinary people on Main Street to the banks on Wall Street and their favoured customers. Growing numbers of ordinary people are finding it impossible to make ends meet, with their credit cards becoming maxed out. Even if interest rates do not rise, it is possible for the credit crisis to be brought on by a combination of loss of wealth and unsupportable debt. In any event, the crisis should be initially signalled by strains in the wholesale money markets.
iSee Kevin Dowd’s summary of how ineffective various bank regulators are at judging bank solvency: https://object.cato.org/sites/cato.org/files/serials/files/cato-journal/2015/9/cj-v35n3-3.pdf p.518
iiibid, p.513
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