Article by Ben Doolin on Feb. 12, 2016
No doubt you’re familiar.
In this new century… we’ve already seen two cycles and are headed into the deflationary portion of the third.
So, why does it happen?
John Maynard Keynes was an Nobel Prize winning economist. His ideas were gleefully grasped by politicians… because they liked half of his theory… and could ignore the rest.
His theory was that the economic health of a nation was based on ‘aggregate demand’. That is, the more people spend, the better… even if that meant more debt or destruction of wealth that resulted in spending (like war or natural disaster).
The theory suggests that, The State should be responsible for smoothing economic cycles by borrowing and spending more during downturns… then using the increased revenue from the shortened downturn to pay off the debt incurred.
So, politicians LOVED the idea of ‘spending for no specific reason’ as this the definition of ‘pork barrel spending’… and is how they buy votes and earn bribes (campaign contributions). They also understood that they would never reduce the national debt… so could ignore the ‘pay it back’ part of the theory.
The result of the embrace by politicians was that anyone that did not fall into line with the Keynesian theory… was unnecessary. This meant that you had little chance of turning an economics degree into a career.
So now… world wide… Keynesian theory is completely embedded.
Another world wide trend, is policies that continue to fail. Decade after decade… with the only explanation that economists can come up with… is that they ‘didn’t go big enough’. They could never question the theory… even though it consistently failed for decades, because it supports spending… one of the primary motivations of politicians.
In the US, after running interest rates to zero (rates being the traditional tool to meddle in markets)… Ben Bernanke (then Fed chief) proposed and executed a ‘new tool’ to force interest rates even lower… Quantitative Easing (QE).
In this program, mortgages and government bonds were purchased in the open market. Purchasing large quantities of bonds increases the price. Interest rates on bonds move inversely to the price… so as the price climbs… the effective rate drops. Since many loan rates are directly or indirectly based on government bond rates… the cost to borrow was pushed lower.
The purchase of mortgages had a similar effect. By buying mortgages, the ‘price’ of the mortgage backed securities goes up… and the corresponding interest rate goes down… as well as additional liquidity being pumped into the mortgage market.
The additional impact of further lowering the interest rate on bonds… was that investors looking for any significant return were forced into equities. That pushed stocks higher which creates a ‘wealth effect’ which usually leads to more spending.
The whole goal was to promote ‘aggregate demand’… even if people had to borrow to spend now.
One serious problem with that goal… is that borrowing to spend… is simply ‘stealing’ future economic activity. It doesn’t increase anything… it just time shifts it… reducing future economic activity and also reduces total activity in the ‘non-financial sector’ by reducing purchasing capacity by the cost of interest paid.
The end result of the perpetual low cost credit is mal-investment. Bad decisions are made, capital expansion (business investment) is made (which is what is desired by the Keynesians)… but those expansions are made into false expectations of a ‘strong economy’. So, production begins, then production expands past consumption. Inventories begin to build since the economic strength wasn’t real… and eventually… inventories need to be liquidated. Being forced to sell below cost (the beginning of the deflationary cycle) is followed by reduction in production, lay offs, plant closures and bankruptcies.
In a free market, when individuals save for retirement… they seek the best return within their ‘safety comfort zone’. As more people save… the price of money (the interest rate) drops as savers compete to ‘lend’ to ‘safe’ borrowers. So, a low interest rate is a real signal (in a free market) that there is increased future demand. So, businesses should, in that environment… look to borrow cheap money to expand… into a market that will be growing.
Central banks… taking the ‘short cut’ of artificially manipulating rates… fool business into an expansion… where there is no ‘pent up or deferred demand’. So, instead of resulting in a solidly growing economy… the result is a bust… and bankruptcies.
Interest rates failed. QE… failed. Up next… is negative interest rates.
The idea is that if your money is constantly becoming worth less… you’ll be more motivated to spend it immediately. Unfortunately the existence of physical cash is a problem. People will just hold all of their wealth outside the financial system, which could collapse the system. This is a current and growing problem for the Euro Zone… with more than a trillion Euros held in cash for fear of instability in their financial system that has resulted in capital controls (Greeks were limited to $60 per day) and ‘bail ins’. So, to go along with negative interest rates… physical cash… will need to be eliminated.
Government loves this idea too… as electronic transactions are much easier to tax.
Could be that the current rout is forestalled by negative rates… but the longer the delay to resolution… the larger the final collapse.
I also expect ‘this collapse’ to be not just your ordinary 7ish year cycle… but a multi-decade super cycle coming to an end.
Individuals, businesses and nations are at peak debt meaning there is no more ‘future activity’ to be stolen. Regulation (would take 30,000 years to read and added to at the rate of 300 pages per day) makes new business or expansion near impossible. Central Bankers are out of tricks and are losing the confidence of The People.
A financial system without faith… can not last.