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Why the Financial System Will Break: You Can’t “Normalize” Markets that Depend on Extreme Monetary Stimulus

Why the Financial System Will Break: You Can’t “Normalize” Markets that Depend on Extreme Monetary Stimulus

Central banks are now trapped.

In a nutshell, central banks are promising to “normalize” their monetary policy extremes in 2018. Nice, but there’s a problem: you can’t “normalize” markets that are now entirely dependent on extremes of monetary stimulus. Attempts to “normalize” will break the markets and the financial system.

Let’s start with the core dynamic of the global economy and nosebleed-valuation markets: credit.

Modern finance has many complex moving parts, and this complexity masks its inner simplicity.

Let’s break down the core dynamics of the current financial system.

The Core Dynamic of the “Recovery” and Asset Bubbles: Credit

Credit is the foundation of the current financial system, for credit enables consumers to bring consumption forward, that is, buy more stuff today than they could buy with the cash they have on hand, in exchange for promising to pay principal and interest with their future income.

Credit also enables speculators to buy more assets than they otherwise could were they limited to cash on hand.

Buying goods, services and assets with credit appears to be a good thing: consumers get to enjoy more stuff without having to scrimp and save up income, and investors/speculators can reap more income from owning more assets.

But all goods/services and assets are not equal, and all credit is not equal.

There is an opportunity cost to any loan (i.e. credit), as the income that will be devoted to paying principal and interest in the future could have been devoted to some other use or investment.

So borrowing money to purchase a product or an asset now means foregoing some future purchase.

While all products have some sort of payoff, the payoffs are not equal. If I buy five bottles of $100/bottle champagne and throw a party, the payoff is in the heady moments of celebration. If I buy a table saw for $500, that tool has the potential to help me make additional income for years or even decades to come.

If I’m making money with the table saw, I can pay the debt service out of my new earnings.

All assets are not equal, either. Some assets are riskier than others, with a less certain income stream or payoff. Borrowing to buy assets with predictable returns is one thing, buying assets with highly speculative returns is another; regardless of the eventual result of the investment, the borrower still has to pay interest on the debt, even if the speculative investment goes bust.

The basic idea here is the loan is based on collateral, that there is something of value that is anchoring the loan above and beyond the borrower’s ability to pay principal and interest.

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