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Reader Mike wonders how interest can ever be repaid in a credit-based economy.
Hi Mish,Exponential Math
I wonder if you would be able to comment on this from Bill Gross in For Wonks Only:
"A credit-based financial economy (as opposed to pure cash) depends on an ever-expanding outstanding level of credit for its survival. Without additional credit, interest on previously issued liabilities cannot be paid absent the sale of existing assets, which in turn would lead to a vicious cycle of debt deflation, recession and ultimately depression.
Put simply, if credit needs to expand at 4.5% per year, then the private and public sectors in combination must create approximately $2.5 trillion of additional debt per year to pay for outstanding interest."
This seems to correlate to reality 100% but the implications are stunning. It means that assets must increase in value at the rate of the original loan plus all interest payments ever made. It also means there will be a very major reversal at some point as there will be a moment when the last loan that someone will actually pay gets written and the system will not be able to expand. I always assumed that debt levels would just reach a very high plateau and stay there but Gross is saying that is not possible.
If the system we have requires the interest to be created every year (in the form of new loans) to survive that seems like the very definition of a ponzi scheme.
Do you know the mechanical reason why the interest payments need to be created by issuing new debt? It is possible, of course, that you disagree with Bill Gross but he probably knows more about how debt works than any man alive so my assumption is that you agree with his viewpoint.
I'm sure you get endless requests for articles but this is such a fundamental question I would be extremely grateful (as I'm sure would many other people) if you are able to write a reply as an article.
We are in this mess precisely because of fractional reserve lending and never-ending policy of inflation by central banks that do not seem to understand the long-term ramifications of exponential math.
I have covered the exponential math aspect before. For details, please see Money as Communication: A Purposely "Non-Educational" Fallacious Video by the Atlanta Fed.
Credit in a Gold-Backed World
There is nothing wrong with credit expansion used for productive purposes. If we had a 100% gold-backed dollar without FDIC, bad debts would be extinguished automatically.
Interest rates would be low for low-risk ventures and high for high-risk ventures, with lenders (depositors willing to lend money) taking the risk.
On high risk ventures, some projects would lose and some win, as it should be.
Importantly, no money held for safe keeping (checking deposits), would ever be at risk in 100% gold-backed system. Nor would there be any mathematical need for credit to expand exponentially forever and ever without end.
30-year mortgages might not even exist, but that would not cause any problems.
Deflation (a natural state of affairs because of rising productivity) would provide price stability central bankers now claim they want.
But that is not the world we live in.
Fiat World Math
Unfortunately, we live in a fiat world, not a 100% gold-backed dollar world. We have fractional reserve lending, and a huge mismatch in duration. Banks borrow short and lend long. It's a recipe for disaster.
Thanks to central bank encouragement and unnaturally low rates for a fiat scheme, credit is out of hand. Loans that have been made cannot possibly be paid back. Unproductive zombie companies survive only because they can roll over debt while expanding it. Covenant-lite debt now accounts for 50% of new debt issuance.
Worse yet, real wages are falling because of central bank inflationary policies in a productivity-driven world increasingly dependent on robots, not human labor.
Minimum wage laws, Obamacare, Congressional fiscal policies, Fed interest rate policies, public unions, and inflationary policies in every phase of government make it likely that companies use robots at a far faster pace than they would otherwise.
Something has to give and it will.
Debtberg Malinvestments and the Zero-Bound Problem
I asked my friend Pater Tenebrarum at the Acting Man blog to chime in on this situation. Pater writes ...
Interest is basically nothing but the discount of future goods vs. present goods. At its root, interest is actually a non-monetary phenomenon. In the modern-day fractionally reserved fiat money system, it has become possible to expand money and credit at immense rates. The reason why the debtberg was able to grow to such immense proportions is that interest rates fell for over 30 years. But now we have arrived at a critical juncture, because interest rates can no longer go any lower. The possibility to refinance existing debt again and again to lower its cost has come to an end.On the Edge of a Cliff
The size of a debt is immaterial if the debt has been used for productive purposes and is so to speak 'self-liquidating'. Imagine you are a company that borrows $200 million at 3%. If you employ this money to produce goods that have a net profit margin of 6%, the repayment of the debt plus interest poses no problem.
But a lot of debt in the system today is a "dead weight" that will produce nothing. All extant government debt is only a reflection of past spending, and the funds have been 100% consumed. The same obviously holds for consumer debt, but consumers at least have an income based on production (i.e., their work will create value in the future). The government's income relies on the production of others, which is coercively appropriated.
In the realm of corporate debt, which may be considered productive in principle, there is the problem that many of the investments that have been undertaken are really malinvestments, as economic calculation has been falsified by monetary pumping. Debt that has funded capital malinvestment is a dead weight as well, although this may only become obvious at a later stage.
So the situation is now this: debt service will now grow with every new addition to existing debt, as interest rates have arrived at their absolute lows. Given total credit market debt of $60 trillion in the US alone, it will become more and more difficult to actually produce the added value required to service this debt. There is indeed an incentive for many to play a kind of Ponzi scheme that is very similar to the government debt Ponzi. Many companies, especially the junk credits, can only survive by rolling over their debt when it comes due.
Nevertheless, Gross' calculation may be a bit too simplistic. After all, if you are a creditor and get paid interest and principal, money is only moving from A to B. It is still there, only its ownership has changed hands. The problem is that central banks believe in inflating debt away and keeping prices "stable".
In a free market economy, prices would not be stable, they would in fact decline. Thus, interest would be quite low to begin with, and every dollar would be doing more work over time (i.e., could be exchanged for more real wealth/goods/services as time passes).
So we currently have a systemic bias toward more and more debt expansion. Obviously, debt service costs in this system are slated to rise, while an offsetting creation of wealth is no longer guaranteed. You can see this from the fact that more and more new debt is added per dollar of GDP growth. So Gross is quite correct that there is a problem - the problem is the ongoing bubble. Such a bubble does indeed require a constant acceleration in debt and money supply to keep going.
Seems to me that it is a system that is coming ever closer to a cliff.
- Japan is on the edge of a cliff
- Europe is on the edge of a cliff.
- China is approaching the cliff, if not already on the edge.
- US is approaching the cliff.
No one can be sure when some country is going to fall off that cliff, but exponential finance, Ponzi financing schemes, and zero-bound interest limitations suggest the outcome is sooner rather than later. As I have stated before, a global currency crisis awaits.
Mike "Mish" Shedlock