How is is possible that everybody is so bullish on stocks and the global economy? The picture is clear and it is not a colourful Monet paint. It reminds more of Pablo Picasso masterpiece Guernica. Indeed the loose monetary policy of central banks has given upwind to the global economy but the boom is not sustainable. It is mainly based on cheap loans and the debt levels raising. The next major crash is just a matter of time. Sure a whole series of economic indicators indicates that production and employment are continuing to grow. This development was probably due to the loose monetary policy by the central banks but to look with Sherlock Holmes eyes we can see dark clouds on the horizon.
We will look at 3 major factors in this context:
- Central banks have cut market rates to extremely low levels. In Europe and Asia we have even negative interest rates. Debtors are able to refinance their due liabilities through new loans on a low interest rate. In this way, borrowers are given new credit to stimulate overall economic demand.
- The central banks have signaled to the financial market that there will in future no longer be unintentional payment losses by over-extended state and bank debtors. This has been the result of the lack of credit in the credit market – the heart of the Fiat money system. Investors now expect the central banks to stand by in an emergency to help stumbling borrowers and provide them with any desired credit and money. The major central banks provide the market participants with a free insurance, a “central bank put”.
- The interventions by the central bank have significantly altered the investor behavior: the risk for investors has decreased significantly. Investors are again ready to invest their money in investments – and hope that the central bank will come to a rescue in case of problems. (This is also referred to as “Moral Hazard”). Only in this way is it easy to explain that overstretched borrowers – such as banks – get new loans without any problems, at historically very low interest rates.
Central Banks are a major player in the credit markets
In all major currency areas, the total balance sheet ( the sum of the central bank plus the commercial bank balance) is expanding. This is an infallible sign of the direction of the monetary policy: in recent years they have intervened in the market in order to finance what the commercial banks can no longer finance or do not want to finance. As a result, they have specifically prevented a shrinkage of the entire outstanding credit and money supply and thus also prevented the economic consequences of such a development.
However, the central banks have become more and more an active player in the credit markets. They are no longer confined only to lend to the commercial banks. They filling the role of the commercial bank more and more themselves, for example by directly purchasing debt securities from states, banks and companies (and paying purchases with new created money). The “classical separation” between the central bank on one side of the hand and the commercial banks on the other is not visible anymore.
Central banks have an interest in inflation
As a result an ever-increasing credit volume is being raised on a given equity base. As a result, the loss of payments, should be avoided if it can be absorbed without jeopardizing the banks’ liabilities against their creditors and depositors. On the other hand, the central banks are on the brink of being on fire: they now have a significantly increased credit risk against states and commercial banks. This increases the political incentive for the central banks to expand the money supply (to inflate) in order to prevent payment default with their borrowers.
The current economic recovery should not hide the fact that the economies are still in a boom-bust cycle. The reason: the uncovered Fiat money. Central banks, together with the commercial banks, continually increase the money supply through bank lending. More precisely, the amount of money is increased by bank lending, which is not covered by real savings! This lowers the market interest rate to below its “natural level” (the level that would occur if no artificial credit and monetary growth were allowed).
Companies are enticed to unprofitable investments
The artificially lowered interest rates encourage companies to start new investment projects. It is attractive for consumers and the states to live on the pump. The economy is starting to pull. Sooner or later, however, companies are beginning to realize that investments are not expected – either because the prices of production factors are rising more than originally calculated or because the “hope-for demand” for the products does not materialize. Companies will begin to reduce unprofitable investments and Jobs are canceled. People will end on the streets.
The economy, which has experienced an artificial upturn (boom) as a result of the initial credit and monetary deposit, coupled with artificially lowered interest rates, falls into a downturn (Bust). In an effort to ward off the approaching recession depression (which in economic terms is in fact a correction of the previous capital failures), central banks are cutting the interest rate further and trying to keep the inflow of credit and money flowing. There is a succession of boom-and-bust because also the recent interest rate cuts and credit and monetary increases ultimately also end in a bust. This economic insight has a current relevance: the world economic recovery is – as mentioned at the outset – produced by an unprecedented historically low-interest policy. There is a lot of evidence that the economies are moving back into a “boom”, which is followed by a bust.
It is not possible to predict with certainty when the next bust will begin and what will trigger it. However, with regard to the functioning of the Fiat money system, some “critical elements” can be identified that deserve to be observed more closely.
- the interest rate
- the steepness of the interest rate curve,
- the development of bank loans,
- the scarcity of banks’ own capital, and
- the stock of non-performing loans.
Rising interest rates
It hardly needs to be explained that rising interest rates are turning the boom into a bust. Rising interest rates have the same effect as a shutdown of the engine, which has stimulated the artificial economic expansion. The fact that the major central banks such as the US Federal Reserve (Fed) and the European Central Bank (ECB) are trying to raise interest rates is, without doubt, the huge danger of bringing the boom closer to the next bust.
Deflation of the yield curve
For the profits of the banks, it is advantageous if the long-term interest rates are above the short-term interest rate (if the interest curve is “steep”). They can then lend long-term loans with short-term funds – thus improving their profitability. A flat (or even inverse) interest curve, on the other hand, acts as a step on the “credit brake”. In recent years, interest rates in the US and Eurozone have tended to be flattened, but they are still relatively steep and favor the banks’ lending operations. If the central banks raise interest rates, the picture is likely to change: the interest curves become flatter.
Slowdown in lending expansion
As a matter of fact, the bank loan expansion brings new money (out of nowhere) into the economic cycle, which is driving the boom. If the inflow of money fails, the boom is stalled, or it tumbles into a bust. To date, the increase in money through bank lending has been (and still is) the most important form of money production in many countries – and growth rates are still positive.
Scarcity of banks’ own capital
In order to produce credits and money, banks need not only the central bank money they receive from the central bank. They also need equity. Finally, they are required to provide equity capital for their risk positions (loans and securities). Equity banks can procure themselves by retaining profits and / or by a capital increase from the outside. The former presupposes that banks can make profits, the second requires the willingness of investors to invest their money in banks. Banks have improved their capital base over the last few years – also by reducing their balance sheet in total relative to equity.
It is part of the banking business that loans fail. However, it becomes problematic when the distressed loans take over (in example the loans for which the debtors have fallen into arrears or are no longer able to afford their interest and redemption payments). Then the bank’s (typically thin) equity ceiling is quickly absorbed. This is also the reason why the bust is causing so much trouble in a highly indebted economy: it threatens the solvency of the banking apparatus. In many countries, problem loans remain relatively high.
The question is when will it happen
There are a lot of possible triggers for the bursting of the price bubble – geopolitical crises, oil price shock, credit losses, etc. Ultimately, however, the functioning of the international credit machine decides whether the current upswing will continue or break down and turn into a bust. For this reason, the current efforts of the US Federal Reserve (Fed) are of particular importance. As the world’s leading central bank, it is particularly determined by the liquidity and credit cost conditions in the international and thus national financial markets. There is caution required as the Fed has triggered the two last financial market bubbles – the stock market crash 2000/2001 and the great financial crisis 2008/2009. Till now the financial market participants are very “relaxed”. The volatility is at its lowest level in years. Dow Jones, SP500 and DAX are at all time highs. The saying “Let the music play till it never stops” is more than true. Banks, Investors are seeking for more and more return of investments but the collapse is a question of time. Till then enjoy the music it might will be the last in a while.