Monday, February 1, 2016

Economic Efficiency Of Credit Is In Collapse

NIRP The Path To A Liquidity Trap
Negative interest rates move us down the path towards a "liquidity trap," a term that can be baffling and difficult to understand. This term has been used by Allen Greenspan and a few others, it represents a huge problem for the economy. It can have several components, but sooner or later all feedback into a loop that disrupts the flow of credit and impacts the real economy. At some point the return on loaning money to banks, governments, and others is simply not worth the risk! Why do you want to loan money if most likely you will never be repaid or repaid with something that is totally worthless? When this happens the only safe place to store wealth will be in "tangible assets" and the only lenders will be those who print the money that nobody wants.

The Negative Interest Rate Policy (NIRP) punishes savers and encourages them to spend money, it also forces banks to lend money rather than hold it and bolster their reserves. In doing so it can also increase the velocity of money. However, at some point we reach a place where too much money or currency makes it a worthless commodity. At that point banks and governments are no longer willing to pay depositors for its use. This creates a real quandary, when inflation begins to exceed the rate of interest paid. The bottom-line is that it might soon become apparent the economic efficiency of credit is in collapse and the additional money poured into the system coupled with lower rates can no longer drive the economy forward. The collapse of credit poses major problems such as what we saw when many sellers were forced to demand payment up front before shipping goods in 2008. When this happens many of our economic policy options will vanish and we are at the end game or poised for a complete economic reset.

The policy of rapid credit expansion while an interesting concept often brings with it negative consequences. Currently it is being put to the test as new problems emerge in China where we saw the extra GDP growth generated by each infusion of money drop over the last four years. This should be taken as a warning that economic exhaustion and overcapacity results from continually priming the pump. In 2014 Wei Yao from Societe Generale warned the debt service ratio of Chinese companies has reached 30% of GDP the typical threshold for financial crises. This means many companies will not be able to pay interest or repay principal. She warned that the country could be on the verge of a "Minsky Moment" when the debt pyramid collapses under its own weight. "The debt snowball is getting bigger and bigger, without contributing to real activity," she said.

The total credit in China's financial system is estimated to be as high as  221% of GDP and has jumped almost eight-fold over the last decade. This means companies will have to pay out $1 trillion in interest payments alone this year. Chinese corporate debt burdens are much higher than those of other economies. Even then it was clear that much of the liquidity that existed in China's economy was being used to repay debt and not to finance output. The fact that new investment in factories has ground to a halt is probably a good thing because China is awash in overcapacity with many new factories idle because of weak demand. This has caused a large-scale capital outflow and the exodus of hot money is disrupting world markets.

While many people clam that China's Central government carries little debt on its books and this gives the central government the option to step in if a worse case scenario develops, local governments are in big trouble. The option of bailing companies out or putting them on life support as Japan did so many years ago is not a real solution. As things get worse China has had to take action to help real estate companies and even worse recapitalize the banking system, but this will not fix all the problems. I'm forced to reflect on how debt is directly effected by interest rates. In Europe the ECB has stepped in to halt the economic collapse of Spain, Italy and several other countries that were on the brink of collapse. By instituting false super low interest rates the ECB has allowed countries to service their national debt at below free market rates that would have led to default.

What you pay in interest on debt does matter except in the current manipulated land of  Modern Monetary Theory (MMT). Believers in MMT see it as a way to remove much of the economic uncertainty ahead and guarantee the economy will always be able to muddle forward by altering and changing the procedures and consequences of how we use the government-issued tokens of fiat money.  Newly acquired tools like derivatives and currency swaps  have allow us to print and  manipulate away problems or at least postpone the ramifications. Unfortunately, the part where you collect a debt that you are owed can be similar to a mirage that keeps moving away each time you approach it. Do not forget the small print that governs most contracts often tells us rules can be changed causing many people and companies to become instantly insolvent.

The bottom-line remains, why do you want to loan money if most likely you will never be repaid or repaid with something that is totally worthless? We are abusing the large amount of wiggle room in our economic system and our ability to put off the day of reckoning only proving that we will until we can't! Modern society has become very good at kicking the can down the road and delaying the consequences of bad policy.  This means that at some point the return on loaning money is simply not worth the risk! Readers of my blog will be familiar with this argument and my strong warning that when the only lenders are those who print the money that nobody wants the only safe place to store wealth will be in "tangible assets."

Footnote; This post dovetails with many of my recent writings, for more I might suggest reading the article below. Other related articles may be found in my blog archive, thanks for reading, your comments are encouraged.


  1. The biggest borrower is government the biggest enabler is the Fed. Once real interest rates rise to a point were the fed isn't remitting its income from bond manipulation to the government everyone begins to experience owners remorse?


  2. The loaners of capital need higher rates since their economies are priced to perfection,

  3. The Fed is paying interest on excess reserves that don't circulate?
    The banks are being paid this to help them better compete against the shadow banking system forvBONDS!
    Every financial entity is looking for bonds as they unload overvalued equity?
    They are going to sea in what they can carry knowing that +5% short rates are for the history books!

  4. CBs monetising debt means they are stepping it to buy it because no-one else will.
    Debt is already way overvalued wherever CBs have done this - Japan, US, China and ECB in Italy, Spain, Portugal, Greece.
    At some point the real value of this debt will be exposed, interest rates and inflation skyrocket and holders crucified.