Doing Everything Wrong
by Sean Corrigan
[Posted November 13, 2001]
Despite yet another half-point cut in interest rates from three of the world
's more important central banks--as well as various reductions from a host
of their satellites--the noose is gradually tightening around banks and
financial institutions everywhere, not just in the Asia, but in the U.S.,
Europe, and Canada, too, as news arrives of multiple increases in loan loss
provisions, matched by default rates on corporate bonds which climb ever
nearer to post-Depression highs.
This clearly demonstrates how widespread is the banking tug-of-war between
the beneficial cash flow impact to be expected from artificially lowered
funding costs, steeper yield curves and higher bond prices, and the
detrimental effects of past poor lending decisions and VC follies on profits
and, more importantly, capital.
Not that the effects will be confined to those nations. Consider that the
latest data for the UK show that lending to the household sector has
increased 1.75 times as fast as disposable income this past year, taking the
debt ratio to nearly 108 percent in the process.
In Australia, too, for much of the past year, credit to individuals has
accounted for fully three-quarters of all lending, and has similarly
outstripped income gains, having grown at 10.3 percent in a year. It is not
just in the U.S. that overstretch is endemic.
We have said before that whereas capital is the loan of the fruits of past
labor, credit is a promise of labor to come. Making that promise in any
form, in isolation from prior saving, can cause distortion enough, but when
individuals give that pledge, they are usually doing it for the sole purpose
of extra consumption.
Since we argue that consumption is the destruction of value (not the source
of whatever "effective demand" is supposed to mean), extra consumption
implies that we are not only destroying value currently being created--and
so reducing the surplus that can go to replacing and augmenting the pool of
productive resources which originally gave rise to the goods we consume--but
that we must be eating into past value as well.
Such past value can only be stored, of course, in one form: capital.
Ergo, consumer credit, unmatched by consumer savings, helps destroy capital
and so lessens the ability to provide for future consumption.
In essence, you can't have your Tomorrow and eat it.
This means we must look askance at the joy that has greeted the advent of
zero-interest auto loans and question the deeper implications of yet another
wave of mortgage refinancing to be triggered by secularly low interest rates
on both sides of the Atlantic.
Adding in this element of consumer finance tends to exacerbate the standard
business cycle phenomenon, whereby the extension of too much nonsaved credit
to producers artificially lowers the rate of interest, making marginal
projects appear profitable while confusing those producers into thinking
that this lower rate signals that there is sufficient slack in the system
for them to be able to complete their undertakings in line with their
This latter tends to misallocate capital by distorting both the time and
price structure of production, and the more credit involved, the greater the
likely scale of errors. Indeed, if individuals are not only not saving more,
but actually borrowing themselves, for the purposes of ready gratification,
they are making the miscalculation both more likely and more costly.
So, we have a situation where one sector is consuming capital and the other
sector is probably misusing what little there is left.
Look at U.S. GDP. Net capital accumulation has undergone a 30-percent plunge
in five quarters, the second steepest fall since WWII.
The financial craziness in the wildcat 1980s took this net capital
accumulation to its nadir at the depths of the 1991 slump, to its lowest
peacetime proportion of GDP since the Great Depression. The recovery back to
median values (gerrymandered by statistical redefinition as it may have
been), came thirteen long years after it first dropped below them.
Alas, we are already back in the downwave after what we were told was a
miracle, but which seems to have been little more than a mean reversion. We
can only guess how much damage has been done to the patient's constitution
by the libertine lifestyle he enjoyed while his disease was in remission
during the Bubble.
Depressions unfold over years, even decades, much like global conflicts.
Those of us wedded to the ticker tape and twenty-four-hour rolling news
would do well to recall that once in a while, in the effort to make sure
that the minutiae of daily tactics do not blind us to the broad sweep of
Eventually, all this discoordination ends in calamity. End products cannot
be sold at a price to cover the costs of input and rent: those inputs
themselves, being competed for more fiercely than was reckoned, cost more to
begin with. Businesses stumble. They strive to shed costs by reining in
expenditure and investment and laying off workers.
The structure of production not only shortens as capital goods and raw
materials industries scale back in favor of firms providing consumer goods
and services, causing the flow of corporate revenues to fall, but, if the
problem is big enough and the rigidities are too insurmountable, overall
production shrinks, and with it income as well.
Two things must be noted. Capital has been consumed and misused. Everyone
would surely be forced to concur that the sooner we cease the first and the
quicker we attempt to correct the second, the better it will be for all of
Instead, what do we find? Interest rates are slashed, reserves are injected
by the central bank, and the mindless chant--"The economy depends on the
consumer, the economy depends on the consumer"--is repeated over and over
again, as if a farm thrives on the crows pecking at the corn, or as if a
boat can be saved from foundering by washing it over the levee on a flood
Every extra dollar borrowed by a consumer now puts us all a dollar further
from recovery, the debtor a dollar closer to default, and his bank a dollar
closer to a bigger loan loss provision than it would have had to face by
foreclosing while there was still something to be salvaged.
Every extra million dollars borrowed by a producer now puts us a million
dollars further from recovery, as the company gets a million dollars with
which to freeze up suboptimally used capital, to engage in a price war, to
hoard labor and so to drag down its leaner, but perhaps less creditworthy,
competitor. This also takes its bank, or bondholder, a million dollars
closer to losses not only there, but elsewhere in their stable of industrial
borrowers, weakened by the lingering death of our lame duck.
All this would be bad enough, but we have government in the game. Even
without the war itself, we have U.S. duties on lumber and tariffs on steel,
we have farm aid and airline cash, we have increased welfare payments and,
in the UK and Australia, public-sector recruitment drives. We have workweek
restrictions in the likes of France and proposals to increase the minimum
wage in several countries.
Even without the war, we are doing everything wrong that the
Hoover-Roosevelt-McDonald governments and the Strong-Norman bankers did in
the 1930s, after their long decade of easy money and paper prosperity
imploded under the weight of too much debt and too great a strain on real
capital resources. Frustrating the market mechanism can cause it to seize
completely. Rarely can a complex watch be forced to a different rhythm
without irreparable damage to its delicate mainspring and levers.
All traders know the injunctions, "Cut your losses" and "Never add money to
a losing trade," and the traders themselves know that the surest way to swap
places with the Wall Street shoeshine boy is to fight against the market's
natural dynamic of searching for a clearing price.
Might it not be possible for the policymaking elite to take such
incontestable rules of thumb from financial markets and transplant them to
their doings in the wider world?
Sadly--if their obsession with price-fixing and manipulation in oil futures
and gold bullion, in forex and short-term interest rates, in stock indexes
and now long Treasury bonds, is any guide--they cannot.
Apres lui le deluge, we might say.
Sean Corrigan is a principal of www.capital-insight.com, a London-based
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