Credit expansion and the coming global economic turmoil
By Jackson B. Miller
The bursting of a housing bubble in 2008 triggered a US financial crisis that exposed the fragility of the global banking system and necessitated massive ‘bail-outs’ (or socialisation of private corporate losses) to prevent systemic collapse. More than a decade later, increasing geopolitical tensions between world superpowers preludes another period of global economic instability.
Every financial crisis is triggered by a unique set of precipitating factors. But when the bridge collapses, you don’t lay blame on the truck that last drove across. So what is the root cause of the accumulated systemic risk in the financial system that brought us to the precipice in 2008, and once again looms large?
The answer lies in Central Bank-driven credit expansion and interest rate manipulation. This form of top-down, centrally planned economic intervention has disastrous long term effects for an economy, which we will explore.
Credit expansion refers to the creation of new money by central banks by the purchase of government debt and debt of commercial banks. This new money is injected into the economy, ‘expanding’ the total supply. Credit expansion is founded on the rationale that increasing the total monetary supply and offering cheaper credit stimulates economic growth, through consumption, spending and ease of access to capital by entrepreneurs.
In theory this appears workable, in practice it breaks down. Credit expansion and artificially low interest rates distort the market mechanism for the most important price in the economy: the price of money. This in turn disrupts economic decision-making that dictates the allocation of money between investment and savings.
Low interest rates lead individuals, corporations and governments to take on massive amounts of debt in search of return on investment, or yield. This causes a misallocation of capital, as investments, business ventures, and projects are funded that otherwise would not receive funding. Savings are strongly disincentivized, as capital saved loses its real value in a compounding manner with the annual inflation rate.
When individuals and corporations load up on debt during times of low interest rates, they become highly vulnerable to rises in interest rates. Debt can only be serviced if interest rates remain low. Above certain levels, interest repayments on debt become so burdensome that they are unable to be sustained, and bankruptcy ensues.
Periods of recession, or negative economic growth, are necessary to correct this misallocation of capital. Bankruptcy and localised failure of businesses or even sectors of the economy serves as an essential means of Darwinian selection that ensures the most efficient allocation of capital.
When the global economy faced recession, as was the case in 2008, in a natural counter-oscillation to years of overheated growth fuelled by cheap credit, central banks doubled down on expansionary monetary policies. Rather than permit such a period of negative economic growth to occur, and thus begin a process of painful but necessary recovery, countries like US and Australia opted to intervene. By lowering interest rates further they created the illusion of wealth while facilitating the ballooning of private, and corporate debt. There’s no such thing as a free lunch, and such a policy of avoidance merely increased the severity of the inevitable correction.
Credit expansion employed as a tool to prevent economic recession is similar to dosing drugs in order to prevent sleep. If wakefulness in the next 48 hours is the only relevant criterion of success, then this is a rational strategy. However, it is hardly a strategy for a long and healthy life. Similarly, government attempts to keep ‘economic growth’ going at all costs is simply sacrificing long term economic health for avoidance of recession in the short-term.
The cripplingly corrosive effects of credit expansion on the economy are multifaceted, not immediately seen, but are long term and devastating.
Credit expansionary policies disproportionately benefit financial institutions, sophisticated investors and those close to the ‘monetary spigot’. They are able to access credit at a cheaper rate than the rest of the people in an economy, and thus can deploy this newly created capital through investment and spending in an environment of pre-existing monetary purchasing power.
Corporations access this cheap credit to perform ‘leveraged share buybacks’, which removes shares from the market, pumping their price while loading the corporation with debt. CEOs then take ‘performance’ bonuses and profit from stock options, having created no new economic value.
Cheap credit is also used by the wealthy to speculate on stocks, property and fine art, which inflates asset bubbles in these markets. They do this in an attempt to avoid the purchasing power loss of money left as savings. Continuous passive price rises benefit existing asset owners to the detriment of younger generations, for whom investment and home ownership become unattainable propositions. The implications of a disaffected youth for societal cohesion do not require elaboration.
Younger generations are not the only group negatively impacted by central bank credit expansion. Newly created money dilutes the purchasing power of salary earners such as firefighters, nurses, primary school teachers, who sense a quietly creeping sense of economic injustice but lack the words to describe the phenomenon.
Perhaps most importantly, credit expansion and loose monetary policy destroys the time value of money, which unconsciously and negatively influences the economic behaviour of the entire economy. Immediate profit and immediate consumption is prioritised over long term investment and decision making. The process of civilisation-building which is founded on generational time scale thinking is ditched for immediate profit and consumption. This effect manifests fractally from the individual to the nation as a whole.
Government intervention in the free market for credit has been justified in the modern era by the need for ‘economic stability’, ’stimulation of economic growth’ and the elimination of periods of volatility or negative economic growth. An audaciously hubristic assumption is that financial markets are unable to correctly function in the absence of intervention, which central bankers provide through ‘timely’ methods of credit expansion and monetary policy manipulation.
Systemic risk in the financial system equates to the decades of accumulated tinder on the forest floor, waiting to ignite into a raging inferno. This has been caused by artificially low interest rates and credit expansion by government central banks, which creates unimaginably large amounts of misallocated capital in the form of unsustainable levels of private, corporate and sovereign debt.
In the face of inflation that occurs inevitably after credit expansion, it becomes politically impossible to raise interest rates without forcing default on loans at every level of the economy.
Today, interest rates around the world are at all time lows. During the next financial crisis, central banks will have little room to take interest rates lower without pushing them negative, a completely perverse concept by which investors are paid to take out credit. This remains a very real possibility, as the only politically palatable option is to continue credit expansion and thus inflate the real value of debt away. History provides insight into the outcomes of this approach.