What can be added to the happiness of a man who is in health, out of debt, and has a clear conscience?
— Adam Smith – Economist
consumer-loan.gif

a few simple words that will change your life - 'credit' and 'debt'        

huh?

 

In the past, banks rarely made ‘consumer loans’; loans for motor car finance, household goods credit deals, credit cards or personal loans as they do today because there is no good security for these loans. Banks generally offered only short-term commercial loans that were fully covered by the value of the assets being financed and they never had to rely on the good faith of the borrower. The banks simply facilitated the finance by standing between the buyer and seller. The idea of a 20-30 year or even a 10-5 year loan was anathema (meaning ‘distasteful’) to sound bankers of the past. A building society might grant a 25 year mortgage to one of its members, with a very significant deposit as down payment; that’s because, although it’s an asset class with value, property is not easily converted into cash quickly, and as we have found out… property can and does on occasion go down in value! Motor car loans and household goods used hire purchase agreements with high initial deposits, relatively high interest rates and one or two year periods unlike today with five or more years loans, interest free and with many special offers.

A friend without a lions head carpet isn’t a friend for long.

A friend without a lions head carpet isn’t a friend for long.

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.
— Ludwig Von Mises

In our modern day we have been taught and encouraged to purchase all we need by using credit unlike past generations who saved up for whatever they needed and paid cash. Saving required a certain degree of discipline, deferring gratification was accepted as a lifestyle where shortages were common and personal goods scarce, created by a regular cycle of wars following the industrial revolution in the 18th century. Today, economies have grown into what has become a ‘consumer society’ where the goal is to ‘out-buy’ our neighbors and display our wealth in a wide range material form. Some blame the ‘Boomers’, the post war bulge of babies, which became the focus of industrialists and merchants to exploit the emerging market for consumer goods financed by never-ending credit. The ‘live-now, pay-later’ mantra of the 1950-60s may well have been instigated by the ever-present threat of Nuclear Armageddon, worsened by the cold war, between the Anglo-American Empire and the USSR eastern block of countries.

No moral issue is intended here; merely an observation that in general the banks and financial elite exploited the advantages offered by unprecedented economic expansion, full employment and the technological advances of the second half of the 20th century. The ‘Boomers’ were allowed to gorge themselves on virtually unlimited, easy credit and enjoy the material delights of excess purchasing power encouraged by the banks loaning out far more than was neither prudent nor responsible. Acknowledging the degree to which responsibility had been forsaken by the banks, there is even a clause in the Consumer Protection (Amendment) Act 2002, which allows for a defense of ‘irresponsible lending’ by a financial institution on the assumption that they should have known beforehand that the borrower would be unlikely to repay the loan.

What? This isn’t your pad!

What? This isn’t your pad!

A culture has emerged with the idea of having to ‘live within ones means’ is unacceptable and even an attack on fundamental ‘human rights’, ignoring of course the concurrent ‘responsibilities’. People have learned that they have a right to have whatever they want now, with little in the way of responsibility, and as a consequence there are inadequate general ‘saving’ levels and poor provision for pensions in later life. Many people are led to believe that the modern ‘high finance ethic’ is not just normal, but essential for society to function today, and they are probably right. Gigantic banks have become big business that requires big credit to make big profits, generally without considering the adverse effects on an individual’s lifestyle, and often causing extreme distress within families and work places.

This is just one of your mansions! Uh… right?

This is just one of your mansions! Uh… right?

The genuine way to become wealthy is by producing more than you consume, and saving the difference. This is a principle which has persisted since time began but has been distorted by the owners of wealth who have instituted financial systems to prey on the frailties of human nature. Credit comes in many ‘forms’, and contains hidden pitfalls for the unwary and those unaware of the devious and cunning strategies used by bankers to lure the financially uninformed into excessive payments and penalties.

Remember, when we speak of ‘bankers’, it’s not the tellers behind the window at the bank.

Later parts of this course describe how personal money management can mitigate the worst effects of debt; in this lesson however, we examine how national, regional, local government and financial institutions have also been entrapped in the odious results of excessive debt and irresponsible credit management.

Over 20% of most Western economies (GDP) is financial in nature. It is real madness that politicians and the financial oligarchy are spending trillions of dollars bundling, swapping, repackaging and trading imaginary money using only promises to pay. As we have discovered money is essentially a medium of exchange and in a sound-money economy it became a store of ‘virtual’ wealth.

It becomes problematic when ‘money’ becomes the basis of a gigantic industry doing deals between themselves just to book imaginary, paper profits.
— Heard on a golf course somewhere...

We might ask: “What is the nature of debt?” A common definition is: “”Debt is future consumption denied.” It is the opposite of: ‘delaying gratification’. But debt is not only about consumption. We have already witnessed, in the lesson about ‘money’, how production and economic development needs to be financed by offering credit to the producers before they receive their income, this is the very nature of commerce and is at the heart of any economy no matter what political system is used. When you take on debt it should create an income stream that services the debt and repays the principle; when it fails to do this it becomes negative for economic growth. Consumers rarely see the difference between borrowings to consume and borrowing to invest, because most of us do not invest borrowed money, we use various means to extend our consumption through loans. Granted we recognize a house as an investment these days but in reality a house is just somewhere to live and strictly should be regarded as a home. We also ‘invest’ in pension schemes, stock markets and other financial vehicles designed to grow our asset base but not usually with borrowed money.

Governments however have no money of their own and they do not produce anything either. They raise finance mainly through taxation and, in theory, redistribute it throughout the economy but can raise much more than just tax income. They do this by issuing IOUs (US government bonds or UK gilts) through the central banking system and use these funds to expand government spending and investment in infrastructure and politicians’ ‘pet’ projects. Governments ought to balance their expenditure against tax income and bonds issued but rarely do. Politicians are as much, if not more, susceptible to over-borrowing and over-spending than you or I. The gap or total accumulated deficit in government spending is known as the ‘National Debt’ and is the subject of lessons 4 and 5 describing how government raises funds, manages its budgets, finances and the workings of government bond markets.

Credit is offered by banks and financial institutions and borrowers take on the debt. The price of debt is interest. The target national interest rate (the base rate) is set by the central bank, but is always at the mercy of financial markets which determine the actual rate of interest by ‘trading’ government bonds on a daily basis in the bond markets. These are massive markets with billions and trillions traded each day. The central bank ‘buys’ the government bonds with newly created ‘money’ (which then goes to fund government budgets) using ‘digital’ money by the government account at the bank being credited with the required amounts. The bank then auctions these bonds, on the bond market, to the highest bidder; buyers are mainly major banks, institutional investors and high net-worth individuals who are seeking a fixed interest rate return on their money. The workings of these markets are covered in Lesson 7, if you’re bold enough to go there!

A primary function of the Fed and the Bank of England is to keep interest rates in line with their target rate (0.5% in 2013) and they do this by purchasing any surplus bonds not bought by investors at the bond market auctions. The higher the demand for bonds the higher the price and therefore the lower the market price the interest rate. If demand falls, as happened in 2008, the central bank has to purchase more bonds to keep the interest rate low and this is the basis of Quantitative Easing (QE) when markets collapsed and investors became nervous about increased risk in the bond market. Because government bonds are unlikely to default they are considered risk-free and represent the lowest rate of interest within any economy. However, governments have been known to default at regular intervals and bondholders have suffered losses as a consequence; an example of which happened recently in Greece.


Ros Altmann, a pension manager and director of the London School of Economics says that quantitative easing has amounted to a: “monumental social experiment“; it is a large-scale transfer of wealth from older people to younger people.
“Anybody who was a saver and had some accumulated savings will have had a reduction in their income, while anyone who had a big debt, particularly mortgage debts, would have had an improvement in their income because their interest payments would have gone down”.

In fact, older people would probably have been better off if they had abandoned prudence and borrowed more; this is obviously not what the central bankers or our political leaders want, but this is the unintended consequence they’ve created.

In an interview in his Ottawa office, the previous Bank of Canada governor, Mark Carney, defended quantitative easing and his own ‘low-interest rate’ policy though he does acknowledge that it has been hard on pensioners and savers. In common with many central bankers he argues there have been consequences but that if QE had not been implemented things would have been far worse. It is not possible to imagine what would have happened had central bankers done nothing and allowed free markets to correct the inherent imbalances created by the 2008 crisis; although it is fairly certain that financial markets, and with them the bankers, would have suffered considerable losses. The introduction of QE at the extreme levels being operated in 2013 is unprecedented in history. ShopSquawk has an inkling of an idea, but really… what the long term effects will be is very difficult to ascertain.


The U.S.A. has been pumping USD 85Bn per month into the financial markets since the announcement of QE3 in September 2012. In 2013, the Federal Reserve is testing the markets by hinting that they will begin reducing this support just to get a feel for the market’s reaction. Every time in the recent past when money printing has ceased the markets have fallen and caused the Fed to institute yet another cycle of QE (again… ‘QE means: Quantitative Easing – a fancy name for ‘we’re printing money to pay our bills’). However the U.S.A. has not been acting alone but uniquely has cooperated with the BoE, ECB and Bank of Japan (BoJ) among others to coordinate their QE policy on a global basis so as to minimize the negative effects of a reduction in the exchange rate of the USD with other currencies.

The central bankers’ intention was for QE to ‘kick-start’ economies and save the bankers from severe losses if they were exposed to open market forces. This has been achieved, but the economies have responded with only a weak ‘recovery’ and a return to ‘business as usual’ have escaped their grasp. High unemployment and ‘slow-to-no’ growth, especially in the West, is forcing policymakers and central bankers to rethink their strategies at group meetings held around the globe, known variously as: G7, G8, G20, and G-String (OK, not the last one). The biggest risk is for a rise in inflation, dispersing around the world like a bad virus (or smell), particularly reflecting in increased prices for essential, basic commodities and food products and lowering living standards for everyone.


Inflation is not the only risk upon which bankers are gambling. The level of government debt is important too because if it begins to exceed the Gross Domestic Product (GDP) of a country, there is a risk that rising interest rates will cause government spending to increase beyond a manageable level. This is already happening in USA, UK and Europe as well as many other countries around the world.

By printing money and using it to buy government bonds, central bankers are in effect financing an increase in government spending and expecting politicians to voluntarily rein in their budgets!

But governments will have to eventually balance their books, and the longer this is delayed, the worse will be the final effect on the general economy. That said, if you know what’s going on, you might be able to avoid the lower standards of living that will cross the globe.

The champagne doesn’t stop flowing!

The champagne doesn’t stop flowing!

Unlike companies, governments cannot become bankrupt because they can always create more money out of nothing to pay their debts… although the effect of too much debt is to cause interest rates to rise (squeezing governments’ budgets and causing a fall in taxes), and an increase in government expenditure (to service higher interest payments on the national debt as well as increased costs of welfare and unemployment). Thus recessions are created and austerity measures applied. While everyone else has to ‘tighten their belts’ the richest one percent can continue to party. “The rich get richer, the poor get stuffed – that’s all you need to know”; so goes a little known poem, and it supports the old adage: ‘money makes money’ allowing inequality of income and assets to grow. Unfortunately this is a feature of all capitalist systems; even the bible describes the parable of the ‘talents’ and shows that if money is not put to use it becomes of little value. However, putting money to use always involves risk at some level and this is where the financial markets offer a meeting place for everyone who wishes to buy or sell debt, both government, consumer and corporate debts.

Companies and financial institutions raise finance in the form of debt by issuing bonds and other financial instruments all designed to increase the return on their money stocks and make profit. Banks are mainly involved in facilitating these issues and collect fees and commissions for doing so. The problem is to be able to measure what is a manageable level of debt and which is too risky. This was thought to be solved in the 1990s by J.P.Morgan Chase, the leading US investment bank, who developed a formula called ‘Value at Risk’ (VaR) which could be used to assess the probability of a debt defaulting, i.e. becoming a ‘bad debt’ or ‘non-performing loans’ [NPL]).

 

You will be tested and whipped if you don’t remember everything you just read!

 

High and rising bad debts are a death knell to banks which causes them to rein in lending to preserve capital, charge higher interest rates and create onerous lending terms and conditions. In turn, business enterprises are forced to cut back on their future plans and even reduce their workforces.

If there is one market that represents the sheer unbridled lack of respect for credit risk it is the Greek Government bond (GGB) market. In 2012, GGB prices have surged 380% from under EUR 14% to almost EUR 67%. This represents a plunge in yields from over 29% in May 2012 to a mere 8% in mid 2013. In comparison US Treasuries yielded 8% in 1994 and we have to ask what is driving all this exuberance to buy GGB? Much of the data indicated the Greek economy had worsened from a year ago measured by unemployment to GDP growth.

This indicates the toxic nature of too much bad debt because there comes a time when the levels become so unmanageable that governments begin to default on their obligations, banks become insolvent and begin to eye the depositors’ and pension funds’ money sitting there ready to grab at short notice.

Did you just forget that ‘NPL’ means ‘non-performing loan’? If so, stop reading and do 25 jumping jacks!

As of 2016 it seems that there is no consensus about debt levels and their effect on general economic health. The nearest anyone has got to pinning down a reasonably acceptable number is fully analyzed by leading economists: Carmen M. Reinhart & Kenneth S. Rogoff in their book “This Time is Different” published in 2009. This excellent research has sparked, in 2013, a vitriolic, venom spewing battle between these economic titans and a leading Nobel Prize winning economist, Prof. Paul Krugman who supports the general idea that government debt doesn’t matter and thus any computed level is irrelevant. Since the USA is the most indebted country in the world, measured by the amount owed now approaching USD 18Tn, it tends to be the focus of the published data and economic statistics upon which so much of the financial and political world rely. The fact that the debt level is worsening at the rate of some USD1Tn per year makes finding a solution all the more urgent.

The world’s future is dependent, to a large extent, upon the outcome of these debates which will set monetary and fiscal policies for many years into the future. It will be the coming generations, and especially Gen X (beginning birth dates from the early 1960s to the early 1980s), who will be seriously affected by the actions taken in the coming months and years. It is they who will be in most need of understanding the completed picture of our jigsaw puzzle. Debt, in all its forms, is at the core of the global problem and to fully appreciate the many implications of financial policies being proposed today, which will adversely affect our individual lives, requires a great deal of dedication in an attempt to understand the issues described here.

If you’re Gen Y and Z you’re not getting out without scars! Better put on your ‘unlearning’ and ‘re-learning’ armor.
— a mouse

By economic convention, the degree of risk attached to levels of sovereign debt is measured by reference to national GDP. Unfortunately, as is common in all economic theory, confusion arises because much depends upon what is determined to be ‘the national debt’ although GDP measurement is generally more robust. A nation’s debt can include a range of government obligations which are mainly assessed by reference to the commitment measured over time. For example: pension funds have massive reserves today but are not required to pay out pensions immediately, they become future obligations over many years. It is much the same with our individual money management thinking. It can be frightening to think that you or your parents have a $150,000 loan to repay against the home but spread over 25 years at the rate of say, 4% per annum, our monthly payment is reasonable, we don’t often think about the total outstanding debt.

This normal, human thinking process is no different for our political and financial masters who are happy to dismiss major financial burdens if they’re more than five years away; it is short-term thinking and created in part by our election cycle. We Americans are fond of using the well-worn mantra: ‘kicking the can down the road’ which you may have heard on occasion. ShopSquawk has avoided including charts and graphs as far as possible because the objective is to paint a word picture of a jigsaw puzzle. We believe this will help to form a deeper understanding of the subject.

Diverting briefly however; Edgar Dale claims (supported by psychological research) that we remember:

10% of what we read
20% of what we hear
30% of what we see
50% of what we see and hear
70% of what we discuss with others
80% of what we personally experience
95% of what we teach others

ShopSquawk makes no apology for presenting this chart of the extreme USA government and private debt levels as an aid to understanding:

Note the difference between public debt (red – government debt) and private debt (blue). Since 2007 (the start of the Great Recession) private debt as a percentage of US GDP has reduced by 40%; this is known to economists as ‘deleveraging’. The difference has been totally made up by the 40% increase in public debt which can only have come from printing money (QE) to compensate for the massive US government annual spending deficits. The overall US economy has not fundamentally deleveraged by simply reversing the increase in debt during the 2008 Great Recession, which was expected to be only short-term, but has maintained levels at or near the start of the Great Recession indicating that no progress on debt reduction has been made.

This is the essence of the current, raging debate about debt levels and where they should be to maintain a sustainable economy and avoid further economic crises. Too much debt reached a pinnacle in 2007 and the resultant crash created the extreme economic conditions we see today; yet our financial masters continue to pile debt upon debt as a supposed solution. The global economy is relying more than ever on the “full faith and credit” of the U.S. government; we have now taken on much more debt in all economies throughout the world but we have no idea what limits should be applied before another crisis occurs; the economists and policy makers are ‘flying blind’ – it is all a grand experiment and a dangerous one at that.

Does this remind you of the famous quote from Albert Einstein? 

Insanity is doing the same thing over and over again and expecting different results.

Truth is, he never said this… but it sure sounds good ; )

The sad conclusion is that many of those who chose to rise above us and have the power to change our lives for the better are displaying such a total lack of common sense that ‘human stupidity’ can be the only plausible cause.

 

                     Who is who?

                     Who is who?

 

Einstein again sums up this proposition:

Two things are infinite: the universe and human stupidity; and I’m not sure about the universe.

Anyhow, to get back to what we were talking about 5 or 6 paragraphs ago, the final result of Reinhart & Rogoff’s calculations was their proposition that, when government debt grows beyond 90% of GDP, the stability of national economic structure becomes unstable. Their book provides a history of financial crises in their various guises; their basic message is simple: we have been here before. Using clear, sharp analysis and comprehensive data, they document that financial fallouts occur in clusters and strike with surprisingly consistent frequency, duration, and ferocity. They examine the patterns of currency crashes, high and hyperinflation, and government defaults on international and domestic debts; they include the cycles in housing, share prices, capital flows, unemployment and government revenues surrounding these crises. While countries do weather their financial storms, Reinhart and Rogoff prove that short memories make it all too easy for crises to reoccur. They offer an essential step toward improving our global financial system, both to reduce the risk of future crises and to better handle catastrophes when they happen.

 

There is much more to understand about government debt and how it is created and is the subject of Lesson 5 about government. Before we go deeper into the beginnings of public debt we need to understand more about how public and private debt is managed. This corner stone of the global financial jigsaw puzzle is the subject of the next lesson about central banks and their pivotal role within the overall system of global finance.