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Regular readers of Goldmoney’s Insights should be aware by now that the cycle of business activity is fuelled by monetary policy, and that the periodic booms and slumps experienced since monetary policy has been used in an attempt to manage economic outcomes are the result of monetary policy itself. The link between interest rate suppression in the early stages of the credit cycle, the creation of malinvestments and the subsequent debt dénouement was summed up in Hayek’s illustration of a triangle, which I covered in an earlier article.^[i]

Since Hayek’s time, monetary policy, particularly in America, has evolved away from targeting production and discouraging savings by suppressing interest rates, towards encouraging consumption through expanding consumer finance. American consumers are living beyond their means and have commonly depleted all their liquid savings. But given the variations in the cost of consumer finance (between 0% car loans and 20% credit card and overdraft rates), consumers are generally insensitive to changes in interest rates.

Therefore, despite the rise of consumer finance, we can still regard Hayek’s triangle as illustrating the driving force behind the credit cycle, and the unsustainable excesses of unprofitable debt created by suppressing interest rates as the reason monetary policy always leads to an economic crisis. The chart below shows we could be living dangerously close to another tipping point, whereby the rises in the Fed Funds Rate (FFR) might be about to trigger a new credit and economic crisis.

living danger 1

Previous peaks in the FFR coincided with the onset of economic downturns, because they exposed unsustainable business models. On the basis of simple extrapolation, the area between the two dotted lines, which roughly join these peaks, is where the current FFR cycle can be expected to peak. It is currently standing at about 2% after yesterday’s increase, and the Fed expects the FFR to average 3.1% in 2019.

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Living Dangerously

June 15, 2018

Living Dangerously

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The Role of Shadow Banking in the Business Cycle

June 11, 2018

THE ROLE OF SHADOW BANKING IN THE BUSINESS CYCLE

1The process of lending and the uninterrupted flow of credit to the real economy no longer rely only on banks, but on a process that spans a network of banks, broker-dealers, asset managers, and shadow banks funded through wholesale funding and capital markets globally. – Pozsaret et al., 2013, p. 10

I. Introduction

According to the standard version of the Austrian business cycle theory (e.g., Mises, 1949), the business cycle is caused by credit expansion conducted by commercial banks operating on the basis of fractional reserve.2Although true, this view may be too narrow or outdated, because other financial institutions can also expand credit.3

First, commercial banks are not the only type of depository institutions. This category includes, in the United States, savings banks, thrift institutions, and credit unions, which also keep fractional reserves and conduct credit expansion (Feinman, 1993, p. 570).4

Second, some financial institutions offer instruments that mask their nature as demand deposits (Huerta de Soto, 2006, pp. 155–165 and 584–600). The best example may be money market funds.5 These were created as a substitute for bank accounts, because Regulation Q prohibited banks from paying interest on demand deposits (Pozsar, 2011, p. 18 n22). Importantly, money market funds commit to maintaining a stable net asset value of their shares that are redeemable at will. This is why money market funds resemble banks in mutual-fund clothing (Tucker, 2012, p. 4), and, in consequence, they face the same maturity mismatching as do banks, which can also entail runs.6

Many economists point out that repurchase agreements (repos) also resemble demand deposits. They are short term and can be withdrawn at any time, like demand deposits. According to Gorton and Metrick (2009), the financial crisis of 2007–2008 was in essence a banking panic in the repo market (‘run on repo’).

…click on the above link to read the rest of the article…

Austrian Economics Is Essential to Understand Booms, Busts, and Money Itself

May 25, 2018

Austrian Economics Is Essential to Understand Booms, Busts, and Money Itself

The boom-and-bust business cycle is a natural result of free-market capitalism, but rather of government intervention.

Looking to the next few years, will America and the world continue to ride a wave of economic growth, improved living standards, and technological changes that raise the quality of life? Or will this turn out to be, at least partly, an artificial economic boom that ends in another economic bust?

Reading the economic tea leaves is never an easy task. But the Austrian theory of the business cycle offers clues of what may be in store. In 1928, the famous Austrian economist Ludwig von Mises published a monograph called Monetary Stabilization and Cyclical Policy. It was an extension of his earlier work, The Theory of Money and Credit (1912).

Many things have happened, of course, over the last nine decades—the Great Depression, the Second World War, the Cold War, the end of the Soviet Union, roller coasters of inflations and recessions, replacement of gold with paper monies, the dramatic expansion of the welfare state, and an era of government debt fed by deficit spending to cover the costs of political largesse.

Then, as today, many governments were busy manipulating the supply of money and credit.

Yet, the laws of economics have not been overturned. As a result, like causes still bring about like effects. Minimum wage laws still price some workers out of the labor market whose value added to the employer is less than what the government dictates he must be paid. Rent controls and restrictive zoning laws create housing shortages when government interferes with market-based pricing.

Mises’ Monetary and Business Cycle Analysis Still Relevant Today

This is no less the case in the area of money and banking. When Mises published Monetary Stabilization and Cyclical Policy in 1928, most of the major countries of the world where still on some version of the gold standard.

…click on the above link to read the rest of the article…

Reflections on Late-Stage Inflation

May 19, 2018

Reflections on Late-Stage Inflation

Without a doubt, we are in a period of late-stage inflation. But how long can it last?

A few days ago I noted that “inflation expectations” were the same or nearly the same for every period from seven years through thirty.

Actually, the thirty-year expectation was slightly less than the 10-year expectation. For discussion, please see Traders Expect Less Inflation Over a 30-Year Period than a 10-Year Period.

I do not think much of inflation expectations but the Fed strongly believes in them, and so do some others.

Pater Tenebrarum at the Acting Man blog commented “I agree . It is typical for the late stage of the business cycle, you get price inflation going, but it cannot last long. Note though that at some point (depending on central bank actions in response to the next bust and contingent circumstances) there could be a tipping point toward another stagflation period.”

Tenebrarum emailed two links where he discussed the setup.

Part 1 Snips

Ben Hunt, author of Epsilon Theory and chief risk officer of Salient Partners, mentioned a specific narrative that has accompanied quantitative easing for almost a decade now (even longer, if we take Japan into account). At first glance it appeared reasonable enough: central bankers argued that QE would help increase “inflation”. This is of course unequivocally true in terms of monetary inflation, but they referred to consumer price inflation. Alas, both CPI and inflation expectations obviously failed to respond appreciably to their ministrations. Ben posits that this narrative may be set to falter in a rather unexpected manner, by continuing to defy widespread expectations.

…click on the above link to read the rest of the article…

An Inflation Indicator to Watch, Part 3

March 10, 2018

An Inflation Indicator to Watch, Part 3

“During the 1980s and 1990s, most industrial-country central banks were able to cage, if not entirely tame, the inflation dragon.”
—Ben Bernanke

Ben Bernanke began his oft-cited “helicopter speech” in 2002 with a few kind words about his peers, including the excerpt above. Speaking for central bankers, he took a large share of the credit for the low inflation of the 1980s and 1990s. Central bankers had gained a “heightened understanding” of inflation, he said, and he expected the future to bring even more inflation-taming success.

Of course, Bernanke’s cohorts took a few knocks in the boom–bust cycle that followed his speech, but their reputations as masters of inflation (and deflation) only grew. Today, the picture he painted seems even more firmly planted in the public mind than it was in 2002, notwithstanding recent data showing inflation creeping higher.

Public perceptions aren’t always accurate, though, and public figures aren’t the most reliable arbiters of credit and blame. In this 3-part article, I’m proposing a theory that challenges Bernanke’s narrative, and I’ll back the theory with data in Part 3. I’ll show that it leads to an inflation indicator with an excellent historical record.

But first, let’s recap a few points I’ve already discussed.

The Endless Tug-of-War

In Part 2, I said inflation depends on a tug-of-war between purchasing power (on the demand side) and capacity (on the supply side), and the war takes place within the circular flow, in which spending flows into income and income flows back to spending. Two circular-flow patterns and their causes demand particular attention:

When banks inject money into the circular flow in the process of making loans, they can boost spending above the prior period’s income, thereby fattening the flow (or the opposite in the case of a deleveraging).

…click on the above link to read the rest of the article…

The Real Engine of the Business Cycle

March 5, 2018

The Real Engine of the Business Cycle

A valuable lesson from the Great Recession is that credit-supply expansions play a key role in subsequent recessions. When lenders make credit more available or more affordable, households respond by taking on debt, which drives up aggregate demand – that is, until the music stops.

CHICAGO – Every major financial crisis leaves a unique footprint. Just as banking crises throughout the nineteenth and twentieth centuries revealed the importance of financial-sector liquidity and lenders of last resort, the Great Depression underscored the necessity of counter-cyclical fiscal and monetary policies. And, more recently, the 2008 financial crisis and subsequent Great Recession revealed the key drivers of credit-driven business cycles.

Specifically, the Great Recession showed us that we can predict a slowdown in economic activity by looking at rising household debt. In the United States and across many other countries, changes in household debt-to-GDP ratios between 2002 and 2007 correlate strongly with increases in unemployment from 2007 to 2010. For example, before the crash, household debt had increased enormously in Arizona and Nevada, as well as in Ireland and Spain; and, after the crash, all four locales experienced particularly severe recessions.

In fact, rising household debt was predictive of economic slumps long before the Great Recession. In his 1994 presidential address to the European Economic Association, Mervyn King, then the chief economist at the Bank of England, showed that countries with the largest increases in household debt-to-income ratios from 1984 to 1988 suffered the largest shortfalls in real (inflation-adjusted) GDP growth from 1989 to 1992.

Likewise, in our own work with Emil Verner of Princeton University, we have shown that US states with larger household-debt increases from 1982 to 1989 experienced larger increases in unemployment and more severe declines in real GDP growth from 1989 to 1992.

…click on the above link to read the rest of the article…

Are Subprime Debt Slaves, a Leading Indicator, Worrying the Fed?

March 5, 2018

Are Subprime Debt Slaves, a Leading Indicator, Worrying the Fed?

Credit problems always appear first at the margins.

The new Fed remains a somewhat unknown quantity: There are still four vacancies on the Fed’s seven-member Board of Governors that forms the core of the policy-making FOMC. The new Chairman, Jerome Powell, has already shown in his testimony before Congress last week that he may use a little more straight talk than his predecessors, and the markets took notice.

No one knows for sure what this new Fed will look like once the four vacancies are filled. But this new Fed will likely try to push interest rates back to a somewhat more normal level and lighten their balance sheet so that they have some options when the business cycle trips over balled-up credit problems.

With consumers, the credit problems appear first among the most fragile, most at risk, and most strung-out – borrowers with subprime credit ratings, and with lenders that went after these consumers aggressively. And this is happening now.

Small banks pushed with all their might into credit cards, loosening credit standards, lowering credit score requirements, raising credit limits, and offering new cards to people who had already maxed out their existing cards and had limited or no ability to service them from their income, and no way of paying them off – and thus are stuck with usurious interest rates that make these credit card balances impossible to service.

For small banks it was the Holy Grail: to profit from the American debt slave.

There are about 4,888 commercial banks in the US. There are the top 100 banks, and there are the 4,788 smaller banks – those with less than $14 billion in assets. These smaller banks have seen this irresistibly sweet deal. Banks were paying next to nothing in interest to their depositors, but they could charge 25% or 30% interest on outstanding credit card balances.

…click on the above link to read the rest of the article…

When Will the Next Credit Crisis Occur?

February 23, 2018

WHEN WILL THE NEXT CREDIT CRISIS OCCUR?

The timing of any credit crisis is set by the rate at which the credit cycle progresses. People don’t think in terms of the credit cycle, wrongly believing it is a business cycle. The distinction is important, because a business cycle by its name suggests it emanates from business. In other words, the cycle of growth and recessions is due to instability in the private sector and this is generally believed by state planners and central bankers.

This is untrue, because cycles of business activity have their origin in the expansion and contraction of credit, whose origin in turn is in central banks’ monetary policy and fractional reserve banking. Cycles of credit are then manifest in variations of business activity. Cycles are the cause, booms and slumps the consequence. It follows that if we understand the characteristics of the different phases, we can estimate where we are in the credit cycle.

With sound money, that is to say money that neither expands nor contracts, cycles in business activity cannot exist, except for plagues and wars which interrupt the balances between money-hoarding, saving and consumption. Any exceptions to this rule are bound to be insignificant and non-cyclical, because with a steady money supply, failures are random instead of cyclically clustered by monetary policy.

Capital is always allocated by entrepreneurs to favour the efficient production of the goods and services wanted by consumers. Allocations of earnings and profits to savings are set by entrepreneurial demands for monetary capital to finance production until the goods and services produced are sold. Failures, the result of errors of judgement by entrepreneurs, are inevitable, but are quickly accepted, and capital is redeployed accordingly.

…click on the above link to read the rest of the article…

How Easy Money Is Rotting America from the Inside-Out

February 9, 2018

How Easy Money Is Rotting America from the Inside-Out

How much of our gleaming new infrastructure will fall into disrepair?

The Federal Reserve has been the main cause of business cycles in America since 1913. For several decades, it has tried to hide the consequences of its policies by enabling easy credit during each recession. As Jonathan Newman wrote yesterday, pouring trillions of dollars into the financial sector obscures the external signs of the recession such as low asset prices and high unemployment and promotes economic malinvestment.

This malinvestment creates the conditions that cause the next recession. Some of the consequences of the Fed’s policies, such as stock market and housing bubbles can be directly attributed to its policies. In other cases, the artificially low interest rates and other “easy money” policies foster an “infrastructure rot” that erodes the efficiency of the American economy, the standard of living of consumers, and eats away at American infrastructure. These effects are difficult to trace back to the Fed’s policies, so let’s concretize some examples to understand how Federal Reserve policies affect America.

At the city level, low interest rates allow cities to fund new public projects such as parks and bridges. While this may seem fine and dandy, all infrastructure projects have a maintenance cost. It’s not sufficient to build a park. One must also have the money to maintain it every year. If there is not enough revenue to pay for maintenance, the park will literally rot until the playgrounds fall apart, the lawns are overgrown, the lights fail, and the park becomes too dangerous for families to play in.

The same thing will happen to streets, bridges, and plumbing. This is one of the ways urban decay happens: easy money policies fund unsustainable urban infrastructure projects which make politicians look good, but end up crumbling a few years or decades later.

…click on the above link to read the rest of the article…

A Stock Market Tumble Is the Correction We Need

February 8, 2018

A Stock Market Tumble Is the Correction We Need

The Fed put us in this predicament. Only the market can get us out of it.

Since hitting rock bottom in 2009, stock prices have consistently increased without much volatility — that is, until these first few days of February when the Dow Jones Industrial Average fell over 2,200 points (-8.5%) and the S&P 500 tumbled 7.9% from their late-January highs. The most popular measure of stock market volatility, VIX, also spiked dramatically to levels not seen since 2011 and 2009.

Financial analysts and writers have pointed to a few events that may be behind the big movements in the stock market:

Tax reform could have caused some extra uncertainty about the future for all businesses.
Bond markets indicate an increase in future price inflation, which means that the cost of doing business could increase.
The increase in expected inflation coupled with a new, optimistic-looking release of official data on wages across the US might be used by the Federal Reserve to justify further interest rate hikes.

But to really get to the bottom of the current stock market decline, we need to go back to the Federal Reserve’s response to the 2007-08 crisis.

Unprecedented Monetary Policy

During that financial and economic collapse, the Federal Reserve responded in unprecedented ways. We saw the biggest expansions of credit and the lowest interbank lending rates ever.

(The blue line above shows the Federal Reserve’s balance sheet expansions. The red line is the Federal Funds Rate, or the rate banks pay each other for loans. It is viewed as the basis for all other loan rates in the US. Together, these show the unprecedented expansionary monetary policy of the Fed in response to the most recent recession.)

…click on the above link to read the rest of the article…

Central Banks Put a Safety Net Under Financial Markets

January 29, 2018

Central Banks Put a Safety Net Under Financial Markets

Most early business cycle indicators suggest that the global economy is pretty much roaring ahead. Production and employment are rising. Firms keep investing and show decent profits. International trade is expanding. Credit is easy to obtain. Stock prices keep moving up to ever higher levels. All seems to be well. Or does it? Unfortunately, the economic upswing shows the devil’s footprints: central banks have set it in motion with their extremely low, and in some countries even negative, interest rate policy and rampant monetary expansion.

Artificially depressed borrowing costs are fueling a “boom.” Consumer loans are as cheap as ever before, seducing people to spend increasingly beyond their means. Low interest rates push down companies’ cost of capital, encouraging additional, and in particular risky investments – they would not have entered into under “normal” interest rate conditions. Financially strained borrowers – in particular states and banks – can refinance their maturing debt load at extremely low interest rates and even take on new debt easily.

By no means less important is the fact that central banks have effectively spread a “safety net” under financial markets: Investors feel assured that monetary authorities will, in case things turning sour, step in and fend off any crisis. The central banks’ safety net has lowered investors’ risk concern. Investors are willing to lend even to borrowers with relatively poor financial strength. Furthermore, it has suppressed risk premia in credit yields, having lowered firms’ cost of debt, which encourages them to run up their leverage to increase return on equity.

…click on the above link to read the rest of the article…

Is There a Way Out of This Financial Mess?

September 25, 2017

Is There a Way Out of This Financial Mess?

We need to open the door to the future but that is only possible by understanding the past. Paul Volcker back in 1979 in his Rediscovery of the Business Cycle “Not much more than a decade ago, in what now seems a more innocent age, the ‘New Economics’ had become orthodoxy. Its basic tenet, repeated in similar words in speech after speech, in article after article, was described by one of its leaders as ‘the conviction that business cycles were not inevitable, that government policy could and should keep the economy close to a path of steady real growth at a constant target rate of unemployment. … But it was not until the events of 1974 and 1975, when a recession sprung on an unsuspecting world with an intensity unmatched in the post-World War II period, that the lessons of the ‘New Economics’ were seriously challenged.”

It gives me no please to point out all out problems. My objective is straight forward. If we understand what is unfolding and why, then we can apply the correct solutions rather than turn toward more government authoritarian control. Make no mistake about this, we are in a battle for our freedom. This era of “New Economics” was set in motion by Karl Marx who advocated that government could control the economy and thus create Utopia. While Russia embraced the Communism of Marx, the West adopted his position trying to be just a little bit pregnant. We rejected everything that Adam Smith discovered and the Invisible Hand, rushing into Socialism for it empowered government rather than the private sector and Laissez–faire.

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Policy Makers, like Generals, Are Busy Fighting The Last War

January 22, 2017

Policy Makers, like Generals, Are Busy Fighting The Last War

The Maginot Line formed France’s main line of defense on its German facing border from Belgium in the North to Switzerland in the South. It was constructed during the 1930s, with the trench-based warfare of World War One still firmly in the minds of the French generals. The Maginot Line was an absolute success…as the Germans never seriously attempted to attack it’s interconnected series of underground fortresses. But the days of static warfare were over – in 1940, the Germans simply drove around the line through Holland and then Belgium. Had the Germans replayed WWI and made a direct attack, the Maginot Line likely would have done its job. But Hitler wasn’t interested in a WWI re-do, so the fortifications were quickly rendered moot. France, Europe, and the world would pay the price for generals fighting the last war rather than adjusting to the contemporary risks they faced.

In 2008, the economic generals at the various central banks likewise pulled out the playbook to refight the great depression…not realizing, this time was an entirely different opponent. Federal governments and central bankers presumed doing what they had always done would again win the day. Cut interest rates (this time to zero) to incent both public and private entities to refinance existing debt loads and undertake new, greater leverage. This nearly free money would reduce debt service levels and the new loans would ignite a new wave of economic activity in the form of capital expenditures and small business creation. Economic multipliers and velocity would ensure general prosperity with job and wage growth. Instead, it’s the “Maginot Line” all over again for our economic generals as economic activity grinds to a stall absent the illusory asset bubbles.
BTW – if you are not a fan of charts or visual representations…this is not the article for you and likely best to stop here.

…click on the above link to read the rest of the article…

Why This Oil Crisis Is Different To 2008

July 17, 2016

Why This Oil Crisis Is Different To 2008

They say history repeats itself, and given the cyclical nature of the oil and gas business, many look to the past when trying to guess what is coming next, but past experience doesn’t always offer an exact model for the present.

Much has changed between the 2008 oil and gas downcycle and the one the industry is currently working through today. The drop in oil prices that started in 2008 took place against the backdrop of the Global Financial Crisis, aka The Great Recession. Economies all around the world sputtered to a halt, and demand for oil dropped. Lehman Brothers filed for bankruptcy protection on September 15, 2008. It was the all-time largest bankruptcy filing.

Oil prices dropped from historic highs of $144.29 in July 2008, to $33.87 five months later. OPEC, the world’s traditional “swing crude oil producer,” took its traditional actions, cutting production by 16 percent in eight months to bring stability to global prices, which was led primarily by the group’s largest producer, Saudi Arabia. Crude oil consumption and production dropped by 1.5 percent and 1.2 percent, respectively, before coming back to parity from 2008 to 2010. U.S. producers pulled back on drilling operations until prices began to improve, switching from conventional drilling to horizontal drilling following the 2008 crash. And except for the banks and car companies, there wasn’t much going on at the bankruptcy court house by the E&P or OilService (OFS) companies.

In aggregate, debt-to-EBITDA for the E&P companies was approximately 1.6x, and the average capital efficiency (EBITDA per BOE divided by finding and development costs per BOE) was 230 percent, while for the OFS sector debt-to-EBITDA was 0.9x, while capital intensity (capital expenditures divided by EBITDA) was 62 percent. The companies, in general, had the cash and balance sheet to work through another downward descent in the 7th commodity cycle since 1981.

…click on the above link to read the rest of the article…

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