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Explaining the Credit Cycle

EXPLAINING THE CREDIT CYCLE

This article summarises why the credit cycle leads to alternate booms and slumps. It is only with this in mind that they can be properly understood as current economic conditions evolve.

The reader is taken through three monetary models: a fixed money economy, one governed by changes in bank credit, and finally the consequences of central bank intervention.

Classical economics provided the basis for an understanding of the effects of bank credit expansion. The theory, embodied in the division of labour, eluded Keynes, who was determined to justify an interventionist role in the economy for the state.

 Neo-Keynesian policies have been responsible for growing monetary intervention. This article serves as a reminder of the distortions introduced by the credit cycle and why central bank monetary policies are fundamentally destructive of the settled economic order that exists without monetary expansion.

Defining the problem

The credit cycle drives the business, or trade cycle. It should be obvious that changes in the quantity of money, mostly in the form of bank credit, has an effect on business conditions. Indeed, that is why central banks implement a monetary policy. By increasing the quantity of money in circulation and by encouraging the banks to lend, a central bank aims to achieve full employment. Other than quantitative easing, the principal policy tool is management of interest rates on the assumption that they represent the “price” of money.

But there is also a cyclical effect of boom and bust, linked to changes in the availability of bank credit, and so modern central banks have tried to foster the boom and avoid the slump.

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

The new deal is a bad old deal

The new deal is a bad old deal

So far, the current economic situation, together with the response by major governments, compares with the run-in to the depression of the 1930s. Yet to come in the repetitious credit cycle is the collapse in financial asset values and a banking crisis.

When the scale of the banking crisis is known the scale of monetary inflation involved will become more obvious. But in the politics of it, Trump is being set up as the equivalent of Herbert Hoover, and presumably Joe Biden, if he is well advised, will soon campaign as a latter-day Roosevelt. In Britain, Boris Johnson has already called for a modern “new deal”, and in his “Hundred Days” his Chancellor is delivering it.

In the thirties, prices fell, only offset by the dollar’s devaluation in January 1934. This time, monetary inflation knows no limit. The wealth destruction through monetary inflation will be an added burden to contend with compared with the situation ninety years ago.

Introduction

Boris Johnson recently compared his reconstruction plan with Franklin D Roosevelt’s New Deal. Such is the myth of FDR and his new deal that even libertarian Boris now invokes them. Unless he is just being political, he shows he knows little about the economic situation that led to the depression.

It would not be unusual, even for a libertarian politician. FDR is immensely popular with the inflationists who overwhelmingly wrote the economic history of the depression era. In fact, FDR was not the first “something must be done” American president, a policy which started with his predecessor, Herbert Hoover. But the story told is that FDR took over from heartless Hoover who had failed to step in and rescue the economy from a free-market catastrophe, by standing back and letting events take their course instead.

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

Coronavirus and credit – a perfect storm

Coronavirus and credit – a perfect storm 

This article posits that the spread of the coronavirus coincides with the downturn in the global credit cycle, with potentially catastrophic results. At the time of writing, analysts are still trying to get to grips with the virus’s economic impact and they commonly express the hope that after a month or two everything will return to normal. This seems too optimistic.

The credit crisis was already likely to be severe, given the combination of the end of a prolonged expansionary phase of the credit cycle and trade protectionism. These were the conditions that led to the Wall Street crash of 1929-32. Given similar credit cycle and trade dynamics today, the question to be resolved is how an overvaluation of bonds and equities coupled with escalating monetary inflation will play out.

This article sees worrying parallels with the collapse of John Law’s Mississippi scheme exactly 300 years ago. By tying in the purchasing power of his livres to the value of his Mississippi venture, Law ensured they both collapsed together in the space of only six months.

The similarities with our Keynesian experiment are too great to ignore. Could a simultaneous collapse of fiat currencies and financial assets happen again? If so both the money bubble and financial asset bubble could be fully deflated into worthlessness by this year’s end.

The epidemic

“Ring-a-ring o’ roses / A pocket full of posies / A-tishoo! A-tishoo! / We all fall down.”

Some folk attribute this old nursery rhyme to the plague in England of 1665. But it seems singularly appropriate for coronavirus or COVID-19, about which, as yet, we know little. Its origin is, allegedly, a mutation of a virus from a snake, bat or pangolin. Alternatively, one school of thought believes it escaped from a biological warfare laboratory in Hunan.

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

Central Bank “Stimulus” is Really a Huge Redistribution Scheme

Central Bank “Stimulus” is Really a Huge Redistribution Scheme

When an economy turns from expansion to contraction there is an order of events. The first signs are an unexpected increase in inventories of unsold goods, both accompanied with and followed by business surveys indicating a general softening in demand. For monetarists, this is often confirmed by an inverting yield curve, which tells them that at the margin the short-term rates set by the central bank are becoming too high for business conditions.

That was the position for the US 10-year bond less the 2-year bond very briefly at the end of August, since when this measure, which is often taken to predict recessions, has turned mildly positive again. A generally negative sentiment, fueled mainly by the escalating tariff war between America and China, had earlier alerted investors to an international trade slowdown, expected to undermine the American economy in due course along with all the others. It stands to reason that backward-looking statistics have yet to reflect the global slowdown on the US economy, which is still buoyed up by consumer credit. The German economy, which is driven by production rather than consumption is perhaps a better guide and is already in recession.

After an initial hit, a small recovery in investor sentiment is understandable, with the negative outlook perhaps having got ahead of itself. But we must look beyond that. History shows the combination of a peak in the credit cycle and tariffs can be economically lethal. A brief return to a positive yield curve achieves little more than a sucker rally. It may be enough to put further monetary expansion on pause. But when that is over, and jobs begin to be threatened, there can be no doubt that central banks will ramp up the printing presses.

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

“Psychologically, They’re Ill-Prepared” – Canadian Chaos Looms

“Psychologically, They’re Ill-Prepared” – Canadian Chaos Looms

Via Grant’s Almost Daily,

I’m your huckleberry

“U.S. hedge funds from time to time have appeared in this country over the last 10 years, with the same hypothesis of shorting Canadian banks, and it hasn’t worked out very well for them,” Brian Porter, CEO of the Bank of Nova Scotia, said yesterday. “There are always going to be those that take an opposing view, and we’ll prove them wrong over the long term.”  

Gabriel Dechaine, banking analyst at the National Bank of Canada, likewise came to his industry’s defense in a note today:

“A trend that is making us believe that sector sentiment is becoming too bearish is the re-emergence of a vocal ‘short Canada’ investment crowd.”

Dechaine writes that a Stanley Cup victory for the woebegone Toronto Maple Leafs (last title, 1967) is more likely than a jump in loan losses. 

One well-known investor is publicly taking the challenge: Steve Eisman, portfolio manager at Neuberger Berman and a protagonist in Michael Lewis’ The Big Short.

“Canada has not had a credit cycle in a few decades and I don’t think there’s a Canadian bank CEO that knows what a credit cycle really looks like,” Eisman, who is short various Canadian banks and mortgage lenders, fired back in an interview yesterday with BNN Bloomberg television.

“I just think psychologically they’re extremely ill prepared.”  

While Canadian bank advocates and their skeptics exchange words, the formerly-white hot housing market is now in deep freeze. March sales in Vancouver collapsed by 31.4% year-over-year according to the local real estate board, the worst showing since 1986 and down 46% from the 10-year average for March. Prices also lurched lower, with the benchmark detached home price falling 10.5% year-over-year to C$1.44 million ($1.08 million). Things are more stable in Toronto, where March sales and benchmark prices were little changed from a year earlier, but those figures remain 40% and 14% below their respective levels from March 2017.

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

The Arrival of the Credit Crisis

Those of us who closely follow the credit cycle should not be surprised by the current slide in equity markets. It was going to happen anyway. The timing had recently become apparent as well, and in early August I was able to write the following:

“The timing for the onset of the credit crisis looks like being any time from during the last quarter of 2018, only a few months away, to no later than mid-2019.” [i]

The crisis is arriving on cue and can be expected to evolve into something far nastier in the coming months. Corporate bond markets have seized up, giving us a signal it has indeed arrived. It is now time to consider how the credit crisis is likely to develop. It involves some guesswork, so we cannot do this with precision, but we can extrapolate from known basics to support some important conclusions.

If it was only down to America without further feed-back loops, we can now suggest the following developments are likely for the US economy. Warnings about an economic slowdown are persuading the Fed to soften monetary policy, a process recently set in motion and foreshadowed by US Treasury yields backing off. However, price inflation, which is being temporarily suppressed by falling oil prices, will probably begin to increase from Q2 in 2019. This is due to a combination of the legacy of earlier monetary expansion, and the consequences of President Trump’s tariffs on consumer prices.

After a brief pause, induced mainly by the threat of an unstoppable collapse in equity prices, the Fed will be forced to continue to raise interest rates to counter price inflation pressures, which will take the rise in the heavily suppressed CPI towards and then through 4%, probably by mid-year.

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

2019: The Beginning Of The End (Free Premium Report)

2019: The Beginning Of The End (Free Premium Report)

What will happen next & what to do now

Welcome to our new readers and a very Happy New Year to everyone!

Now that it’s 2019, we’re going to start the new year here at Peak Prosperity by responding to the wishes of our premium subscribers and making our most recent premium report free to everyone.

For those unfamiliar with our work, it’s based on the idea that humanity is hurtling towards a disaster of our own making.  Several powerful and unsustainable trends are all converging towards an ever-narrowing gap in the future.

Because of this, the individual and collective choices we make today take on ever-increasing importance.  Our collective choices — around such issues as rampant money-printing by central banks, the failure to wean ourselves off of fossil fuels, and tossing an entire younger generation under the bus because that’s most convenient for an older generation afraid of living within its actual means — are all pointing to a diminshed and disappointing future. We need to make better choices that align ourselves with these (and many other) looming realities.

This is our work here at Peak Prosperity.

For ten years now, we’ve been pointing out the many predicaments society faces. And we will continue our vigilance.  No because we enjoy crisis, or that we relish delivering hard messages, but because these are the times in which we live — and those, like you, who are awake to reality, need unvarnished facts and data to make informed decisions.

So we offer to you, today, a peek behind our premium subscription curtain.  The people who subscribe to our work do so to make themselves more resilient, as well as to support Peak Prosperity financially as we carry on our mission of “Creating a world worth inheriting”, which invoves bringing difficult messages to reluctant audiences.

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

The Arrival Of The Credit Crisis

The Arrival Of The Credit Crisis

Those of us who closely follow the credit cycle should not be surprised by the current slide in equity markets. It was going to happen anyway. The timing had recently become apparent as well, and in early August I was able to write the following:

“The timing for the onset of the credit crisis looks like being any time from during the last quarter of 2018, only a few months away, to no later than mid-2019.” [i]

The crisis is arriving on cue and can be expected to evolve into something far nastier in the coming months. Corporate bond markets have seized up, giving us a signal it has indeed arrived. It is now time to consider how the credit crisis is likely to develop. It involves some guesswork, so we cannot do this with precision, but we can extrapolate from known basics to support some important conclusions.

If it was only down to America without further feed-back loops, we can now suggest the following developments are likely for the US economy. Warnings about an economic slowdown are persuading the Fed to soften monetary policy, a process recently set in motion and foreshadowed by US Treasury yields backing off. However, price inflation, which is being temporarily suppressed by falling oil prices, will probably begin to increase from Q2 in 2019. This is due to a combination of the legacy of earlier monetary expansion, and the consequences of President Trump’s tariffs on consumer prices.

After a brief pause, induced mainly by the threat of an unstoppable collapse in equity prices, the Fed will be forced to continue to raise interest rates to counter price inflation pressures, which will take the rise in the heavily suppressed CPI towards and then through 4%, probably by mid-year.

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

Every Bubble Is In Search Of A Pin

Every Bubble Is In Search Of A Pin

The ‘Everything Bubble’ has popped

Now that the world’s central banking cartel is taking a long-overdue pause from printing money and handing it to the wealthy elite, the collection of asset price bubbles nested within the Everything Bubble are starting to burst.

The cartel (especially the ECB and the Fed) is hoping it can gently deflate these bubbles it created, but that’s a fantasy. Bubbles always burst badly; it’s their nature to do so. Economic suffering and misery always accompany their termination.

It’s said that “every bubble is in search of a pin”. History certainly shows they always manage to find one.

History also shows that after the puncturing, pundits obsess over what precise pin triggered it, as if that matters.  It doesn’t, because ’cause’ of a bubble’s bursting can be anything.  It can be a wayward comment by a finance minister, otherwise innocuous at any other time, that spooks a critical European bond market at exactly the right (wrong?) moment, triggering a runaway cascade.

Or it might be the routine bankruptcy of a small company that unexpectedly exposes an under-hedged counterparty, thereby setting off a chain reaction across the corporate bond market before the contagion quickly spreads into other key elements of the financial system.

Or perhaps it will be the US Justice Department arresting a Chinese technology executive on murky, over-reaching charges to bully an ally into accepting that unilateral US sanctions are to be abided by everyone, regardless of sovereignty.

How was it that the famous Tulip Bulb bubble came to a crashing end back in the 1600’s?  No one knows the exact moment or trigger. But we can easily imagine that in some Dutch pub on the fateful night on the Feb 3rd1637, a bidder on the most-coveted of all bulbs, the Semper Augustus, had an upset stomach and briefly grimaced when hit by a ripping gas pain:

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

I Was Asked: “How & When Will the Next Financial Crisis Happen?”

I Was Asked: “How & When Will the Next Financial Crisis Happen?”

China has a lot of balls in the air at the moment.

FocusEconomics asked me and a bunch of other illustrious luminaries, “How and when will the next financial crisis happen?”

First things first. A “financial crisis” is somewhat of a latex-term that can be defined in many ways and stretched in many directions. For our purposes, a recession or a stock-market crash is by itself not a financial crisis. They’re more or less normal parts of the credit cycle – or the business cycle as it used to be called.

A financial crisis is decidedly not a normal part of the credit cycle – though in some countries such as Argentina, it appears to be part of the normal cycle. A normal recession in the US is over after a few quarters. It cleans out the cobwebs from the business environment. It pushes zombie companies into default and allows bankruptcy courts to clean up after them. This process has a cleansing quality that allows businesses to shed stifling debts at investor expense.

Financial crises are often related to a banking crisis, when credit freezes up, when companies or governments can suddenly no longer borrow enough money to stay afloat. Financial crises involve all kinds of problems, including deep recessions, widespread asset-price crashes, markets with no liquidity, defaults of healthy companies that are suddenly cut off from funding, and the like.

In emerging market economies, financial crises usually involve a currency crisis and either the fear that the government would default on its foreign-currency debts, or an actual default on its foreign currency debts. Government funding dries up and the economy spirals down.

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

The Credit Cycle is on the Turn

We are on the verge of moving into an era of high interest rates, so markets will behave differently from any time since the early-1980s. There are enough similarities with the post-Bretton Woods era of the 1970s to give us some guidance as to how markets are likely to evolve in the foreseeable future.

u turn 1

The chart above says much. Last week, the yield on the 10-year US Treasury bond broke new high ground for this credit cycle. The evolution of key moving averages in bullish sequence (for higher yields, but sharply lower bond prices) is a model example out of the chartist’s textbook. The underlying momentum looks so powerful that a quick rise to 3.5% and beyond appears to be a racing certainty. The credit cycle, transiting from a period of cheap finance into higher borrowing costs is clearly on the turn.

In the fiat-money world, everything takes its valuation cue from US Treasury bonds. For equities it is theoretically the long bond, which is also racing towards higher yields. Having ignored rising yields for the long bond so far, the S&P500 only recently hit new highs. It has been a fantasy-land for equities from which a rude awakening appears increasingly certain. It is likely that the current downturn in equity prices is the start of a new downtrend in all financial assets that have been badly caught on the hop by the ending of cheap credit.

At some stage, and this is why the bond-yield break-out is important, we will face a disruption in valuations that undermines the relationship between assets and debt. This has been a periodic event, with central banks taking whatever action was needed to rescue the commercial banks. When the crisis happens, they reduce interest rates to support asset valuations, propping up government bond markets and ultimately equities.

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

Irrational Beliefs are Ruling Markets

To understand the consequences of the credit cycle, we must dismiss pure opinion, and examine the evidence rationally. This article assesses the fate of the dollar on the next credit crisis, a subject of increasing topicality. It concludes that the late stage of the credit cycle has important similarities with 1927, when the Fed eased monetary policy, following evidence of a mild recession.

Contemporary financial markets are inherently emotional, mainly because they are awash with government-issued currencies. Investors and speculators would never be as careless with sound money as they are with infinitely-elastic fiat. Instead, they are ready to gamble with it, partly because they know that standing still guarantees a loss of purchasing power and partly because rising asset prices, which is actually the reflection of a falling currency, makes selling currency for assets an appealing proposition. Furthermore, credit for speculation is freely available through futures and options.

Financial markets are also irrational due to modern economics, the explanation for it all, having become a belief system. If all central banks pursue economic beliefs, as an investor you will probably do so as well, otherwise you are out of step in a world that follows trends. That works until it doesn’t. Central bankers pursue policies which are a mishmash of neo-Keynesianism and monetarism, the balance between the two setting the fashion of the day, with an overriding assumption that unregulated markets are the source of all our economic and systemic troubles. But there is one element of monetary policy that does not change, and that is a conviction that everything can be cured by monetary inflation.

Is this condemnation of monetary policy over the top?

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

The environmental consequences of monetary dysfunction

The environmental consequences of monetary dysfunction

Dysfunction of the money-system underpins the problems of the world’s multiple converging crises. Discuss.

Might that assertion be taking an ideological position, encouraged by the echo chambers of like-minded twitterati? This piece is an attempt to tease out the nature of the underlying connection, and in doing so describe some of the attack surfaces that are available to those bent on change.

From an environmental perspective the most damaging money-system dysfunction is the misallocation of credit. Commercial banks have been given the responsibility of deciding who should receive loans – for capital investment, mortgages and asset purchases for example – and the privilege of charging interest on those loans. They are largely unconstrained in this process – while there are theoretical constraints, in practice their main concern is making sure they get their full whack of interest due over the term of the loan. They therefore generally prefer lending secured against an asset that they can repossess if necessary than against the uncertain (and difficult to assess – at least for today’s disconnected and centralised account managers) future productive capability of entrepreneurial projects. This is borne out by figures for productive investment which tend to show lending for productive use at about 15%.

The first consequence of this preference is that the banks find themselves in an unholy alliance with asset owners, with a joint interest in ever rising asset prices and a reluctance to moderate activity in asset markets lest their loans lose collateral value. They all know in their hearts that this will eventually mean painful busts. But they also know that when the time comes they will be bailed out by the government, that many of their more savvy and comfortably-connected friends will have disposed of their assets ahead of the peak, and that the greater part of the associated pain will be experienced by less well connected ‘outsiders’. There is no real sanction on the banks or their senior management from buying into this toxic cycle. So we should not be surprised when it repeats. They operate in any case with a sort of herd mentality, and taking a heterodox stance would fail the wine-bar peer-reviews. There is no way that this cycle can avoid the progressive concentration of wealth. (In passing we might note that this in turn puts a misplaced emphasis on philanthropy and volunteerism as means to address society’s ills.)

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

The Real Engine of the Business Cycle

Puerto Rico streetMARK RALSTON/AFP/Getty Images

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…

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…

Olduvai IV: Courage
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Olduvai II: Exodus
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