MONEY FOR NOTHING…
A MODEL FOR ECONOMIC COLLAPSE

When we examine the dynamics of financial analysis, all too often we look only at what we can see, and ignore the under-currents flowing beneath the surface.

In 1989 Japan was experiencing an 8% growth rate and low inflation - while the Nikkei and real estate values were soaring to untenable record levels.

Supremacy in manufacturing and technology made them the richest people on earth - and money was so abundant that they were exporting it as a "commodity" to the rest of the world. But things change. While most of the rest of the world has enjoyed substantial growth since 1990, the Land of the Rising Sun has managed to ike out only minimal growth, despite a large fiscal stimulus and 0.5% interest rates - the lowest on record of any country.

That the richest people on earth should sustain such a destruction of wealth during a time of great technological advancement and world growth is truly ironic and paradoxical. While the Japanese will bear the greatest destruction of wealth, many other countries will suffer similar fates. Subsequent to many years of encouraging growth, South-East Asian economies are falling apart at the seams.

To fully comprehend the financial dynamics affecting these hapless economies, we must understand how debt affects national accounts . When an individual borrows to make a consumer purchase, retail sales increase - and we call it growth. When governments borrow to fund programs, government spending increases - and we call it growth. When corporations borrow to build a new manufacturing plant, capital spending increases - and is called growth. This type of growth is a direct result of an increase in debt. Within today's economic environments, growth is perceived when debt is increasing, and conversely, contracting when debt is decreasing.

Per traditional economic theory, growth does not distinguish between goods purchased from income (profits), or goods purchased from debt. NEVERTHELESS, how purchases are funded has real economic significance. When someone borrows to purchase an automobile, retail sales increase in the month of the purchase. However, retail sales fall by the amount of principle - and interest payments in subsequent months. Since principle and interest payments will be substantially above the purchase price at the end of the loan amortization period, the fall in retail sales will exceed the original purchase of the automobile by the amount of interest paid.

Let's examine this concept on a personal basis. Given that you will only earn a fixed amount of income in your lifetime, it follows that you will be able to purchase more items in your lifetime, IF your purchases are made AFTER you have earned the income - rather than making the purchases via debt financing prior to earning the income. In this context rising long-term debt will indeed reduce economic growth, which is the opposite conclusion of conventional economic reasoning.

It is imperatively relevant to focus on the present banking system's modus operandi, and more importantly, on how it reduces real growth - which consequentially leads to economic destruction.

To begin we must understand the significance of what really happens when a bank gives out a typical new loan for $10,000. The bank makes two electronic entries. It credits the borrower's checking account for $10,000, and creates a loan account (debit) for $10,000. The bank's assets (loans) have increased by $10,000, and so has its liabilities (deposits). Everything balances. In essence the bank has created $10,000 in new money out of nothing. The bank now charges the borrower interest on this money that it created from nothing. (There are few businesses I know of that earn vast sums of money simply by creating off-setting bookkeeping entries) Should the borrower decide to repay the loan, the bank would debit the borrower's checking account for $10,000, and credit the borrower's loan account. The loan is repaid and the borrower has $10,000 less in his checking account. Ergo, $10,000 has been destroyed.

When banks create loans, they create money. Since an economy will now have more money chasing the same amount of goods, this must be inflationary. Similarly, when loans are repaid, money is destroyed. This results in less money chasing goods, and a deflation results.

In theory bank loans may increase without limit. The more loans a bank makes, the more money it creates, and the greater the income it earns. As banks initiate this system of money creation, the increased money supply will push up asset prices. It is precisely these assets that are most the security backing many bank loans (i.e. collateral). This system of increasing the money, increasing debt, and swelling asset values may safely proceed until loan repayments match the free cash flow of the borrowers. If money and debt creation stop at this point, future loan payments will then start to cause a reduction in money and loans. As a result we will see a reduction in asset prices due to a decrease in the money supply. However, as both loan balances and asset values will both be decreasing, bank security should not be adversely affected.

Seemingly, this system functions. However, we see a tremendous transfer of wealth from society to the bankers of the world - which invariably must lead to a reduction in economic growth. In fairness to the bankers it should be recognized they indeed pay deposit interest on the money that they create , so that the net sum taken from society is the difference between what is charged for loans and the interest paid on deposits.

Bankers also perform a very valuable service. This occurs as a result of their skills in financial analysis - when they direct loan money into areas that will make the most efficient use of resources.

Once the economy has reached the point where loans can be repaid from cash flow - and loans begin declining, the economy will enter into a period of money destruction - witnessing a fall in asset values and a decline in economic growth. Thus, there is a natural tendency to foster loan growth and money creation beyond what can be repaid from cash flow.

As money creation continues, asset values will continue to rise. However, investment returns will begin to shrink as investments become more marginal in an extended economy. If left unchecked, this will lead to a surplus of marginal investments. At this point over-capacity will lead to price reductions - which will eventually reduce the investment returns and cash flow of all members of the economy. Investment returns may then approach zero or even turn negative, resulting in many borrowers unable to pay even interest payments. At this point new loans to purchase assets are halted by the bankers, forcing many borrowers to attempt to sell assets in order to repay their loans. Both actions will cause the value of assets to collapse further, pushing their value far below the value of the loans they secure. Banks are now left with unperforming loans and collateral whose value has collapsed. To hide losses and therefore avoid insolvency, banks must make new loans to borrowers - whose cash flow has all but dried up - to cover past due interest and principle.

In extreme instances borrowers will be losing money even before debt repayment. The resulting loss of working capital will force bankruptcy, unless working capital is replenished. Since the bankruptcy of the borrower would expose the hidden loan losses of the banks, banks will forced to make additional loans to cover the losses of the bankrupt borrowers. While bank loan levels will appear to be stable or slightly increasing, money is now staying within the financial system. Without additional money chasing assets, the value of these assets will invariably and inevitably to fall. Furthermore, it follows that without new money entering the economic system, this will lead to an avoidable contraction in the economy.

At some point in this financial maelstrom, bank depositors will begin to fear that the financial institution will be unable to return their savings, since the economy is contracting and asset values are falling. When this indeed occurs, depositors attempting to withdraw their money will collapse the bank - unless the bank can borrow funds from other sources. Should this happen on a mass scale, the Central Bank will be called upon to provide emergency funds. Once the amount of emergency loans exceeds the resources of the Central Bank, it will be forced to print money, eventually destroying the value of all money and credit in society.

This is the ultimate irony of today's financial system. Society pays interest to banks on money that financial institutions created from nothing. After banks have leveraged the maximum gain from society , then society is asked to pay for the losses of the banking system as it falls apart.

When debt levels have increased beyond the capacity of the economy to repay, there are two alternatives for remedy. The first will be to maintain the value of the debt. This will initially result in all funds from productive activities being transferred to the banks. This ultimately results in bankruptcy, forcing an end to productive activity. Once this happens, loan losses will wipe out the banking system. The second option is to eliminate the debt as soon as possible - either through debt forgiveness or more likely a debt-equity swap. This will cause the failure of the banking system, as the value of the equity obtained will be far less than the nominal value of the debt. However, the economy is left producing goods and employing people.

The policy response of the IMF to the financial crisis in South Korea, Thailand and Indonesia even goes to a further ridiculous extreme in inadvertently provoking corporate bankruptcies and resulting loss of production and jobs. Not only has the IMF attempted to maintain the value of debt, but the IMF has substantially increased interest rates, escalating the transfer of funds from production sectors to the banks, and thusly accelerating bankruptcy rates and the loss of production and jobs.

Banks in Japan, Korea, China, Thailand, Hong Kong, Malaysia and Indonesia all have loan levels far above the borrowers' abilities to generate cash flow. These economies are deflating. Asset values have declined sharply in recent months - and continue to fall. Everywhere in Asia there are strong signs of economic contraction. The strong growth these economies previously enjoyed was simply the result of an explosion of growth in money and loans that was not sustainable.

The next stage will witness the collapse of the banking system in these nations, and ultimately the destruction of all money and credit. Against this backdrop U.S. investment markets may only be seen as a speculative bubble. And like all bubbles, it can only be sustained by foreign liquidity. The over $2 trillion that has come in from Asia and Europe since 1995 has been the source of Wall Street's liquidity. Once money stops flowing in, the bubble will burst. Consumer debt has increased by over 50% over the last four years. And with America's savings rate now down to a mere 3.5%, there is clearly insufficient cash flow to service debt requirements.

Those expecting that Asia will be able to sustain the asset bubble will be sadly disappointed. Asia is rapidly deflating as profits and incomes plummet. In reality Japan - as well as the rest of Asia - requires a massive savings injection. Japan's government borrowings will exceed U.S.$780 billion this year. Additionally, Japanese banks require in excess of U.S.$1 trillion to cover loan losses. A savings drain out of Japan will only accelerate the collapse of the Japanese economy. The same scenario holds true for every other country in Asia. Essentially, we now have a savings drain out of Asia into the U.S. This will collapse the highly indebted Asian economies, while fuelling the U.S. asset bubble. Once Asia collapses, we will see liquidity leave the U.S. - which together with a loss of export markets will finally burst the U.S. asset bubble.

World financial markets have additional concerns. Global banking and a U.S.$96 trillion global derivative exposure guarantee that the worldwide banking system will be very adversely affected by any meltdown.

And if all the above were not enough to foster worldwide market and monetary turmoil and consequent financial chaos, please recall we are just 18 months away from the looming Y2K problem - which could very well have a devastating impact on and the world's economies and banking system.

Many ivory tower economists still hold to the archaic and illogical ideas of conventional monetary and fiscal policies. They believe that most recessions happen because of a shortfall in aggregate demand - and thus may be cured simply by printing money. NOT SO.

Just prior to Japan's real estate crash in 1989, one particular section of Tokyo was worth more than the entire State of California!

Recessions result when loan creation ceases and bank debt can no longer be repaid from cash flow. As abundantly described above, this happens in an environment where asset values are collapsing. To bring the economy back into equilibrium, the bad loans MUST be eliminated. In an economy where cash flow can no longer repay debt, this can only be accomplished by debt-to-equity swaps or by printing money. In an economy like Japan's, where collateral values have dropped by 80% (as they have with commercial property), the amount of money that requires printing could easily approach 80% of the banking system. (It should be mentioned that the fall in asset values will not stop until all the security - collateral - for bad loans has been sold. In Japan, despite a 80% drop in commercial real estate values since 1990, very little of their security has yet to be sold by Japanese banks.)

The printing of the amount of money required to bring the banking system back into equilibrium will cause hyper-inflation and the destruction of money. As money is critical in facilitating the division of labour, the printing of money will cause very serious problems in the operation of the economy.

Current economic theories failed to anticipate the Asian financial crisis, have failed to explain what is happening , and have again failed to anticipate the crisis soon to invade American shores. By failing to understand the effects of money and debt creation, these ivory tower economists follow an illusion. As mentioned in previous articles, these ivory tower economists have spread other illusions of economic thought. While many think that paper money represents real wealth, it must be realised that it is only a piece of paper, and may be created or destroyed in unlimited amounts.

The economic business cycle presently unfolding will result in the destruction of most of the money in the world. Should the central banks respond to this crisis by printing money, the amount of money that will be required to print will be so large as to destroy the value of all money. Many think that government bonds represent wealth. However, governments cannot repay their debt by selling assets or from any income that they earn. At best, government bonds only represent a transfer of assets. They represent a transfer of assets between taxpayers and bondholders. When taxpayers and bondholders represent the same economic unit , this transfer amounts to zero - with the repayment of the bond equaling the increase in taxes. In this context government bonds must be viewed as being a derivative, the value of which depends on the government's ability to transfer assets. As this economic cycle unfolds, government revenues from taxes will drop substantially, while demands for government payments will rise. Thus putting government budgets into massive deficits. When it becomes clear that governments are unable to raise sufficient tax revenue to cover basic services, investors will then realise that the government will also be unable to effect the transfer from taxpayers to bondholders. At this point, the value of the bonds must approach zero.

It is interesting to note how the issuance of government bonds ties in with the creation of money and loans within the banks. Many bond traders borrow vast sums of money to purchase government bonds. In a simple example, a $10,000 loan is given to purchase $10,000 in new government bonds. In this case, $10,000 in new money is created - which is transferred to the government in exchange for the bond. In this way government deficits may be financed by the creation of new money. By accepting government bonds as security for these advances, banks are essentially securing advances with derivative contracts, the value of which must approach zero in a severe economic contraction.

Those economists who view government deficits as fiscal policy, should first see how these deficits are being financed to see if these deficits are really part of fiscal policy , and not a disguised part of monetary policy. As I have discussed in previous articles, when the government finances deficits, not by the creation of money, but from the transfer of resources from the private sector to the public sector, we must understand that this is exactly what is happening (i.e. the transfer of assets). The transferring of assets from the private sector to the public sector does not necessarily improve the economy - and in many cases will contract the economy. One must certainly question how economists can call this transfer of assets as economic growth - and indeed put in serious doubt the sanity of Keynsians who believe that the transfer of assets out of the private sector represents no cost to the economy.

When subject to independent and objective critical analysis, the financial events currently engulfing in the world are relatively simplistic and certainly well understood by the rich and powerful who control world financial markets. Why then were extreme asset bubbles allowed to develop in Japan, China, South-East Asia and the United States? Why has the policy response to these bubbles been to destroy the real productive capacity of the economy? These asset bubbles, the extremes of government debt, derivative exposure and the Y2K problem will soon send the entire world economy into a depression far worse than the 1930's. Will the emergency response of governments then be the loss of personal freedoms on a massive scale? Is this a deliberate plan by the rich and powerful to control mankind and bring in their "New World Order?"

Can we now not see the manipulation of the precious metal markets as necessary for these powerful forces to gain control of gold, silver and diamonds - the values of which will soar when financial markets collapse?

We must understand that financial analysis is based on simple mathematics - and the collapse of the worldwide banking system is a mathematical certainty. The rich and powerful will then use this to destroy production and jobs, creating a state of anarchy from which they will be able to manipulate the human race.

John Kutyn
9 June 1998