Greenspan's Legacy? Worldwide Debt Folly

Similar to democracy, monetary freedom via central banking is a concept that only works with responsible participants. Without appropriate responsibility, we get anarchy. Governments have hijacked monetary freedom under the banner of good intentions, by claiming absolute right to the creation of money. Yet, wielding this power always requires more power and more wielding. With misguided citizens and irresponsible central banks, intervention breeds debt in the name of "economic stimulus". This breeds more intervention and more debt. As I'll describe in this article, the long-term world wide economic impact is likely to be astronomic.

A friend asked me whether excessively leveraged consumer mortgages are the reason for the red-hot real estate sector. It seems to be a straightforward answer to ascribe at least some blame to these geared mortgages, yet that would not be entirely true. I had to draw on my 27 odd years of experience in banking and my economic training to answer such a simple question truthfully. No. The real reason is the absence of market forces in the decisions regarding the amount of money in the world economy and the absence of market forces in establishing the price of money, interest rates, in the world economy. Both belong to government and central banks and, in this, Greenspan rules all. Here's how.

Debtors have a misguided high propensity to gear themselves to the maximum they are allowed by the providers of credit, alternatively as a low down second, to the maximum that they can afford. The first question that everyone asks is not what the interest rate is, but "how much can I get". Second is, what will the monthly repayments be. Creditors tend to calculate how much they think the debtor can afford to repay and a deal is struck. Simple. The price of credit is seldom a serious issue provided that it falls within the expected rate range. Almost like buying a burger, price is not relevant, provided that it is more or less the same as other burgers. That is the deception of price control over money, or interest rate policy.

How much can I borrow? As much as you can afford to repay. The repayment amount is then calculated as a function of the interest rate and the term. Will a debtor in this controlled monetary environment be turned away for a lack of money? No. He who controls the price also controls supply and in today's "accommodative environment" will provide whatever is called for. Here is the central banker's and the debtor's temptation all rolled in one. Drop the price of money low enough and debtors will foolishly demand almost unlimited amounts of debt. All that is left to do is to supply unlimited amounts of money. Is it the makings of an economic miracle or as I believe, an economic nightmare?

After trying to explain this to my friend, he looked at me with one of those "what the heck is he talking about" expressions. This example simplifies what's going on. A debtor with an absolute ability to make a $10,000 monthly payment on debt can afford to borrow a maximum $1,036,246 over 20 years at a 10% pa interest rate. At 5%, he can borrow $1,515,253. That increases to $ 2,705,485 if he can stretch his term to 30 years and interest rates drop to 2%. As you can see, I explained, he can now "take-out" an additional $1,669,238 in debt, if he wishes. And that, I conclude, is why we have among other economic abnormalities, a red-hot residential market.

A quick simplistic economic calculation whereby the payment is stated as equal to the debtor's monthly "savings" reveals that he has just obtained the capital equivalent of almost 14 years of savings to spend. Now if only we can guarantee a world of 1% interest rates forever and unlimited supply of debt at this price, then we have arrived in financial paradise. Not quite. A debtor can do this only once, all things being equal. His marginal consumption now reverts back to what it was before the monetary boost. Any increase in consumption must be accompanied by yet lower interest rates if one can go lower than 1% or an increase in income. That's it. Otherwise he has to repay and reduce his consumption. That's the debtor's folly. I will not even mention rising interest rates on variable rate debt.

After evaluation, it became apparent to me that this is the avenue by which a consumer-based economy enjoys short-term stimulation, courtesy of central banks, that is in effect, a "one-time event". The amount of "new debt" that can enter the economy in this manner is astounding. Yet after the party reaches its inevitable conclusion, the piper must be paid. We are seeing the first long chapter of this debt-based bubble now in the red-hot real estate market.

The economic nightmare is the one where the central bankers encourage the misguided debtors to commit the debtor's folly in an attempt to stimulate an economy out of a recession. That is Greenspan's gambit. Can it work in a sustainable manner? I don't think so! A temporary turbo boost in consumption from debt and price control, will have to be followed by a severe contraction in consumption approximating at the least the extent of the stimulation, even if interest rates were not to increase at all. Remember, until the debt is paid off, a debtor can do this once only. Once used, repayment must follow. Any increase in interest rates will make the contraction even greater. Following this process to a logical conclusion is truly the wellspring of all economic nightmares.

Such debt folly is documented by examining the macro-picture. First let's take a look at the behaviour of households as a group to see if in fact, the group does behave in the same manner as illustrated above. Household Financial Obligations as a percent of Disposable Personal Income (Source: Board of Governors of the Federal Reserve System) increased from 17.76% in the first quarter 2001 to 18.09% in the last quarter 2003. Interest rates started falling in May 2001. Thus not only did households maintain debt repayment levels, they in fact committed the gravest sin of increasing payments in a falling interest rate environment. Checking it against the Household Debt Service Payments as a Percent of Disposable Personal Income (Source: Board of Governors of the Federal Reserve System) shows another increasing trend from 12.47% in the first quarter 2001 to 12.98% in the last quarter 2003, confirming the Household Financial Obligations data.

Time to evaluate the ultimate long-term consequences. It follows, that a contraction in consumer spending at least equal to the stimulation effect will now manifest without any increase in interest rates. Exactly how much of it can be ascribed directly to the falling interest rate stimulation is difficult to pin point but hardly relevant as the simple answer is "the majority". The conservative answer is "a significant portion". You can decide how much poison. I think it matters little, as it will be too much poison even if you are only inclined to ascribe less than the majority to the stimulation. Looking at the official numbers is however most revealing.

Personal Consumption Expenditures (Source: US Department of Commerce: Bureau of Economic Analysis) grew by $1.037 trillion from April 2001 to January 2004. Household Sector: Liabilities: Household Credit Market Debt Outstanding (Source: Board of Governors of the Federal Reserve System, "CMDEBT") increased by $2.203 trillion from April 2001 to January 2004. More than double the Personal Consumption Expenditure! Between 33% and 67% of the growth in CMDEBT, judging from moving averages in growth in CMDEBT during the 90's can probably be ascribed to the stimulatory effect. A once off effect due to the falling interest rates to 1%, an effect that cannot be repeated as 1% is about as low as you can go. Using the data as is, points to the conclusion that the total increase in Personal Consumption Expenditure since April 2001 is due to a falling interest rate policy and an "achievement", which cannot be repeated. Here's the paradox, Personal Consumption Expenditures must now fall by say $1.1 trillion just to remain the same as before the artificially induced debt quantum. The effect is immediate for the individual debtor who followed Greenspan's advice and took out the maximum debt. That is almost 3 years worth of debt-induced "growth" in Personal Consumption Expenditures! Is there anything else that can take its place? Probably not. This is simple cause and effect.

I have not touched on any effect from rising energy prices, which are likely, or the potential for rising interest rates due in part to the US government's record-breaking debt load. We're only looking at what will not re-occur. How much poison is an inevitable $1.1 trillion contraction in consumer spending? At best, it's at least equal to what would be needed to force an economic contraction equal to the simulative effect provided by all that extra debt. At worst, it is enough poison to kill off a number of economies particularly those of the US and China, and probably more than enough to cause the world economy to be hospitalised in intensive care for years to come.

As you can see from our current debt-induced economic predicament, similar to democracy, monetary freedom via central banking is a concept that only works with responsible participants. Greenspan's legacy? A worldwide debt-induced folly!

12 September 2004

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