Q.: What are the main roots of the present economic and financial crisis?
A.: "There is only one main root, the same as that for the Great Depression in the 1930's: destruction of capital. Erosion or consumption of capital has been going on unnoticed for decades. The process ends when there is no more capital left to consume. After the seven fat years, a period of seven lean years must commence.
Capital erosion is not natural nor is it inevitable. Rather, it has been inflicted upon the world economy by the unmindful and irresponsible monetary policy of the United States in deliberately driving the rate of interest to zero.
Falling interest rates, which are lethal, must be carefully distinguished from low but stable interest rates, which are salutary. A falling interest rate structure, foisted upon the world by the Americans obsessed with the idea of preserving the hegemony of the dollar, works insidiously and unobserved. As the rate of interest falls, the liquidation value of debt rises.
Far from decreasing it, falling interest rates increase the burden of debt. Economists, chartered accountants, and bank examiners do not recognize the concept of liquidation value of debt, let alone its inverse relationship to the rate of interest, although it is exactly the same inverse relationship that is well-recognized to exist between the market value of a bond and the rate of interest. As the interest rate falls, creditors refuse to accept the face value of the bond in settlement of debt. At the lower rate the income stream of coupons falls short of amortizing the face value of the bond. To compensate for the shortfall the market value of the bond must be increased. Accordingly, creditors bid up the market price of the bond. If debtors want to get out of debt before it matures, then they will have to pay the market price exceeding the face value of the bond.
This conclusively proves that the fall in the rate of interest increases the liquidation value of debt. As soon as the liquidation value of liabilities less assets surpasses capital, the firm becomes insolvent. Its capital is gone. It can no longer attract credit.
This is what has happened to the banks in the U.S. and the U.K. This is what has also happened to the American auto industry, and all the other American industries now extinct.
Those who dismiss my analysis of the present crisis in terms of capital destruction as an improbable single- cause explanation of a complex phenomenon must answer the following question. What are the statistical odds that the banks, financial institutions, as well as the three big automakers go bankrupt all at the same time? Well, the odds are virtually zero, unless they fail due to a single cause."
Jake, our champion, was kind enough to copy an interview of Antal E. Fakete explaining his thinking on the current financial crisis. The excerpt above states what he believes is the cause of the downturn. The remainder of the interview, definitely worth a study, can be viewed in Jake's comment at the bottom of my article A Little More on Preferences and Plunder.
Fakete's logic is that unnatural depression of interest rates upsets the financial balance of firms and causes the massive insolvency problems we are witnessing. As rates are forced down by the Fed, existing bond prices are forced up. Since this is a primary funding tool of corporations everywhere, their balance sheets are adversely affected. In order to liquidate their held bonds to improve their financial balance they must pay above the face value of the bond since falling interest rates inflate bond values. In plain terms their liabilities increase. He refers to this as the "destruction or erosion" of capital.
During the upswing of a cycle, firms are motivated to act in opposition to this phenomenon. Depressed interest rates cause malinvestment which in turn artificially swells asset values. Swollen assets in turn prompt banks to overland to corporations who over invest in more and more assets. This in turn bloats stock prices and validates assumption of increased liabilities at virtually whatever rates are available. Those who sit out the madness, instead practicing prudence are looked upon as slow witted. It appears to be a never ending cycle of growth and profit but the overriding factor here is the restriction of rates of interest to naturally adjust to economic conditions.
When interest rates are free to move within the economy they react inversely to the availability of capital. As supply of capital increases, rates will decline and vice versa. A productive and growing economy will normally produce capital. Initially the cost of this capital is high but as more capital is produced and becomes available the rates fall. As you would think this tends to accelerate the economy.
But again, when the production of capital is dependent upon the output of the economy and not the actions of the Fed, there is a natural tendency for interest rates to contain the velocity. As excess capital is put to use, the resulting growth must also reflect the needs of the society to consume. If not, inventory grows, accumulation occurs and capital production begins to fall off.
The pent up demand for capital in combination with lower capital production applies upward pressure on interest. With higher rates and less production, the demand for capital drops and again rates decline, accommodating the slowing economy. The natural interest rate tends toward equilibrium and avoids the extremities of directed economic cycles. A firm with a decent product and good managers has little problem weathering this climate.
If the only instrument the Fed wielded was the initial or discount rate, they would merely be directly or predicting interest "profits". The initial recipients of the rate would simply "turn" the rate to the next buyer and make a tidy, unearned profit by extracting the difference between the market interest rate and the Fed rate. To combat this, the Fed oversupplies the quantity of money, insuring depressed rates throughout the system. With virtual endless monetary supply there is no possibility of achieving a natural rate.
It certainly is possible to boost production and revenues from this action, but the effect on assets is much more pronounced. Much of this easy money is transferred to asset price, as this is the path of least resistance. The Fed continues its actions, bent on sustaining the unsustainable. When asset price levels reach an altitude that completely forsakes any possible utility value, the downturn begins.
This is usually when the Fed does the most damage. Sensing the slowdown they move to suppress rates further. It is the combination of asset devaluation and the upward valuation of bonds and liabilities that spell doom.
But, there are other factors involved. The easy credit which prompts increased valuations has fostered a culture of investment over enterprise. With corporate conglomeration establishing near or total market monopoly, product revenues are assured. With the bulk of this competitive force eliminated the quasi capitalist is left to channel his energy and resource primarily to outside investment rather than product or internal capital development.
The combination of loose Fed funds, which replicates but does not replace true capital, and universal acceptance in the financial world of the primacy of investment over enterprise have a multiplier effect on the workings of the market. Unprecedented highs are attained and with equal velocity ancient lows are reestablished.
The seemingly eternal promise of future lower interest rates has a predictable result. There is no reason to store capital and every reason to dispense of it and let it pay its own way, since it always seems to be cheaper in the future. With a downturn, this practice accentuates Fekete's capital erosion, since firms have little capital to erode and much debt that becomes revalued.
In summary, this monetary system which those responsible for its enactment viewed as the path to the perfect financial world, engineered to shake the constraints of an imperfect free economy, is truly successful at inflating asset values. And it is also successful at inflating liabilities. The end result can certainly be devastating.
Other related articles by Author:
A Little More on Preferences and Plunder
The Stimulus Package Could Work.
Theories of Value and the Recent Downturn
Deflation the Great Wealth Builder
MV=PT A Classic Equation and Monetary Policy
A Bonehead Solution to End Government Debt
Fiat Monetary System Harms Environment
©2009 Gene DeNardo, all rights reserved. You must have written permission from the author in order to republish this work.
Published: Sunday, February 8, 2009
Last modified: Sunday, February 8, 2009
The views expressed in this article are those of Gene DeNardo only and do not represent the views of Nolan Chart, LLC or its affiliates. Gene DeNardo is solely responsible for the contents of this article and is not an employee or otherwise affiliated with Nolan Chart, LLC in his/her role as a columnist.
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