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Booms and Busts, Anecdotes and Analyses
During the latter half of the 1990s, business journalists described in detail the ascent – sometimes within hours and very often to dizzying levels – of the market capitalisations of Internet, telecommunications, biological and other ‘technology’ companies. Similarly, accounts of the decline – and, in significant numbers of instances, collapse – of ‘New Economy’ enterprises have been thick on the ground since April 2000. With few exceptions this coverage has been anecdotal. Mainstream business publications, in other words, have tended to pay little attention and devote few column-inches to systematic explanations of these events’ causes, attributes and consequences (for reasons why, see the circulars entitled The Mass Media and Value Investing). Accordingly, many yarns about but a small number of analyses of boom and bust have appeared in the aftermath of the ‘tech wrecks’ of April and October-November 2000.
Yet a variety of analyses of financial manias and mornings-after do exist. (Eminent analyses include the middle-of-the-road Charles Kindleberger’s Manias, Panics and Crashes; the interventionist John Kenneth Galbraith’s The Great Crash; and the laissez-faire Murray Rothbard’s America’s Great Depression). Irrespective of their starting points, principles and methods, which differ greatly, they tend to draw attention to two sets of things. The first are monetary phenomena and their surface manifestations such as interest rates; the second are responses to these phenomena – particularly the level, rate of growth and quality of debt. Given their predilection for anecdotes and disinclination to analyse underlying causes, it comes as no surprise that during the past several years most business media have devoted little attention to the correlations among interest and debt, boom and bust. Three exceptions to this rule, which have appeared in leading business publications during the past several months, thus merit more than passing interest:
Exception #1: “the level of bad debts and delinquent loans [in Australia] is about to increase for the first time in many years. The big four banks – because they have 75% of the small to medium sized business loan market – will bear the brunt” (Ivor Ries, The Australian Financial Review, 14-15 October 2000).
Exception #2: “in the American credit market a recession, and not a particularly benign one, is under way” (James Grant, Grant’s Interest Rate Observer, 12 November 2000).
Exception #3: “...the Nasdaq phenomenon, in fact, represents a classic, liquidity-driven, speculative bubble. Such bubbles always culminate in debt problems. It is clear that we are nowhere yet near the end of this bear market in the U.S. because the focus on such debt problems has barely begun. This is in spite of the fact that the symptoms of debt problems are everywhere – corporate debt, consumer debt, margin debt [and] borrowing by Wall Street itself” (Christopher Wood, The Wall Street Journal, 8 December 2000).
Perhaps on the premise that there is safety in numbers, many market participants, aided and abetted by brokers, financial advisors and other ‘experts,’ think and act like a herd. In sharp contrast, when members of the crowd ignore an issue – and particularly when a small number of knowledgeable people of divergent philosophical hues draw attention to it – I find it instructive to observe carefully and think things through from first principles. Part I and Part II of this circular apply these principles and observations to possible causes, attributes and consequences of booms and busts. They lead me to conclusions and actions (set out in Part III) which differ from those of most market participants.
Principle #1: Savings and Credit
Consider two types of economic development: growth induced by individuals’ savings and growth induced by credit created by banks. Their effects are initially very similar. But their eventual consequences are very different: savings create opportunities for the growth of genuine wealth whilst credit begets boom and bust.
The level of savings and investment is determined by the supply of and demand for loans. Supply reflects the willingness of individuals to save and lend their savings at various rates of interest; and demand reflects the willingness of businesses to borrow and undertake investment projects. The higher the rate of interest, the greater the extent to which, other things equal, individuals have an incentive to forego jam today, lend their savings, receive interest payments and thereby expect to have more jam in the future. Yet higher interest rates increase the cost of borrowing and thus reduce borrowers’ willingness to incur debt. The market-clearing rate of interest represents a compromise between individuals’ supply of and businesses’ demand for funds; and associated with each market-clearing rate is an amount of funds saved, lent and borrowed.
If individuals become more thrifty, future-oriented or otherwise become more willing to forego consumption today in order to consume more tomorrow, they save more and thereby increase the supply of lendable funds. As a result of this increased supply, the rate of interest falls; and as a result of this decrease of the rate of interest and cost of borrowing, businesses are enticed to undertake investment projects which they previously considered to be unremunerative. At this lower market-clearing rate of interest, in other words, the amounts of both saving by individuals and investment by businesses increase. To the extent that businesses invest wisely and increase the economy’s productive capacity, they produce wealth and enhance the material standard of living.
Principle #2: A Cause of Booms
Consider now a situation in which (i) individuals’ thrift, orientation towards the future and willingness to forego consumption today, etc. remain unchanged and (ii) the central bank or commercial banks (or both) create credit and inject it into credit markets. Given this inflation of the supply of lendable funds, the market-clearing rate of interest falls and businesses are tempted to borrow. Projects and investments which would not have been considered viable if the rate of interest had not been influenced by the banks, and which therefore would not have been undertaken, are now regarded as profitable. Depending upon the amount of credit created and injected and the number of investment projects undertaken, a ‘boom’ is initiated. Given the decrease of the rate of interest and the unchanged proclivity towards thrift, however, individuals’ incentive to save falls. Padding the supply of lendable funds with money not derived from savings thus pushes the market-clearing rate of interest to an artificially-low level. It also drives a wedge between individuals’ savings and businesses’ borrowing. The low rate of interest, in other words, has stimulated borrowing but has not stimulated – indeed, it has discouraged – saving. Under these conditions credit is relatively plentiful but savings are relatively scarce; and to the extent that wealth derives from savings rather than credit the boom thus rests upon weak and unsustainable foundations.
By issuing fiduciary media (e.g., bank notes not backed entirely by gold or other assets, current accounts not backed wholly by domestic savings or other assets, etc.) banks are in a position to expand the supply of credit considerably. Indeed, these fiduciary media permit banks to ‘pyramid,’ i.e., to extend credit well beyond their own assets and the funds entrusted to them by depositors. With any given amount of capital reserves, however, banks can expand credit neither indefinitely nor in limitless quantities. Credit, by its very nature and as Australia’s Post-Olympic Reality Cheque emphasised, facilitates ‘marginal’ transactions. It enables an additional (n’th) increment of loans to an additional (n’th) increment of borrowers. It expands the debt industry and relaxes lending standards. In practice, to increase the quantity of credit by fiduciary means is eventually to underwrite a greater number of less creditworthy borrowers with more debt – and thereby to decrease the quality of resultant debts. Hence the witticism that banks, which once refused to lend to anyone who actually needed the money, now make their worst loans during the best times.
Observation #1: A Huge Appetite for Debt
Two conditions which re-appeared during the latter half of the 1990s facilitated the development of a credit-induced boom. The first was the creation of a huge supply of credit not backed by savings. Inflation of the money supply in OECD countries proceeded at an average rate of 7% per annum between the late-1980s and early 1990s, and increased dramatically from an annual rate of 3% in the mid-1990s to 11% in 1999. The amount of credit, in other words, has vastly outstripped the amount of savings. U.S. GDP, for example, grew by approximately $400 billion per year during the late 1990s, but the volume of new credit swelled by $1.4 trillion in 1997, $2.1 trillion in 1998, $2.25 trillion in 1999 and an estimated $1.9 trillion in 2000.
The second condition, a response to the decrease in market interest rates caused by the avalanche of credit, was a huge appetite by corporations for cheap debt finance: between 1994 and 2000, American companies’ debt obligations increased from $2.65 to $4.62 trillion. Their total debt thus grew by 75% – a compound rate of 10% per annum and a much more rapid rate of growth than either GDP or profits. As a result corporate debt grew to 46% of GDP by 2000. (Net household debt rose from $4.2 to $6.7 trillion over these years and now constitutes 67% of GDP.) Emboldened by the stampeding bull markets of recent years, consumers have used unrealised capital gains – and ebullient assumptions about further gains in the future – as collateral to feed their escalating appetites for debt-financed consumption. Infused by the same market developments, businesses have borrowed more and more on the basis of ever more optimistic assumptions about their future earnings.
It is axiomatic that these developments, which apply to lesser extents in Australia (where, in sharp contrast to the household sector, corporations’ debt-to-equity ratio has decreased since its peak in the early 1990s), Britain, Canada and New Zealand, cannot continue indefinitely. The components of an aggregate, in other words, cannot grow more quickly than the aggregate itself: to assume otherwise is to encounter certain intractable mathematical difficulties. Accordingly, at the point when households’ anticipated capital gains fail to materialise – and when corporate earnings fall short of expectations – then debt, which is presently regarded as a boon, may quickly become a burden.
Observation #2: Financed by Credit Rather Than Savings
It takes two to tango: the legal and moral obligation created by the transfer of funds from a creditor to a debtor is recorded as a liability on the debtor’s balance sheet and as an asset on the creditor’s balance sheet. Although it is usually forgotten, one man’s debt (liability) must necessarily be another’s credit (asset). When lent to sound businesses and put to a sensible use, savings can create capital; and the growth of productive capital, in turn, is a necessary and sufficient condition of a sustainable rise in the material standard of living.
In Anglo-American countries since the mid-1990s, however, domestic savings have financed surprisingly little of the strong growth of corporate and personal debt. Indeed, rates of personal savings in these countries have fallen, sometimes precipitously, for a decade or more. In several of these countries they currently stand at levels not seen in decades; and in the U.S. have fallen close to (and arguably below) 0% – a level not seen since the Great Depression. Accordingly, debt obligations have been financed more and more from foreigners’ savings and by credit created by central and commercial banks. Under these conditions debtors face a set of related risks. One is a diminution of the flow of foreign creditors’ savings into these debtor countries; another is the repatriation of these savings; and a third is the imposition of tougher conditions by lenders upon borrowers. These events, and any other event which might tend to unwind or liquidate the corporate debt accumulated in recent years, would bode ill for borrowers and debtors.
...continued in Part II
 
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