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A Sombre Conclusion
From the reasoning set out in Part I and Part II follows an uncomfortable conclusion: the buoyant economic conditions celebrated during the latter half of the 1990s in Australia, Britain, Canada, to some extent New Zealand and most notably the U.S. rest on relatively weak foundations. The ‘New Economy’ is at least as much a consequence of unsustainable and ultimately harmful developments (i.e., the creation of bank credit not backed by savings, decrease of market rates of interest below their natural rate and increase in borrowing and indebtedness) as they are of permanent and salutary phenomena (i.e., thrift, more capital and more productive capital).
In this vein The Economist (27 January 2001) noted that “America’s boom has also been fuelled by massive borrowing by companies and households. American firms’ borrowing binge has left lenders exposed to some nasty risks. And if corporate debt is not alarming enough, consumer borrowing has been even more rampant. By borrowing against gains in share values, households have been able to shop until they dropped, not bothering to save.” The Economist concluded that “[contemporary] America is but one more example of an age-old phenomenon, in which rapid increases in asset prices encourage a credit binge that [proves] unsustainable once asset prices fall. It is no co-incidence that the deepest and most protracted recessions in recent decades have taken hold in countries that experienced booms in property and share prices and a large build-up of debt.”
More generally, from the reasoning set out in Part I and Part II it follows that a bust (also known as a ‘slowdown’ or ‘downturn’ – the term ‘recession,’ to say nothing of ‘depression,’ has been banished from the economic lexicon) is the culmination of the period of unjustified borrowing, lending and investment. And to some extent Australians and New Zealanders (together with Americans, Britons and Canadians) are living on both borrowed time and borrowed money. Investment encouraged by subsidised rates of interest can be continued only so long as central and commercial banks make credit available at sub-natural rates. It is this margin between the subsidised and the natural rate which misleads entrepreneurs and gives their investments the false appearance of profitability. It also misleads consumers and gives their shopping sprees the false appearance of sustainability. When the boom ends, it does not cause difficulties: it merely makes apparent difficulties which inhered all along in credit inflation. The defining feature of booms, then, is not that they are periods of good business – rather, they are times when capital is squandered on bad investments.
Accordingly, if over a period of years an expansion of bank credit pushes the market rate of interest below its natural rate (i.e., that at which the supply of savings matches the demand for loans) and induces individuals and businesses to misdirect resources into what eventually reveal themselves to be dud investment projects, then there is little a central bank can – or should – do to avert the resultant credit crunch and liquidation of malinvestments. Not only can and should central banks do little to ‘engineer soft landings’ – their attempts to do so, usually in the form of lower funds rates and discount rates, risk setting the stage for another artificial and unsustainable boom.
A Minority View
It is important to appreciate that this is a minority, reprobate – even an iconoclastic – view. Far more prevalent and comforting is the view that uncertainties, market failures and irrational behaviour, which are perceived to be deep-seated features of market economies, dominate businesses’ and consumers’ decision-making. These uncertainties, reflected in the level of “business and consumer confidence underpin psychological explanations of prosperity and recession. The notion that slowdowns, slumps in confidence and the like may be attributable to pessimism on the part of business people and consumers suggests the need for central direction and policy activism. According to this conventional view, prosperity consists in strong consumer spending; this spending, in turn, depends upon strong, prescient and optimistic leadership (i.e., inflationary policies) by politicians and central bankers.
Unlike politicians and central bankers, I disclaim any ability to predict (to say nothing of influence) the future course of interest rates; nor do I know whether the business cycle will turn (or whether it has turned) downwards; and still less can I claim to know when, to what extent or by what process this reversal of fortune might occur. Yet on the basis of the reasoning in Parts I and II and the conclusion in this circular, I can and have structured Leithner & Co.’s portfolio in response to three possible risks and one possible opportunity.
A Conclusion and an Opportunity
The possible opportunity, in Mr Buffett’s words, is that “the best time to buy assets may be when it is hardest to raise money (Fortune 23 October 1989). A good time to invest, in other words, is when others are unable or unwilling to invest. Leithner & Co. therefore looks with equanimity towards a credit crunch, if that is what is developing, not for its own sake but because they often make good businesses available at sensible prices.
Risk #1 The Integrity of Interest and Debt
Balancing and possibly outweighing this opportunity are a series of significant risks. The first is a misplaced obsession with rates of interest. The relevant question to ask about interest relates not to its level but to its integrity. The natural rate of interest is determined by the time horizon of the general public: the shorter the time preference (i.e., the greater the preference for consumption today rather than more consumption tomorrow) the greater the natural rate of interest. In the absence of intervention, investments’ rates of return tend to equal the rate of time preference. Given considerable intervention by governments, investors should therefore ask themselves whether time preferences – and changes therein – convey accurate information. Acting on them, would individuals make reasonable choices? Or would they undertake ‘malinvestments’?
A number of studies that grew out of the financially-chastened 1930s and 1940s found that default rates on debt instruments varied significantly with the year of their issuance. That finding has been replicated much more recently: the shakier issuers that sold debt in the easy-credit environment of 1997 and 1998 are now tending disproportionately to default on their bonds and bank debt. Historically, it is during the third and fourth years of the life of a corporate bond that the risk of default is greatest. That tends to be the amount of time it takes for risky borrowers to run into trouble, out of money or both. According to James Grant (Minding Mr Market: Ten Years on Wall Street With Grant’s Interest Rate Observer), “the relevance of that finding for our own day, it seems to me, is that one ought first to try to assess the market’s attitude towards debt. Is it properly sceptical? If the answer is ‘no,’ as I’m sure it is, we ought to be careful. It almost goes without saying that that if the road to risk were really paved with promissory notes, then poverty would have been abolished ages ago.”
Risk #2 Central Banks and Moral Hazard
The second risk is that the confidence (and in some quarters unshakeable conviction) in the ability of central banks to ‘engineer soft landings’ may be misplaced. Warren Buffett once remarked that the stock market is an interesting place when the tide recedes – for it then that you see who has been swimming naked. Morgan Stanley Dean Witter’s Asia-Pacific strategist, Ajay Kapur, has adapted this insight: when the tide ebbs, those swimming naked are often thrown a towel by central banks. The phrase ‘moral hazard’ refers to the tendency of some contractual arrangements to reduce one or more of its parties’ appreciation of risk. It typically manifests itself in the transfer of risks or costs – but not benefits – associated with an action away from the individuals who undertake it. In so doing it encourages those individuals to undertake riskier and costlier actions than they otherwise might.
If not carefully worded, insurance contracts can create moral hazards. If I am an insurer and I contract to indemnify members of a group for all of their mistakes, then it is likely that members as a whole will subsequently undertake riskier behaviour than they would in the absence of my indemnity. More specifically, if motor cars are insured against theft then (unless the insurance agreement is carefully worded and the policy-holders carefully selected) their owners’ incentive to lock them, remove the keys from the ignition and take other precautions when they leave them unattended may decrease. Moral hazards can also materialise in financial settings. Indeed, they may inhere in fractional-reserve banking arrangements: if bankers are not obliged to make provision against all of their exposure to the risk that borrowers might default on their debt obligations, then borrowers and lenders alike have an incentive to assume more risk than they otherwise might. That is to say, banks might lend more than is prudent and borrowers might borrow more than they can comfortably repay.
Moral hazard, or something akin to it, may currently attach to the actions of central banks. Market participants expect – and not infrequently stridently demand – that they reduce interest rates at the first sign that share prices may be under pressure. As Barron’s (12 June 2000) noted, “up to now, the Fed has been playing it cute. They’ve been raising rates but at the same time they’ve allowed the money supply to expand. Thus, the Fed has tried to put a ceiling on the market with rising rates while at the same time putting a floor under the market with copious cash. In the end, we may get the worst of both worlds – a slowing economy and rising inflation. The net result of all this is that the Fed’s manipulations are extending the stock market’s lengthy topping-out process, dragging it on and on and on. The Fed objects to the ‘irrational exuberance’ of the stock market but at the same time is afraid to let the stock market go into the tank.” At the same time, however, and as The Australian Financial Review (5 December 2000) noted, no central bank should be “keen to bail out investors. As they come to expect rates to be cut whenever the market collapses, investors become too willing to accept risks in the belief they won’t bear the full costs of their mistakes. The moral hazard problem got worse with the 1997 Asian crisis and the U.S. Federal Reserve’s subsequent bailout of Long-Term Capital [Management].”
Risk #3: Are Lower Interest Rates Really a Good Thing?
The third risk is that the consequences of recent decreases in interest rates in Australia, Britain and Canada (the Reserve Bank of New Zealand is smarter in this respect), if maintained and extended, may be harmful rather than beneficial. For today’s debt-burdened consumers and businesses, in other words, lower market rates of interest may do more harm than good. Not only may they delay the liquidation of the ‘malinvestments’ of recent years; if they maintain or extend the disparity between market and natural rates of interest, they may exacerbate the very difficulties which they intend to alleviate. Ludwig von Mises, writing during the 1930s, noted that “it has often been suggested to ‘stimulate’ economic activity and to ‘prime the pump’ by recourse to new extension of credit which would allow the depression to be ended and bring about a recovery or at least a return to normal conditions; the advocates of this method forget, however, that even though it might overcome the difficulties of the moment it will certainly produce a worse situation in a not too distant future.” Much more recently, Thomas Donlan (Barron’s 8 January 2001) reminds us that “lower rates don’t necessarily cure bad loans. If the money was spent unwisely, the loans are still bad. Lower rates don’t necessarily raise markets. If the investments were ill-targeted, equity remains destroyed. So we wonder: Is Alan Greenspan serving as physician or bartender?”
The Economist (27 January 2001), very much a mainstream publication, nonetheless seems to concur: credit inflation is presently being demanded in order “to reduce the value of debts whilst simultaneously widening profit margins by raising prices faster than costs, particularly labour costs. This in turn will release withheld capacity, or so it is assumed. But nothing has been purged. All those ‘deadbeat companies’ will still be with us, having been given a second monetary wind. However, it will only be a matter of time before the symptoms will re-appear. Sooner or later these ‘deadbeat’ companies will have to go.”
Although for very different reasons, John Quiggin (The Australian Financial Review 18 January 2001) also concurs: “aggressive cuts in interest rates and big tax cuts for the rich may defer the necessary adjustment, but they will not prevent it. A soft landing for the US economy will involve at least a year of zero or negative growth. The hard-landing scenario for a deflating asset bubble may be seen in Japan’s decade-long economic stagnation.” Quiggin adds (AFR 15 February 2001) that “...moreover, the downturn has spread from the flashy but economically inconsequential dot coms to the large, and massively indebted, telco sector, while the chronic decline of manufacturing has accelerated. Belief in miracles is still strong, however, most notably with the idea that the chairman of the US Federal Reserve, Alan Greenspan, can make the whole problem go away by making marginal adjustments to interest rates. The longer such naïve optimism clouds the thinking of US investors, the more the necessary adjustments will be delayed and the worse will be the subsequent pain.”
 
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