The Effect Debt Has in Creating a Financial Crises

I don’t normally write about debt-driven crises, because it’s not my area.

However, it’s a subject financial experts the world over debate endlessly. And it also happens to be one that worries average investors more than most.

Investors are concerned about global indebtedness, due to its potentially destructive effects on stock markets. In times of market distress, investors naturally reassess their own investment strategies. Not least because they’re reminded time and again that debt is one of the main causes of financial crises.

But is that belief justified? I think it is.

Debt is as much a political tool as it is an integral part of the capitalist system. Governments, businesses and individuals all borrow to finance spending. So why do rising debt levels drive economies into crises? And why do we even have rising debt in the first place?

In today’s Money Morning, I will make a few observations on debt, and the effect it has in creating financial crises.

I want you to imagine an economy with a stable level of economic activity — a horizontal straight line over time. Now I want you to imagine an external force pushing the initial starting point of the line downward; like a parent pushing a child on a swing to make it sway. Visualise this line now curving downside which, in this example, indicates a slowdown in economic activity.

Now, I want you to imagine that, when economic activity falls to a certain point, a hypothetical central bank using policy tools, such as interest rate cuts, to drive up economic activity. Let’s assume that the degree of policy stimulus is ‘just right’, and that economic activity starts to swing in a positive direction.

Economic activity is now under the influence of policy stimulus. It keeps going higher and higher, until a point when policymakers decide that growth is too fast, and the economy is overheating. Perhaps inflation is too high, forcing the central bank to raise interest rate, tempering the level of economic activity in the process. But let’s assume they carry out this rebalance ‘just right’ again…

In the event, economic activity would repeat this motion of swinging between the up and downside over time — economic expansion, followed by contraction, then expansion, and so on. Let’s call that the ‘perfect business cycle’.

If we operate in a perfect world like what I just described, the use of debt-driven stimulus during downturns is perfectly balanced by the withdrawal of that stimulus during market upturns.

Life goes on, and everyone is happy…

That is the hypothetical world most central bankers live in…

But the real world does not operate in that fashion, and they know it.

One crucial reason for why the ‘perfect system’ does not exist is that policymakers ‘support’ the economy way too early, well before the downturn has a chance to hit its hypothetical optimal point.

And this is one thing that many free market advocates talked about during the Global Financial Crisis. There is a handful who believe the ‘rescue’, and everything that followed (QE etc.), should never have happened.

You may have heard statements like, ‘the banks should be allowed to fail…incompetent people should go out of business…the system has to be allowed to reset.’

Most people would consider such statements as the musings of madmen. And the government would agree…

Of course, as we all know, policymakers didn’t allow things to sort themselves out. They did the exact opposite. To this day, monetary stimulus supports the global economy, addicted as policymakers are to it. Some people describe the world economy as having left the ‘Intensive Care Unit’. To me, it is in a permanent state of limbo.

The argument for ‘saving everyone’ during a crisis is that economic malaise would be more severe without interference. People would lose their jobs. It is this fear of mass unemployment that I believe strikes at the heart of what’s going on.

What upsets our ‘perfect economy’ is the political motivation to maintain social stability — employment.

Think about it, the Federal Reserve even says it outright — they look at the strength of the economy and employment numbers. That prompts them to start stimulating the economy way before it has a chance to run its course on the downside. Historically, the Fed tends to keep the stimulus ‘tap’ on for far too long.

And what happens when it does?

The excess on the downside remains in the system. Economic activity swings to the upside, with the ‘support’ of debt-driven stimulus only serving to create asset bubbles.

And what happens when you have a bubble? It bursts, sending economic activity to the downside, steeply and quickly.

It’s at this point that policymakers take control yet again…pushing the ‘swing’ higher before it has a chance to digest its momentum on the downside. The process repeats, generating more excess, more bubbles, more need for debt-driven stimulus and, unfortunately, more problems for social stability in the long run.

Needless to say, the child on the swing is in grave danger…

But debt is not the enemy here.

Debt exists on the willingness of the lender to accept the level of risk. If a creditor is willing to lend you $1 million, it’s fine as long as that lender is willing to do so. The problems arise when that willingness is limited.

Over the long term, the reduction of interest rate to zero, and ultimately to negative rates, can be explained by an imperfect system due to political motivations (what I explained earlier) and a real loss of demand, competitiveness or rise in supply side efficiency.

Each unit of debt creates an expansion in economic activity which. But this growth isn’t perpetual. It is capped by natural constraints such as population, efficiency-gains, and demand. In essence, if you have a declining population, slowing demand, and rising efficiency (which boosts supply abundance), things are going to be tough no matter how much debt you create.

Economic activity is ultimately about the need for people to satisfy their individual consumption requirements. You can’t make five people consume an amount more appropriate for 500, regardless of how much debt you create.

So do we have problem in our system? Of course we do, and it is getting worse.

What can save us?

We need a real ‘revolution’ in technology, which should result in a boost to demand.

We need real demand growth as a result of demographic factors, such as population growth.

And we need economic reforms that allow more developing economies to pursue modernisation.

Achieve all three, and we can ween the global economy of its addiction to debt-driven growth.

Cheers,

Ken Wangdong,

Analyst, Emerging Trends Trader

From the Port Phillip Publishing Library

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