The credit cycle and zombies’ downfall

Dec 16, 2021·Alasdair Macleod
Leading central banks like to think that through careful interest rate management, they have tamed the economic cycles which lead to regular economic downturns. Instead, they have only managed to bury the evidence.

To appreciate the extent of their delusion one must understand the source of economic instability. In modern times it has always been driven by a cycle of bank credit. In this article the role of commercial banking in this regard is explained. The effect on non-financial economic sectors in the context of Hayek’s triangle under today’s currency regime is re-examined.

With cyclical variations in the economy buried under a tsunami of currency, market participants are oblivious to the dangers of a cyclical downturn in bank lending and the consequences that flow therefrom.

This article gives the problem its economic and monetary context. It concludes that the global banking system is horribly over-leveraged and, with empirical evidence as our guide, on the edge of a bank credit contraction of historic proportions, likely to undermine the entire fiat currency system.


Readers of articles that dissent from the mainstream media’s complacency might be aware that there are many zombie corporations which only exist courtesy of low interest rates or government support. The story often goes further. These are businesses loaded to the gunwales with unproductive debt, vulnerable to being swamped and sunk by higher interest rates. The extent of the problem is undoubtedly greater than most people think.

We have arrived at this point with economies around the globe cluttered with unproductive businesses which would otherwise have been cleared out in an unsuppressed interest rate environment. Schumpeter’s process of creative destruction would have done its work. Without it, the current situation presents enormous dangers now that with price inflation rising, interest rates will almost certainly increase in the coming months. Central banks appear to be conscious of this danger, given their evident reluctance to permit rates to rise, even fractionally. Rising interest rates also blow holes in their narrative, that they have succeeded in managing economic cycles out of existence.

Austrian business cycle theory

It appears that central bankers and their advisors are unaware of Austrian business cycle theory or deem it irrelevant. While the effect is manifest over an economic cycle, the root of it is credit expansion, and I’ve always maintained that for this reason it should be described as a credit cycle — a repetitive cycle of bank credit expansion and contraction, rather than as a trade cycle (Mises) or a business cycle (modern Austrians). The primary cause can be firmly attributed to the human behaviour of a commercial bank cohort reacting to events and information. But bankers are not the only party involved. Austrian school economists, such as von Mises and Hayek explained how businesses were affected. And Hayek also taught us that it could be explained by means of a triangle, with production time to market for consumer goods on the x-axis and immediate consumer spending on the y-axis. the swing-factor being the ratio between immediate and deferred consumption (savings), which sent vital signals to industry about consumer behaviour. This is illustrated in Figure 1.

At any given time, investment is made at the expense of consumption, because investment in production is funded through savings, or consumption deferred. It therefore follows that an increase in savings leads to a fall in consumer spending and an increased availability of capital. In turn, other things being equal, the increased supply of capital reduces interest rates, fundamentally altering business calculations.

Simplistically, the longer it takes for a product to be produced, the higher the cost of financing its production. A pre-existing production facility can be financed in cashflow terms by current production; but a new production proposal takes time to set up, which until the final product is rolling off the production line can take several years. Reducing the interest rate, which is the consequence of increased savings, allows an entrepreneur to consider longer-term business strategies, such as the building of a completely new factory rather than adapting an existing facility.

The longer timeframe permitted by higher savings levels is illustrated by the pecked line in Figure 1. On an economy-wide basis, the whole production profile of a nation changes, placing greater emphasis on earlier stages of production and less on the final. Thus, sales of intermediate production goods and technology aimed at improving product quality and reducing costs benefit relative to retailing, which suffers from the fall in direct consumption. Even in these inflationary times, a grasp of the Hayekian concept explains the relative post-war successes of the German and Japanese economies, which relative to the Anglo-Saxons were savings-driven economies versus the Keynesian policy of waging war on savings.

In today’s heavily financialised world, perhaps Hayek’s triangle might seem less relevant than the sounder monetary background to the 1930s when Hayek was teaching at the London School of Economics. Furthermore, increasing quantities of bank credit are now taken up by consumers themselves. And industrial financing has shifted in recent credit cycles from a dependency on bank credit and corporate bonds to equity participation, facilitated by the evolution of financial markets over the last forty years.

In addition to these evolutionary changes in bank lending there has been the expansion of base money by the central banks, and on this current credit cycle, banks have increasingly expanded credit in favour of the state as opposed to commercial debt.

The world of currencies and credit has evolved from the days when there was a gold standard of sorts, and people behaved as if their currencies were fundamentally sound. That was when Hayek devised his triangle to explain the Austrian theory of business cycles. Even though there have been significant changes in the economic and monetary environment the motive forces driving cycles of credit still exist — it’s just that they are somewhat different.

In this article I cover the various aspects of the credit cycle relevant today, looking at them from the interests of the principal economic parties involved: businesses, the commercial banks, and central banks. And with these parties, the rest of us will also be profoundly affected.

The origin of changes in bank credit

Like any other human, a commercial banker is driven by not only plain commercial factors but subjective ones as well. With respect to lending policies the balance of fear of losses and greed for profit varies in accordance with his view of lending risk at any one time. He also pays close attention to the actions of his competitors, cementing a high degree of groupthink into his banking strategy. Fear of losses is always greatest when there has been a downturn in the economy, putting the bank’s capital at risk. In describing a banker’s response to changing conditions, we shall use the end of a downturn in business activity as our cyclic starting point.

A commercial banker’s perception of risk changes over a complete credit cycle, and is summed in the following sequence:

  • At the depth of the recession a bank will be nursing bad debts which will have been magnified as losses suffered by the bank’s shareholders due to balance sheet gearing. If the bank survived the downturn, it will have been because it had restrained its operational gearing before economic conditions had fully deteriorated in the previous credit cycle. Perhaps it had called in loans before its competitors, thereby benefiting from the liquidation of loan collateral before financial asset values had materially declined. A cautious approach to lending would have led to a bank being in a strong position relative to its competitors at the bottom of the business cycle.
  • A process of capital reallocation from loss-making businesses to more profitable deployment begins. Company doctors, experts in insolvency work and corporate restructuring, propel this process. And those with an established track record are sought after by the banks to retrieve some value from their bad and doubtful debts. To facilitate the process, banks begin to be persuaded by company doctors to extend credit to back refinancing operations. Other than in these instances, banks are generally unwilling to extend extra credit, even in the form of short-term working capital to industrial borrowers.
  • The process of reallocation of capital from unprofitable to potentially more profitable restructured enterprises leads to the contraction of bank credit ceasing and the beginning of the earliest stages of its expansion. Bankers are still reluctant to make credit more widely available, but the gradual stabilisation of lending conditions leads to the first signs of lending optimism returning. Large established businesses are the first to benefit, being judged to be the least risky proposition. Financing of capital restructuring operations evolves into corporate takeover activity, which encourages stock markets to recover and ends the bear market. It is signs such as these that begin to encourage bankers to think the worst is behind them and to contemplate lending opportunities with increasing confidence.
  • With investment banking beginning to see a sustainable upturn in business on the back of takeover activity, normal lending for working capital purposes becomes more widely available. The previous crisis is now forgotten, and in reflecting initial increases in demand for credit, interest rates stabilise and begin to reflect a firmer tendency. Improved lending margins allow banks to begin to compete for lending business, even cutting margins to get corporate borrowers on the books in the interest of future lending and investment banking prospects. Consequently, large, and more aggressive borrowers can now shop around for the best rates for bank credit, which they were previously unable to do.
  • By now, on the back of increasing bank credit, economic recovery appears to be well underway. This is when more aggressive banking reaps its rewards, with banks’ share prices rising and their balance sheets expanding. Instead of having a ratio of assets to equity of perhaps five or six, banks begin to expand to eight times or even more. All bankers are doing it, and no banker can afford not to expand his balance sheet for fear of being accused by his shareholders of underperforming his peers. Confirmation bias holds full sway. Under the influence of this credit expansion, the economy appears to be increasingly strong, further encouraging bankers to throw all lending caution to the winds.
  • But credit expansion begins to lead to demand for production inputs that cannot be easily satisfied. Banks find that their borrowers are having to pay up for the factors of production, including raw materials, intermediate goods, and labour. The right skills are in short supply. Prices for everything have begun to rise because of supply constraints and a boom in consumer spending. The natural level of interest rates appears to be rising, and bankers begin to look for opportunities to increase their margins rather than to just compete for business. They maintain deposit balances by increasing deposit rates. Slowly, bankers begin to see risks beginning to emerge, realising that the gearing on their balance sheets now exposes their banks to potential risks from deteriorating lending conditions.
  • Finally, rising interest rates begin to undermine bank customers’ business models and increasing numbers of them request loan extensions and increased borrowing facilities. More prescient bankers, who have experienced several credit cycles, recognise the signs of a lending downturn early and take action to control risk exposure. Collateral values will have already begun to decline, driven by the rise in interest rates. And any borrower unable or unwilling to provide extra loan cover will be speedily foreclosed. With surprising rapidity, the lending environment changes with all bankers beginning to replace their former greed for geared profits with a new fear of losses. And as outstanding bank credit begins to contract the economic outlook begins to look exceedingly grim, with the more highly leveraged banks facing the prospect of escalating bad and doubtful debts that could require a state bail out.
It is the balance of fear and greed over the lending cycle driven by the banks’ response to the economic conditions which leads to the expansion and contraction of bank credit. The expansion of credit is as inflationary as the expansion of currency by an issuing central bank. The subsequent contraction of bank credit is suddenly deflationary. It is a cycle of remarkable consistency, both in its consequences and duration.

While we can identify common factors, the way successive cycles of bank credit expansion terminate depends on where the expansion was previously focused. In 2000-2002 it was the collapse of the dot-com bubble. In 2008-09 it was the boom and bust of residential property. Today, financial speculation evidenced by otherwise worthless cryptocurrencies and non-fungible tokens is probably at the highest levels ever recorded. This time the credit contraction is shaping up to be a wider collapse of financial assets, driven by rising interest rates undermining valuations —perhaps a repeat of the 1929-1932 bear market being the initial effect. The difference from the Wall Street crash ninety years ago is in the money: that crash happened under a sound money standard; this time currencies are pure fiat, as flaky as Germany’s paper mark in the early 1920s and unlikely to survive such a substantial economic shock.

How relevant is the Hayekian triangle today?

Another feature of the credit cycle that has evolved since Hayek devised his triangle is the growth of consumer debt. It has partly neutralised Hayek’s model by interfering with the simplistic ratio of consumption to savings, which through interest rates coordinates consumer demand with production. Hayek was effectively saying that a higher savings ratio was an economic signal to manufacturers of goods that those which take longer to produce will be profitable, because lower interest rates are significantly less costly for longer-term projects. And while the signal from the decline in immediate consumption was to the disadvantage of retailers and businesses close to the consumer, it would be those remoter business activities that would benefit from investment. It therefore follows that if a central bank suppresses interest rates it sends a false signal to producers, leading to malinvestments.

But a greater interference comes from state-driven currency inflation. Governments and their central banks use the expansion of fiat currency to replace savings as the source of capital in the economy. Today, the character of the credit cycle has taken on a new form, with borrowers increasingly borrowing to take advantage of the wealth transfer effect of depreciating currencies at rates which rob depositors of their purchasing power.

This is borrowing for borrowing’s sake, rather than to deploy capital for commercial purposes. In recent decades it has led to the financialisation of Western economies. And when one considers the US dollar personal savings rate illustrated in Figure 2 below, the trend increase recorded since 2005 from about 2.6% to the latest 7.3% owes more to income being put aside for speculation in financial assets and is the counterpart of consumer borrowing for speculation rather than what the classic Hayekian assumption about deferred consumption represents.

With personal savings being increasingly diverted into financial speculation, not only do Hayekian signals appear irrelevant in our corrupted currency system but increasingly we find capital for production is being sourced from the state through its monetary policies. It accords with the Concluding Notes in Keynes’s General Theory, where he expressed a wish for the euthanasia of the rentier (saver) and for “an increase in the volume of capital until it ceases to be scarce”.[i]

The consequence of undermining business calculations has been an indefinable, but no doubt substantial increase in unproductive debt. And now that fiat currency debasement has accelerated everywhere to record levels, the logic hidden behind the Hayekian triangle might come back to bite everyone. This is because time preference factors determined by markets are sure to drive interest rates up, exposing borrowers at suppressed rates as having made fatal errors in their business calculations.

Nowhere will this be truer than in jurisdictions with negative interest rates. Large corporations in the Eurozone and Switzerland have even been able to borrow at marginally negative nominal rates, an incentive for non-financial businesses to take out debt for debt’s sake instead of for productive purposes. The same will be true of Japanese corporations borrowing yen. And because of zero US dollar rates, the same is also true in the US, if only marginally less so.

Even in China, where state-managed interest rates have been kept well away from the zero bound, things are unravelling in the property sector with Evergrande, the second largest developer by sales now insolvent. Insolvencies in property development are a reliable signal of the end of a bank credit cycle, confirming its timing, at least in China. State control over private sector activity is far greater than in Western democracies and the Communist Party has greater control over outcomes. Whether they manage to supress the evidence of the end of the credit cycle in China should not fool us: on a global basis the financial system is set up for a contraction in outstanding bank credit.

The falling economic tide waits for no man, exposing him to the consequences of earlier actions. Rising interest rates will turn the bank credit cycle into its contraction phase, exposing unproductive borrowing indiscriminately. Zombie corporations will no longer walk the earth but be forced into their graves. We must then consider the time-honoured effects on the banks, which have unwisely expanded their credit on the back of central bank and bank regulators assurances that it has been safe to do so. Table 1 below shows the relationship between total assets and equity for the global systemically important banks — the G-SIBs — the largest international banks most capable of spreading a global banking crisis beyond their home jurisdictions. It should be noted that the thousands of smaller more domestically oriented banks around the world will include some with even higher leverage ratios.

The high level of gearing for many of these major banks is ignored in US-centric commentary because, in general terms, US banks are less geared than in other jurisdictions. Furthermore, with the exceptions of Wells Fargo and Citi, US G-SIBs have a price to book ratio of more than one, which indicates that markets, with these two possible exceptions, are not immediately concerned about the banking sector’s financial health.

The same cannot be said of Eurozone G-SIBs. With banks sporting asset to equity ratios of up to thirty times (Credit Agricole), only one (ING Groep) is close to book value, while the others are at deep discounts, market ratings that seriously question their survivability.

China’s G-SIBs are slightly more geared than those of the US, but their shares are at substantial discounts to book value. China appears to have acted to curb speculation in financial markets, and furthermore these banks are an extension of the state. The deep discount to book value probably reflects these factors as well as the likely kleptocracy of the state in the event of a financial crisis.

Japan’s three G-SIBs are the most highly leveraged as a group and they have price to book ratios of about 44%, a worryingly deep discount. British banks are similarly of concern and the two Swiss banks are also highly leveraged.

As we have seen in our analysis of bankers’ crowd psychology above, the turn of the credit cycle will undoubtedly lead to a swift change in bankers’ attitudes. There can be no doubt that they will seek to reduce their balance sheet gearing to as little as possible in a stampede to protect their shareholders. The collapse of Evergrande in China indicates that the state-controlled banks there, if they were operating in the same market and regulatory conditions of their G-SIB counterparts, are already on the edge of a bank credit contraction. This is not yet a visible condition elsewhere.

Prices of commodities, labour, intermediate products, goods, and services are rising everywhere. As I write, it is announced that the US producer price index has risen 9.6% year-on-year. Last week we heard that the US consumer price all-items index rose 6.8% in the year to end-November. These figures represent a fall in the dollar’s purchasing power, and when taken in conjunction with evidence that they under-represent the true situation there can only be one outcome: the markets will force interest rates to rise, or else the purchasing power of the dollar and other fiat currencies will accelerate the pace of their loss of purchasing power.

Where the downturn in bank credit leads

There can be no doubt that with interest rates around the world rising from negative and zero rates, credit conditions will be changed substantially. And with a preponderance of zombie corporations the world over, bankers will become acutely aware of the risks. It will not be long before loans are called in, and collateral sold into the markets.

This article concludes that with rising interest rates now inevitable, they will lead to a bear market in financial assets, which can only accelerate the contraction of bank credit. The operational gearing in global G-SIBs is at record levels and is truly alarming. There must be no doubt that higher interest rates and the scramble to contain the fall-out will make the collapse of Austria’s Credit-Anstalt in May 1931 seem a relatively minor failure in comparison.

We also must not doubt that the reaction of the monetary authorities will be to rescue failing banks because they have no alternative. The consequences are that the central banks will be damned if they do and damned if they don’t. Therefore, anyone wholly committed to preserving wealth in the fiat currency system risks losing everything and should take out some insurance by owning some real uncorruptible money — physical gold and silver.

[i] See Keynes’s The General Theory of Employment, Interest and Money, Concluding Notes II.


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