When will the next credit crisis occur?Feb 8, 2018·Alasdair Macleod
The timing of any credit crisis is set by the rate at which the credit cycle progresses. People don’t think in terms of the credit cycle, wrongly believing it is a business cycle. The distinction is important, because a business cycle by its name suggests it emanates from business. In other words, the cycle of growth and recessions is due to instability in the private sector and this is generally believed by state planners and central bankers.
This is untrue, because cycles of business activity have their origin in the expansion and contraction of credit, whose origin in turn is in central banks’ monetary policy and fractional reserve banking. Cycles of credit are then manifest in variations of business activity. Cycles are the cause, booms and slumps the consequence. It follows that if we understand the characteristics of the different phases, we can estimate where we are in the credit cycle.
With sound money, that is to say money that neither expands nor contracts, cycles in business activity cannot exist, except for plagues and wars which interrupt the balances between money-hoarding, saving and consumption. Any exceptions to this rule are bound to be insignificant and non-cyclical, because with a steady money supply, failures are random instead of cyclically clustered by monetary policy.
Capital is always allocated by entrepreneurs to favour the efficient production of the goods and services wanted by consumers. Allocations of earnings and profits to savings are set by entrepreneurial demands for monetary capital to finance production until the goods and services produced are sold. Failures, the result of errors of judgement by entrepreneurs, are inevitable, but are quickly accepted, and capital is redeployed accordingly. As soon as a non-commercial force, such as the state, corrupts the free market’s interplay between entrepreneurial production and consumer demand, the progression of an economy becomes unbalanced. Variations in the quantity of unbacked money to achieve a managed objective are particularly disruptive. The consequence, not accepted by the vested interests of interventionism, is a cycle of credit expansion leading to a compensating crisis.
This is the outcome of monetary policy. It creates nothing but an illusion of genuine economic activity by debasing the unit of account. In pursuing an objective of economic growth, governments are simply recording the application of the unsound money they and their licensed banks have created. It is our damnosa hereditas, our ruinous inheritance.
The purpose of this article is to establish where we are in the global credit cycle, and to estimate from that the likely time-scale to the next credit crisis. And yes, it is a global phenomenon, made more powerful by global synchronisation of monetary policies through forums such as the G20. Trying to understand where we are in the credit cycle of one particular nation misses out a bigger picture. But we can observe where we are in it by assessing the interplay between business sentiment and monetary factors.
Understanding the credit cycle
The credit cycle can be broken down into the following phases: post-crisis stabilisation, recovery, expansion and finally crisis. The transition from one phase to another is somewhat arbitrary, and each cycle differs in length and character. For these reasons, applying a statistical approach to identifying the different phases usually fails to elucidate analysis. It is far better to have an understanding of shifts in sentiment in the minds of consumers, producers and lending banks, and how they interact.
At the beginning of the credit cycle, central banks exert the most economic influence through monetary policy. They do this by ensuring, as far as they can, that the market does not clear. By this we mean that the accumulation of malinvestments in the previous cycle is protected, thus preserving jobs in businesses that in a free market would have been abandoned as producing an inadequate return. The capital employed in these unserviceable industries becomes locked in, not quickly redeployed as it would in an efficient economy. And by capital we include not just money, but all the other factors of production that must be acquired, including labour.
In today’s interventionist, neo-Keynesian world, prices must never be allowed to adjust downwards to establish new price equilibriums, as they would in free markets. The balance between savings and immediate consumption is encouraged to adjust in favour of immediate spending to shore up falling prices.
This gives us a basic rule, which has always held to date: by debasing the currency and reducing, eliminating or even reversing the time-preference inherent in unhampered free markets, central banks have always stoped the credit crisis from running its full course.[i] There were moments in the last two crises when this nearly did not happen. We all stared into an economic and financial abyss of complete systemic failure, with the potential to destroy the banks and all their customers’ balances. And without banks, the production of all goods and services were likely to cease or be provided through nationalisation. In both instances, the Fed under the chairmanship of Alan Greenspan and then Ben Bernanke came to the rescue.
The first crisis of the new millennia was primarily the result of a credit-fuelled dot-com bubble unwinding and had similarities with the stock market crash of 1929, which preceded the depression. The Fed was not going to allow that to happen again, and stock and bond markets were rescued by aggressive reductions in interest rates. Consequently, monetary expansion regained its momentum, with a new feature developing, the alphabet soup of securitisation, amounting to extra, unrecorded off-balance sheet credit expansion through the growth of shadow banking.
The second crisis followed in 2007-09 (we must be vague about actual dates), this time in residential property markets, which had been puffed up on expanding credit more than any other asset class. The credit-driven boom and bust cycle had developed as one might have expected, similar to the run up to the UK’s secondary banking crisis of November 1973.
At that time, Britain’s credit cycle had evolved in the usual way. There was a well-defined sequence of events, in an economy whose presiding government was running large budget deficits. From late 1970, the then Chancellor, Tony Barber, caused the Bank of England to expand the money supply and reduce interest rates from 7% to 5%.[ii] Initially, gilt-edged bond yields fell, and equities rose. Bond yields bottomed in January 1972 and yields then rose. The equity market peaked the following May, five months after the bonds, and then entered a significant bear market. In June that year, the Bank of England increased interest rates to 6% and then in progressive steps to 9% by the year-end.
There were two mounting problems. Price inflation was picking up and the Government had difficulties financing its deficit. Periodically, the Bank of England had to raise interest rates sharply in order to sell gilts. Today, we are aware of the potential for price inflation, but generally not so much of the potential for a government funding dislocation.
The irony, to equity investors anyway, was that while equities began in May 1972 what turned out to be the early stages of a vicious bear market (prices fell over 70% by December 1974), companies were reporting enhanced levels of business activity and growing profits. However, by late-October 1973, price inflation fears suddenly escalated when OPEC proclaimed an oil embargo. The Bank raised interest rates to 13% in early November in response to the oil crisis and equities crashed.
Commercial property prices also collapsed, taking banks down in what came to be named the secondary banking crisis. Paradoxically, on the eve of the secondary banking crisis, commercial property was seen to be a cast-iron hedge against price inflation, which had been a growing concern since equities began to drift lower the previous May.
These were some of the defining characteristics of Britain’s credit cycle at that time, which rhyme with those of today, though interest rate levels were very different. The stimulation through deficit spending, interest rate suppression, and measures to encourage bank lending are common to both. The initial effects of monetary stimulation for bond prices and equity markets are similarly observed in both cycles. Bond yields have now started to rise, as they did in early 1972. Equity markets are clearly vulnerable to entering a bear market if bond yields rise further, which puts the fall in equities this week in a sharp perspective.
Therefore, it appears that in its credit cycle today, the global economy is where the UK was in May 1972. At that time, bond yields were rising, because demand for credit from the non-financial sector began to accelerate, as businesses and lending banks became more confident of business prospects. Banks sold down their short gilts to accommodate increasing lending demand, undermining values of financial assets generally. It was rising gilt yields that undercut equity prices, despite the improvement in the business outlook.
Today, in all the major jurisdictions, bond yields are now rising. A bank which bought 5-year US Treasuries last September is now sitting on a painful loss of 4.4%, wiping out perhaps between a third and a half of the core capital allocated to back the investment. Similar stories can be told of banks invested in other government bond markets. Yet, it is only in the last few months that economists and financial commentators have begun to accept that the world is set for a coordinated phase of economic growth. Plainly, we are heading into the equivalent of the period between May 1972 and October 1973, which lasted fifteen months. Except, this time, the scale is global and may not last as long.
The expansionary phase is upon us
We can therefore hypothesise with a high degree of certainty that we are in the early stages of the expansionary phase of the credit cycle, the last phase before the crisis that will end it. We can be sure the crisis will happen, because every credit cycle ends with a liquidation. However, we must now refocus our attention away from pursuing today’s similarities with Britain’s credit cycle of the early 1970s for two reasons: firstly, 1973 ended with a sudden oil shock in November, and secondly, with today’s credit cycle being coordinated globally, the crisis is likely to be all-embracing and far more destructive.
The 1973 oil shock was politically timed, and were suddenly unleashed upon financial markets. This time, oil prices are likely to rise more gradually, driven by growing demand for energy and a falling purchasing power for the dollar.[iii] A synchronised world-wide economic recovery in the coming months otherwise shares the price inflation characteristics observed in 1970s Britain, amounting to a credit-driven debasement of the currency.[iv] It should be noted that this debasement is recorded as an increase in nominal GDP, which simply reflects a larger quantity of money chasing a similar amount of goods and services in the non-financial economy.
In the coming months, globally recorded growth is likely to be higher than during the 1972-73 period, because the potential flows of credit and portfolio money into non-financials from financial markets are significantly greater, and price inflation deflators have been subdued through hedonics and other statistical manipulations. An unprecedented increase in the quantities of base money earlier in the credit cycle is ready to back the redirection of bank credit from financial activities into purchases of commodities and to finance other factors of production. Portfolio money, currently overweight in dollar-denominated financial assets, is also due to be redirected into infrastructure projects, particularly in Asia.[v] Global synchronisation of the earlier credit bubble moving from financial to non financials suggest the price effects ahead of us could be far greater than commonly expected, leading to a rise in interest rates sufficient to trigger the credit crisis sooner, rather than later.
An important factor that led to increases in official interest rates in 1972-74 was the difficulties the UK Government had in funding its deficit. So far, in the current cycle this has not been a problem. While undoubtedly globalisation of credit has made it easier for governments to fund their deficits in the general sense, a prerequisite for ease of funding is that the expansion of credit is confined to the financial sector. So long as that is the case, a central bank can retain some control over interest rates and portfolio flows. When it is not the case, control over interest rates is determined instead by the aggregate actions of the non-financial commercial sector, and the central bank finds it is forced to respond to monetary events, instead of controlling them.
As soon as bank credit and portfolio flows leave financial assets in favour of non-financials, governments are likely to experience severe funding difficulties. Very few of us expect this to become a serious problem, so it will be an unwelcome surprise.
History and mature reflection tell us a global government funding crisis is bound to happen. We can therefore surmise that the central banks which issue the euro, Japanese yen, British pound and the US dollar will have to raise their interest rates above that demanded in the markets in order for their governments to fund themselves. The Chinese, who have a budget deficit of about 3%, also have this cyclical problem, but without the detrimental effect of an escalating long-term welfare burden.
In 1970s’ Britain, raising interest rates to clear a government funding backlog was referred to as the Grand Old Duke of York tactic, after the nursery rhyme. The Bank would raise interest rates to the point where the funding logjam was freed, then march them back down again.
Doing that today would certainly trigger the credit crisis, because of the sheer level of debt in individual economies. Governments are effectively trapped. McKinsey estimated in 2014 that global government debt amounted to $58 trillion, and it has obviously increased markedly since then.[vi] It is not just President Trump increasing borrowing to pay for tax cuts, but for most other governments, borrowing large amounts additional funds to debt refinancing is now business as usual.
The following chart, of the Fed Funds Rate, illustrates the impact of increasing levels of dollar debt on the height to which interest rates can be raised before the next credit crisis is triggered.
The pecked line shows the declining trend of the previous interest rate peaks, where interest rates rose to the level at which a credit crisis was triggered. Thus, a FFR of a little over 6% was enough to deflate the dot-com bubble in 2000, and a FFR of over 5% to trigger the great financial crisis of 2007-09. Today, a FFR above 2.5% would be very dangerous, so even a minor funding dislocation from hereon is likely to trigger a credit cycle crisis. The level of debt outstanding is now truly of cataclysmic proportions.
The next credit crisis will soon be upon us
The current expansion phase is unlikely to last long. The assumption made by nearly all economists is that global growth in GDP will lead to some price inflation, but the dominating factors are hopefully assumed to be beneficial, with corporate profits rising, and therefore tax revenue for governments eventually reducing their deficits. Empirical evidence from the early 1970s suggests this optimism is unwarranted.
Analysis of credit cycles by Austrian economists tend to emphasise the later effects of an earlier expansion of money and credit on subsequent prices over time, and indeed, this is a theme shared in this article. The limit of this approach is analysts risk taking insufficient account of the hangover of unliquidated debt and malinvestments from previous credit cycles. No doubt, the accumulation of economic distortions from previous credit cycles will ensure the next credit crisis will be even more dramatic than the last.
In a modern world of massive portfolio flows, things are even more dangerous. After several credit cycles during which government borrowing has not been disrupted it is likely to become a “crowding out” issue this time round, whereby governments compete head-on in bond markets with private sector borrowers. This conflict seems set to push up the market rate of time-preference, beyond the control of monetary policy. It is also likely to push down the dollar, which is the currency where the bulk of international portfolio money is currently invested. The banking system, being fractionally geared, remains highly vulnerable to these shifts, despite the increase in base money since the last crisis. Eurozone banks are a notable risk, being most highly geared and heavily exposed to falling government bond prices.
Our conclusion is this. Taking into account the combination of price inflation pressures, the fall in purchasing power faced by the dollar, the likely redirection of financial assets by international investors exposed to declining dollars and the potential for a global funding dislocation, we will be lucky if the next credit crisis, taking all this into consideration, does not strike before the year-end.
[i] In free markets, time-preference is the higher value given to immediate possession compared with future possession of property, or a good. It is the basis for interest rates.
[ii] At that time, central bank policy was under the control of the Treasury.
[iii] The assumption here is the dollar will be sold on the foreign exchanges, reflecting a growing US trade deficit, China’s desire to reduce and eliminate the dollar’s role in her trade settlements, and the liquidation of dollar assets in foreign-owned portfolios.
[iv] In 1970s Britain, powerful unions were able to force up wages. In this cycle, wage inflation is absent, a notable difference. Higher wages are now replaced by consumer borrowing.
[v] This overweighting of the dollar in foreign portfolios is the natural result of earlier dollar strength, which is no longer the case. In June 2016, this amounted to a record $17.39 trillion.
[vi] See https://www.mckinsey.com/global-themes/employment-and-growth/debt-and-not-much-deleveraging
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