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The Cotton Candy Market
by Keith Weiner
As I have discussed previously, if you borrow cash then it’s not income. This is why no one in his right mind borrows to buy consumer goods. Those who try cannot sustain it for long.
What if someone else borrows? Suppose someone else—let’s call her Jordyn—buys your house from you, at a higher price than you originally paid for it. You can spend some of the gain.
Of course she is just paying you with her borrowed proceeds, but most people think this is totally different than if you borrow to spend yourself. They feel comfortable spending part of the profit from the sale of a house or other asset.
What is borrowing? Stripped of the money and accounting, borrowing is simple. The borrower immediately consumes what he would have consumed tomorrow or next year. Someone gives him the right to this consumption, in exchange for his promise to repay—the right to consume even more in the future.
If borrowing adds to production, then it's good borrowing. For example, in 1977 Steve Jobs borrowed $170,000 to launch Apple Computer. This was a good use of proceeds, because he build a productive empire that continues to create value, nearly 40 years later.
What if the proceeds aren’t used to build a wealth-generating business? What if they are simply consumed?
None other than former Federal Reserve Chairman Alan Greenspan spoke quite clearly on this topic. Testifying before the Joint Economic Commission in 2002, he discussed the “extraction” (his word) of equity out of homes. He noted two things. First, the gain in home equity is the same as the increase in net debt. Second, this fuels purchases of goods and services.
Thank you Dr. Greenspan for saying it clearly.
Picture millions of Jordyns, all across the economy. Debt is growing. Since the sellers of assets receive part of this debt as income, it fuels their consumption of food, energy, cars, or entertainment. The sellers may feel rich, but are they? Let’s look at a bigger example.
Suppose Andrew Alderton owns a house free and clear. It’s worth $100,000. Bill Baker borrows that amount and buys it from Andrew. Bill has the same asset that Andrew had, but unlike him, Bill has a liability to match. Andrew had $100,000 equity in the house, but Bill has none. When Andrew spends some of the cash he got for the house, it is really Bill’s credit he is spending.
Next, Charles Collier borrows $110,000 and buys the house from Bill. Bill can spend his $10,000 gain which is just Charles’ credit. Dave Duncan borrows $125,000 to buy it from Charles. Eric borrows to buy it from Dave, Frank buys it from Eric and so on. Eventually Zachary Zorander borrows $1,000,000 to buy that same old house from a certain Mr. Yankovich. By now, old Andrew is looking down on earth, shaking his head.
At each step, someone sells the house for a profit, and presumably spends part of it. The buyers, who borrow to buy the house, would never think of spending their own credit. However, they achieve the same thing by spending someone else’s credit. Like in Shubik’s
Dollar Auction, people take perverse action when subject to perverse incentives.
The result is a perverse outcome. It’s still the same old house, but now there’s far more debt. This process does not happen to only the old Alderton house, but every house in the nation.
This is like a cotton candy machine. It spins sugar, with the help of heat and air, into something many times its original size. The Federal Reserve operates a similar machine for the housing market. It spins the price of a house, with the help of credit and debt, into something many times its original size.
This article is from Keith Weiner’s weekly column, called The Gold Standard, at the
Swiss National Bank and Swiss Franc Blog SNBCHF.com.
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If Joe Sixpack would start thinking, he would indeed never buy ANYTHING on credit except a house. All the rest is written down and/or consumed within max 3 years. Only the banks get better from it. This is what I did all my life and it bore me nice fruits - I am NOT a debt slave for one and never was. My house is mine, the cars are mine, and I even have savings. I borrowed for my very first house only ( which I renovated completely, took me 9 years ), paid off the principal in 11 years instead of the contractual 20 and since then, I never borrowed 1 penny in my whole life and I can assure you I faced tough times - having to live off 800 US$/month for 3 years is NOT easy. But I kept my freedom.
The most important variable involved is not mentioned.
Is the currency provided for the loan axiomatic or does it come to be ex-nihilo?
Is the debt funded by money or counterfeit?
In almost all cases, debt is money created by the lender out of thin air - i.e. by the bank. As you pay down on the principal, this newly created money disappears since the bank has to write it down off their activa. So, money is debt. The real culprit is interest - that money has to come from somewhere and this somewhere is the printing press of the federal reserve. The minimal inflation level possible equals the average interest on all outstanding loans. If the Fed would not print that amount of extra money EACH year, nobody would be able to pay for his mortgage etc. since there would simply not be enough money. Anyhow, fiat money loses value each year. Now, bankers/the Fed speaks of deflation and the like - just forget about it. Last century, an average interest you got from your savings account would be around 5% and 1 million of US$ would get you a decent pension. Today, with say 0.5% interest rate on savings, you need 10 millions in order to get the same return ( 50.000 US$/year ). Now THAT's what I call inflation ..... it's hidden under ZIRP. NIRP is even worse ....
Yesterday I was having breakfast with some old friends, one of which is nearing retirement and owns a successful printing business. He mentioned that he had been approached mutiple times over the past 10 years by private equity companies who wanted to either buy him out or "merge" him in with their existing printing operations.
I had never worked for a private equity owned company, but I had been on the selling side to and on the attempted buying side from. So, I shared my experience with him. In both cases the first private equity company sold to a second after levering the companies up with high price debt the private equity companies provided (obviously at a lower cost to the PE company), took out their initial investment in interest and the stripping of cash and then sold to a second PE company after about 5 years at a signficant premium to the purchase price. The second PE company did the same. The third sale after again about 5 years each time went to a publicly listed company that massively overpaid, but through the miracle of acquisition accounting set themselves up for future write-off and lower taxes and stuck a huge amount in goodwill and intangibles.
When I was on the selling side, I was working for a corporation that was "shaping" their business per the advise of Wall Street and they did not really care what they sold for ... and Wall Street rewarded them well with higher stock prices for selling the businesses per their advisement.
On the buying side, I was then with a private company that did not have access to the low cost debt that the PE companies had (and not wanting to simply become a shell with massive debt, but from a practical standpoint owned by a bank), we were not able to compete, using reasonable business school metrics. Clearly we did not understand that we were supposed to become debt-slaves to the bank to become richly rewarded.
This seems to be another aspect of the "cotton candy" market. However, at some point someone brings the balloon down to earth and buries the excess buildup that has been pumped into Wall Street and their private equity and corporate cronies. The business does not improve and in both of the cases above actually shrank. The workers are not rewarded. No value has been added to the system, rather it has been sucked out by the financiers and executives ... who themselves added no value, but fired a lot of people and rearranged debt.
All true in principle, but as you are suppose to be paying of your mortgage (debt,) most the money you get back from the sale is not more debt, its debt you have paid off. IE its a wash, of course with 40 year mortgages principal payment are minimal. If you the add that the housing market generally grows with inflation you could then argue that an increase in debt is not required to buy a house but your currency has simply lost its value.
This is why no one in his right mind borrows to buy consumer goods. Those who try cannot sustain it for long.
Saw this first statement and because its epidemic in our country I laughed outloud. Thankfully, the follow-up sentence brought things down to earth.So then we should rename inflation, and now call it cotton candy, or the new normal,,,I suppose it depends which language you use.
And yet there is the dumbass factor, sometimes referred to as irresponsibility, it is the human element that left unbridled whether top, middle, or bottom of the barrel, gets you to today's latest wreckage, it seems that Frank, Dave, & Zachary...etc. represent this quite well.
wwxx
Really it should be called "debtflation"
It's 'fluffy' money and it requires a lot of fluffing.....
eventually the sugar wears off and we need moar, ha...
Question: If Zachary Zorander who borrows a million to buy the house and then defaults who ends up getting stiffed?
No One.
Taxpayers.