The Inescapable Reason Why the Financial System Will Fail

Authored by Charles Hugh Smith via Peak Prosperity blog,

Modern finance has many complex moving parts, and this complexity masks its inner simplicity.

Let’s break down the core dynamics of the current financial system.

 

1

The Core Dynamic of the “Recovery” and Asset Bubbles: Credit

Credit is the foundation of the current financial system, for credit enables consumers to bring consumption forward, that is, buy more stuff today than they could buy with the cash they have on hand, in exchange for promising to pay principal and interest with their future income.

Credit also enables speculators to buy more assets than they otherwise could were they limited to cash on hand.

Buying goods, services and assets with credit appears to be a good thing: consumers get to enjoy more stuff without having to scrimp and save up income, and investors/speculators can reap more income from owning more assets.

But all goods/services and assets are not equal, and all credit is not equal.

There is an opportunity cost to any loan (i.e. credit), as the income that will be devoted to paying principal and interest in the future could have been devoted to some other use or investment.

So borrowing money to purchase a product or an asset now means foregoing some future purchase.

While all products have some sort of payoff, the payoffs are not equal. If I buy five bottles of $100/bottle champagne and throw a party, the payoff is in the heady moments of celebration.  If I buy a table saw for $500, that tool has the potential to help me make additional income for years or even decades to come.

If I’m making money with the table saw, I can pay the debt service out of my new earnings.

All assets are not equal, either. Some assets are riskier than others, with a less certain income stream or payoff.  Borrowing to buy assets with predictable returns is one thing, buying assets with highly speculative returns is another; regardless of the eventual result of the investment, the borrower still has to pay interest on the debt, even if the speculative investment goes bust.

The basic idea here is the loan is based on collateral, that there is something of value that is anchoring the loan above and beyond the borrower’s ability to pay principal and interest.

The classic example is a house: the lender issues a mortgage based on the market value of the house, i.e. what it can be sold for should the buyer default on the mortgage and the lender has to sell the collateral (the house) underpinning the loan.

The value of the collateral is obviously contingent on the market; the value of the house goes up and down depending on supply and demand, the availability and cost of credit, and so on.

If a lender loans me $500 to buy a new table saw, and I default on the loan, the table saw is the collateral. Unfortunately for the lender, the market value of the used tool is perhaps $250 at best.  So the lender loses $250 even after repossessing and selling the collateral.

If the lender loaned me $500 to buy champagne and I default, there is no collateral at all; the loan was based solely on my ability and willingness to pay principal and interest into the future.

When I say that all credit is not equal, I’m referring to the creditworthiness of the borrower.   

Lenders make money by issuing credit to borrowers.  The incentives are clear: the more credit they issue, the higher their income.

Given this incentive, it’s easy to convince oneself that a marginal borrower is creditworthy, and that a speculative investment is a safe bet.

This is especially true if the government guarantees the loan, for example, a home mortgage. With the government guarantee, there’s no reason not to take a chance on a marginal (risky) borrower buying a marginal (risky) house.

If we take some home mortgages and bundle them into a mortgage-backed security, we can sell the future income stream (i.e. the payments made by the borrowers in the future) as securities that can be sold worldwide to investors.  I can make risky loans, skim the fees and pass the risk onto global investors.

All this debt is now considered an asset to investors.

There’s one last feature of credit: liquidity. Liquidity refers to the pool of credit available to refinance or roll over existing debt.  If I’m having trouble paying my credit card, for example, and there’s plenty of liquidity in the credit system, I can obtain a larger line of credit and borrow enough to pay my monthly principal and interest on the existing debt.

If I can refinance my existing debt at a lower interest rate, so much the better.

Credit can be issued by private-sector lenders to private-sector borrowers, or by public-sector central banks to private-sector lenders.  Central banks can buy public and private debt (government and corporate bonds, mortgages, etc.), effectively transferring debt from the private sector to the public sector.

These are the basic moving pieces of the credit expansion that has fueled both the “recovery” and the reflation of asset valuations, which have now reached historic extremes.

The Current (Flawed) Logic We're Pursuing

In response to the Global Financial Crisis (GFC) of 2008, central banks lowered interest rates to near-zero to boost private-sector lending, and increased liquidity to enable private-sector lenders and borrowers to refinance existing debt and generate new credit.

They also bought assets: government bonds, corporate bonds and in some cases, stocks via ETFs (exchange traded funds).

The goal here was to prop up the collateral underpinning all the debt.  If liquidity dried up, consumers and enterprises would default, handing lenders catastrophic losses, as the crisis had crushed the market value of the collateral that lenders would have to sell to recoup their losses.

And so central banks pursued heretofore unprecedented policies aimed at goosing private-sector lending and borrowing while boosting the markets for stocks, bonds and real estate—the collateral that supported all the debt that was at risk of default.

All this low-cost and easily available credit, coupled with the central banks’ public messages that they would “do whatever it takes” to restore credit mechanisms and reflate the private-sector markets for stocks, bonds and real estate, worked: credit expanded and markets recovered, and then soared to new highs.

While these policies accomplished the intended goals, boosting both new credit and asset valuations, they also generated less salutary consequences.

By lowering interest rates and bond yields to near-zero, central banks deprived institutional owners who rely on stable, high-yielding safe investment income—insurers, pension funds, individual retirement accounts, and so on—of exactly what they need: safe, stable, high-yield returns.

In this “do whatever it takes” environment, the only way to earn a high return is to buy risk assets—assets such as stocks and junk bonds that are intrinsically riskier than Treasury bonds and other low-risk investments.

The Stark Conundrum We Face

Central banks are now trapped. If they raise rates to provide low-risk, high-yield returns to institutional owners, they will stifle the “recovery” and the asset bubbles that are dependent on unlimited liquidity and super-low interest rates.

But if they keep yields low, the only way institutional investors can earn the gains they need to survive is to pile into risk assets and hope the current bubbles will loft higher.

This traps the central banks in a strategy of pushing risk assets—already at nose-bleed valuations—ever higher, as any decline would crush the value of the collateral underpinning the titanic mountain of debt the system has created in the past eight years and hand institutional owners losses rather than gains.

This conundrum has pushed the central banks into yet another policy extreme: to mask the rising systemic risk created by asset bubbles, central banks have taken to suppressing measures of volatility—measures than in previous eras would reflect the rising risks of extreme asset bubbles deflating.

In Part 2: So What Comes Next & How Can We Prepare For It?, we’ll ask: how does this resolve? Can central banks raise rates without popping the bubbles the system needs to remain solvent? Or can they keep yields near zero and keep pushing asset valuations higher for years or decades to come?

Or is this all much more likely to end in a massive financial/currency crisis? One characterized by default and liquidation of America's high-fixed-cost, heavily indebted households and enterprises that have only stayed afloat by borrowing more money?

Click here to read Part 2 of this report (free executive summary, enrollment required for full access)

Comments

Andrew-Winter curbjob Dec 31, 2017 10:40 AM Permalink

That plan does indeed work.  In many cases.

But the concept of "Planned Obsolescence" has led to many "things" particularly small electronic "things" being so cheap that, even if you do the work yourself, the cost of repair exceeds the cost of the new item.

History:  Planned obsolescence came of age in the early 1960s in the development of military aircraft.  It was easily observed and widely commented on that all of the "century series" fighters were two years obsolete before the prototypes flew.

In addition, during the Vietnam War, battle damage repair to electronic systems on these same aircraft became a "Time Hole" where a otherwise perfectly good airplane would be grounded for weeks while electricians tried to find that one single wire that was clipped by a piece of schrapnel.   This led to printed circuits, miniaturized electronics components that could be could be removed and just thrown away, then replaced.   Then, even if the part was bad, it could be replaced in minutes or hours instead days and weeks.

So a lot of the "throw away" tech we have came from the necessity to fast prototype, and also, the need to make cheap throw away components to make repairs happen a lot more quickly, and in that context a LOT more cheaply.

Thus, in my situation, it will be cheaper for me to dig into my dishwasher and re-seat that damned DOOR and make it work,  it would NOT be cheaper to have it repaired by a service technician, who quoted me over 150.00 just to come to the door and open it up. 

That's the essential problem.   I can buy a mig welder and re-weld that old mower deck, but I have NO skill at soldering a microcircuit board in small drone, or a computer or a phone.  And, I do not have the time left in my life to learn that skill.   Eyes are too bad and the hands shake.

So, You plan works!  ... sometimes ... depending on how many "gadgets" you want to do without.

In reply to by curbjob

takeaction Inannasbitch Dec 30, 2017 4:35 PM Permalink

This story has been told for the past 30 years....We did have the Dot.com...we had the "Financial Crisis".  Something will again happen...just be prepared...diversified...and then forget about it.   Don't live in the closet.  Enjoy life.  And enjoy having TRUMP in the fucking Whitehouse...stand proud and lets ban together and keep draining this swamp.  I have my 11 employees STOKED...because of the new with holding tables.   Some were liberals...but if you break it own to them and show them the fact on how they get to keep more of what they earn...and break it down into 3rd grade math.  They get it...and then they spread the word.

I explained it to them like this.....

#1...Let's take Mike's check.  His last paycheck we took out $480 for Federal tax withholding.

#2 I showed Under the new withholding chart on Feb 1st we will only take out $355 Federal.  So each check you will instantly get $125.00 more of your money to keep. 

Of course each situation is different....but remember....people here on ZH understand all of this like 4D chess.  With Lib/Dems and employees you need to break it down so it is comprehendible.    Once they get it...they really get it.

I showed each of my employees this and their mind was blown, and then they asked..."Then why does the news keep saying this is a gift for just the rich?"   What a DREAM question.  It opens up some amazing dialog.  My favorite answer is this....

"It is NOT A GIFT.......how is it a GIFT to just keep more of what is already yours?.....So that being said.....the more you make, the more you will be able to keep.  Isn't that fair?"   And you can see the lights turning on.

It is a great day folks.

Let these fucking pricks keep pushing the Russian narrative...and let them keep swinging.  If this economy continues like this, and how I think it is going to explode...the dems/Libs have NOTHING to run on in 2018.  

Sorry to keep going...but one more thing...

My 70 year old Dem/Lib neighbor....this is the one that told me "He will never win" when I put a Trump sticker on my car when there were 16 Republican Candidates...I yelled at him today..."Do you have my check ready??"  He was like "What the fuck are you talking about...?"   I said "This stock market would have NEVER happened like this under your candidate Hillary, Since I helped to get Trump in office, you have made an extra $1 million in 1 year in your stock holdings, so do i get a cut...?"   He just waved me off and went in his garage.....  We live in a high end community....and he has MSNBC on in his garage 24/7.  I also told him..."You like that Rachel Maddow???.......I don't like that guy...."  Oh he blows a gasket.

It is going to be a great year...Happy New Year.

 

In reply to by Inannasbitch

Honest Sam takeaction Dec 30, 2017 5:14 PM Permalink

 "......is a gift for just the rich?"   What a DREAM question.  It opens up some amazing dialog.  My favorite answer is this....

"It is NOT A GIFT.......how is it a GIFT to just keep more of what is already yours?"

 

Amazing how the narrative has been manipulated by the governors so that nearly everyone thinks that their money is a gift and and not their own in the first place.

Now that's propaganda made manifest.

In reply to by takeaction

Endgame Napoleon takeaction Dec 30, 2017 5:49 PM Permalink

Most of us who must cover all bills on one earned-only income will be getting $24 per paycheck. Many of those with kids are given thousands of dollars in every stimulus, and that does not help me afford rent that absorbs half of my pay one little bit. That is why employers tend to hire parents with access to unearned income from spouses or with monthly welfare and refundable, womb-based tax welfare to bump up their earned income so that the employer does not have to do it. I hope your employees work harder for that government-provided incentive. 

In reply to by takeaction

new game takeaction Dec 31, 2017 9:28 AM Permalink

exactly how i see it. moar of mine and less for the bankrupt guv.org.

that is a win.

i don't really give a fuk about dc. ignore the shit.

what counts in my reality.

and these gains will pay down my capital investment all the faster as i head towards retirement this summer. the asset will be right side up as a windfall when sold, leaving moar cash to fuk off.

thanks trump...

In reply to by takeaction

mobius8curve ThrowAwayYourTV Dec 30, 2017 4:14 PM Permalink

They will want gold up until the last day:

Ezekiel 7:19 They shall cast their silver in the streets, and their gold shall be as an unclean thing; their silver and their gold shall not be able to deliver them in the day of the wrath of Jehovah: they shall not satisfy their souls, neither fill their bowels; because it hath been the stumblingblock of their iniquity.

For those who want to know when the last day is in relation to the last 8 years please enter here:

https://sumofthyword.com/2016/10/04/the-rapture-of-the-church-is-after-the-tribulation/

In reply to by ThrowAwayYourTV

Consuelo Dec 30, 2017 3:03 PM Permalink

 

 

"Let’s break down the core dynamics of the current financial system."

 

Uh, let's not Charles...   You've already served this warmed-over hash a thousand times...

 

lew1024 Consuelo Dec 30, 2017 3:23 PM Permalink

Writing is a means of understanding. Until you can explain things clearly, in writing, you don't understand it. Every time CHSmith writes about a topic, he has a new understanding, which careful readers with enough interest see and appreciate.

Newbies in the topic get to start at a higher level.

Nobody makes you read anything. The editors chose it. If you want to critique someone, critique the editors.

As for me, I read Charles' work because I always learn something from it, I invest my time in understandings.

In reply to by Consuelo

Griffin Dec 30, 2017 3:05 PM Permalink

There are economic crashes and bubbles exploding all the time trough out history and somehow we always manage to survive.

I would not worry to much about it.

I would rather be optimistic about the future. There are lots of things that are improving, and many new interesting developments.

https://lilium.com/

Griffin tion Dec 30, 2017 7:10 PM Permalink

Economic crashes and bubble explosions are often designed events.

When they happen they can have terrible effects on some people, but there is also a cleaning effect, some issues are dealt with and the whole system taken under the microscope and analysed.

People know a lot more about how the world works now, and scams can very easily backfire.

 

 

In reply to by tion