The Debt Bubble

The US stock market has just reached new record highs, as measured by the major indices, with valuations that are in no way supported by the earnings of the underlying businesses. Share prices are, in fact, supported by debt. The expansion of debt has created the liquidity needed to spur the markets to their current unrealistic levels and these levels can only be maintained through a continued expansion of debt. In fact, to prevent a collapse in the bubble of debt that lies beneath the sky-high share prices, the rate at which new debt is created must be continually increased. Failure to do so would cause the share prices to collapse and economic growth to disappear.

In today's monetary system, when a bank makes a loan the total supply of money in existence increases by the amount of the loan. By the same token when a bank loan is re-paid or defaulted on, the total supply of money is correspondingly reduced. In other words, debt creation and repayment (or default) affects the value of all the existing currency units. When the rate of debt repayment plus debt default climbs above the rate of new debt creation, then the total supply of money will begin to contract and asset prices to fall.

The US Federal Reserve is now trying to dampen the speculative fire which has been burning in the stock market by suggesting that maybe things are moving just a little too fast and that the next move in official interest rates might be up. They can't actually raise interest rates because that would burst the debt bubble, but they can talk (very carefully) about raising rates. Greenspan is once again professing a concern regarding potential inflation down the track, as though the US has not already experienced rampant inflation over recent years. What he is really concerned about is 'bad inflation'. 'Bad inflation' is when the prices of the things you buy (consumables) go up, whereas 'good inflation' is when the prices of the things you own (investments) go up. The US has experienced a severe bout of 'good inflation' and now the concern is that the rapidly increasing money supply will lead to a bout of 'bad inflation'. In either case the root cause is an increase in the quantity of money or, more to the point, an increase in the amount of debt.

Many people appear to be under the impression that real interest rates in the US have been high in recent years, thus giving the Fed scope for further interest rate reductions. This opinion arises because the CPI has remained low and real interest rates tend to be calculated by deducting the CPI from the nominal interest rate. This then begs the question - if real interest rates are high, why have we seen such huge gains in the stock market? After all, high real interest rates choke economic growth and make debt repayment more costly, not exactly the ideal environment for a massive credit-fueled blow-out in share prices. This conundrum comes about due to a false premise – the belief that real interest rates can be determined by subtracting the official government measure of inflation from nominal interest rates. When we use the only true and objective measure of inflation, the rate of increase in the supply of money, we see that the US has actually been enjoying negative real interest rates for the past 2 years. Negative, or at least very low, real interest rates facilitate the formation of debt and asset bubbles. This was the Hong Kong experience during the 2 years leading up to August 1997, and it is now the US experience. When nominal interest rates in Hong Kong were increased substantially in defense of its currency, leading to a corresponding rise in real interest rates, stock and property prices quickly fell by 50%.

Falling asset prices do not, by themselves, affect the money supply. Apart from the small component of the total money supply that circulates as cash, all money resides within the banking system. When I buy shares in a listed company I am not, contrary to popular belief, putting money into the stock market. The money required to pay for the shares is transferred from my account to someone else's account, but the money remains within the banking system. If the shares I have bought subsequently plunge in value the total supply of money is unchanged, although my ability to borrow and spend may now be somewhat impaired. The point is that there is a large difference between deflation (a contraction in the supply of money) and wealth destruction. However, it is clear that in a debt-based monetary system the two are inexorably linked since falling asset prices reduce the collateral available as backing for both new and existing loans, causing a contraction of credit and debt defaults.

Where a giant credit expansion has resulted in unsustainably high asset prices, the challenge for the monetary authorities is to slow the growth of debt without inflicting a devastating injury to the stock and property markets. This is an impossible challenge as there are limits (as yet to be defined in the US in 1999) to the amount of debt that can be supported by the incomes of the borrowers, and any contraction in credit (money supply) would inject a dose of 'realism' into the markets.

Eventually, the limits are always reached. Credit always begins to tighten and asset prices to fall at some point following a prolonged credit expansion. However, the current expansion is not a normal occurrence, it is a bubble. As such, any tightening in the credit markets and / or fall in asset prices would most probably lead to a total collapse (refer to Japan post-1989). The consequences of the expansionary actions of the past few years must therefore be avoided by 'loosening' monetary policy even more in the hope of offsetting the ever-growing repayment burden on the existing debt and postponing the inevitable collapse. Whether or not the escalating supply of 'easy money' is successful in buying time, it is likely to bring about a cycle of 'bad inflation' characterised by rising commodity prices. Any serious decline in asset prices will be met with ever-increasing buckets of money until, eventually, prices are forced upwards. At the end of the day the purchasing power of the national currency will be traded for the short-term appearance of prosperity.

In today's fiat money world, all asset price bubbles and all economic crises are debt related. Money and debt are not just linked, they are effectively the same thing. This means that changes in the amount of debt ripple through the entire economy and, during the expansion phase, cause asset prices to reach unrealistically high levels. During the contraction phase (stay tuned) asset prices become as under-valued as they were over-valued in the preceding cycle. Oscillations between over-valuation and under-valuation are not a product of our current monetary system, but the extreme size and high frequency of these oscillations certainly is. Although such wildly volatile markets may be nirvana to short-term traders, the immense destruction of wealth that occurs when the expansion finally ends is devastating to the real economy and the wage-earning population.

Milhouse
Hong Kong
The reader is invited to respond to Milhouse's wisdom via email: [email protected]