UNDERSTANDING CREDIT AND ITS COLLAPSE / MACLEOD FINANCE

Understanding credit and its collapse

It has been said that not one man in a million understands money. Even fewer understand credit. Yet we are in the largest credit bubble in history. It will not end well.

ALASDAIR MACLEOD

The reason that financial asset values will collapse along with currencies is the common factor of excess credit, an excess which has accumulated over the last forty years.

Nothing else matters. 

Forget “growth” which is actually growth in credit misleadingly described as GDP. 

Forget unemployment. 

Forget inflation, forget Fed policy. 

For too long macroeconomists have taken our attention away from the real issue — the tsunami of non-productive credit and the matching debt which is set to collapse.

In this article I point out the inevitable consequences of the unproductive inflation of credit whose value is now detached from real legal money, which is gold. 

Economic intervention by clueless governments has led to a cycle of increasingly large credit bubbles never being allowed to wash out economic distortions. 

Instead, they have been feeding into each other successively. 

Consequently, we are now living with the largest credit bubble in the history of mankind. 

Ultimately it will crash, driven by rising interest rates, bond yields and collapsing currencies. 

The current rise in bond yields signals that that moment has almost certainly arrived.

It is vital to understand the distinction between money and credit — without that knowledge we all become victims of our ignorance. 

The purpose of this article is to walk the reader through the evolution of money and credit from early history to the present day. 

Only when we have a clear understanding of the distinction between money and credit can we take the decisions to protect ourselves from what promises to be the most destructive collapse of credit ever recorded.

Introduction

Sadly, even financial experts don’t understand money. 

Nor do most of those who profess to know either, confusing money with credit. 

Money rarely circulates in post-medieval economies, a role entirely filled by credit.

For clarity at the outset, in this article money is defined as the ultimate medium of exchange without counterparty risk — physical gold. 

Gold very rarely circulates, being hoarded instead. 

The rest is credit.

Credit must have existed before the convenience of money, a fact almost never recognised by monetary historians. 

The Phoenicians were trading without money long before it emerged as a medium of exchange. 

They will have relied on promises to compensate providers of the wherewithal to equip the vessels, provide the slaves and the food to mount trading expeditions across the Mediterranean and beyond, bringing wealth to their city states from trading.

The nature of these promises, or obligations, will have been in the form of agreements to repay them at the conclusion of a trading expedition by way of a share of the spoils. 

These arrangements will have fulfilled the definition of credit, which is comprised of an advance of the necessary goods and an obligation to repay. 

In accounting terms, a credit is always matched by an obligation to repay it, so for every creditor there must be a matching debtor.

The Phoenicians are thought to have been trading between their city states since the early bronze age, at least two millennia before Rome first codified their law in the Twelve Tables (or Tablets) enacted in 449BC. 

In Table VII, it was ruled that “…articles sold and delivered shall not be acquired by the purchaser unless he pays the price to the seller or in some other way satisfies the seller by giving a surety or pledge.” 

The distinction between immediate and deferred settlement was thereby legally established in this ruling.

It is thought by historians that at about that time the first Roman coin came into existence to facilitate immediate settlement. 

This was the aes, a bronze ingot weighing a Roman pound. 

Coins of silver and then gold came much later. 

Rome’s money gave definition to final settlement, and also that which was deferred or promised: i.e. credit. 

And all the successor nations to the Roman Empire, which colonised almost the entire world beyond Chinese and Japanese spheres of influence have this distinction embedded in their common law.

Therefore, from the dawn of monetary history the value of credit was irrevocably tied to final settlement in a monetary metal. 

Attempts to do away with this relationship between money and credit have always failed.

Credit as a tradeable commodity

It was not long before third parties in a transaction appeared in the form of bankers. 

A banker is one who deals in credit. 

Whether banking in this form existed before the Twelve Tables, as opposed to the earlier Greek practice of an individual acting as a custodian of metallic money need not concern us. 

But it was from the earliest Roman law that banking evolved into the form that we know today.

For some seven centuries, that is until the second century AD, a banker would have provided the credit necessary for merchants and traders to do their business in simple terms. 

The next evolutionary step was to be able to buy and sell creditor obligations. 

Initially, the Roman juror Gaius (AD 130—150) ruled that the law at that time made no provision for the trading of debts. 

Therefore, a debt could only be transferred with clear title to new ownership with the agreement of the debtor, meaning that the debtor would have to endorse each transfer of the debt.

It was an uncertainty which had to be dealt with. 

This altered following the findings of two later jurors, Ulpian (?—228AD) and Julius Paulus (contemporary with Ulpian) who argued that debts were transferrable without the agreement of the debtor. 

It was the findings of these two jurors which were eventually confirmed in the Digest of Justinian’s Pandects. 

Without these rulings, capital markets would not exist today.

The status of credit today

We can see that the distinction between money used in final settlement and credit which is always matched by an obligation to finally settle were firmly linked by value in Roman law, and in its successors’ common laws to this day. 

Of this fact there can be no doubt. 

Currency is unarguably credit and does not satisfy the description of money without counterparty risk, being recorded as a liability on its issuer’s balance sheet. 

But because a currency serves as the common accounting medium, it can be regarded as the highest form of credit. 

It is not and never has been money as commonly stated today.

We know or should also know that commercial bank deposits are not money but are a bank’s debt obligation to a depositor. 

But credit doesn’t stop there: there are far larger amounts of unrecorded credit between individuals, all of which are settled with reference to the currency in common use. 

A tradesman will give a customer credit for his employment which is matched by the customer’s obligation to pay, extinguished when he has delivered his employment and been paid.

The payment might be currency cash or by bank cheque or transfer — further forms of credit which substitute one counterparty obligation for another. 

While the tradesman and his customer have finally settled their business, the obligations have been passed on to other parties. 

All business is conducted this way.

Tradeable government or corporate bonds are credit as well. 

The promises of an enterprise’s management to maintain its shareholders’ equity interests in it are also credit. 

It is on the basis of these promises that wealth is created. 

The greater the level of debt, the greater is the quantity of wealth, so long as the integrity of debt obligations remains intact.

It is when the value of debt obligations are questionable that the colossal system of credit becomes vulnerable to default on some or more of the obligations behind it. 

Clearly, this risk is minimised if the credit outstanding is matched by debt which is productively deployed. 

It is when it is not productively deployed that the trouble starts.

Economists of the Austrian school have noted the danger from excessive credit in the confines of the banking system. 

When leading Austrians such as Mises, Hayek, and Schumpeter did their valuable work on credit cycles (which they termed business cycle theory), currencies were linked in their value to gold as gold substitutes.

Total recorded credit could and would fluctuate. 

It is the sum total of currency plus bank deposits at the central bank, and the deposit obligations of commercial banks to the general public. 

[Note: money supply statistics exclude commercial bank deposits at a central bank, but they exist as credit nonetheless]

But as we have seen, credit can only contract if debt obligations are extinguished at the same time. 

Under a gold standard, credit could be extinguished if it was exchanged for gold supplied by the currency issuer. 

That is no longer the case today.

There is now only one way in which credit can contract without obligations being transferred elsewhere, and that is when it is extinguished by a debtor’s default.

An individual bank can reduce its obligations to depositors, by effectively transferring them to another bank. 

In the event of a run on deposits, a central bank might come to a commercial bank’s assistance, but unless gold reserves come into play that is always by replacing one form of credit with another.

What happens in a credit bubble?

There have been times in the history of money and credit when credit has been increased to fuel speculation. 

Tulipomania, the Mississippi, and the South Sea bubbles come to mind. 

These and other bubbles existed because banks and other credible providers of credit expanded their loans and debt obligations to satisfy credit demand for speculation. 

Financial speculation is rife today, evidenced by “momentum buying” which deliberately ignores value.

The suppression of interest rates below their natural level has aways fuelled credit expansion, a point made by Austrian school economists. 

Before central bank intervention, this was a cyclical phenomenon driven by banks competing to lend to businesses while playing down associated risks. 

Banks’ balance sheets would become dangerously extended, while at the same time the expansion of unproductive credit always led to an increase in the general level of prices. 

The natural level of interest rates would rise to compensate, disrupting earlier profit margin assumptions for businesses when their plans were drawn up and rates were lower. 

Naturally, the higher risks to a bank’s balance sheet from potential business failures make bank managers cautious, reducing their exposure to borrowers deemed riskiest.

Without state interventions, credit contracts when borrowers default on their loans to the banks and the weaker banks can go under, defaulting on their obligations in turn. 

Most spectacularly, this is what happened in the wake of the 1927—1929 credit bubble in America, when thousands of banks failed in the early 1930s. 

Credit simply disappeared from the statistics.

Today, this has not been prevented over multiple successive credit cycles. 

Business and bank defaults have been deferred ed by central banks suppressing interest rates. 

Consequently, the number of zombie corporations has increase continuously, companies which will never be commercially viable under interest rates at a natural level. 

This accumulation over several credit cycles of expanded and unproductive debt has postponed the crisis of a credit deflation by rolling it up into the following credit cycle.

Over the last forty years, the financialisation of bank lending has particularly fuelled credit expansion into financial activities and financial asset values, including a plethora of derivatives. 

Credit booms and their busts being postponed by central banks supressing interest rates have led to the accumulation of the largest credit bubble in history. 

Additionally, unproductive government spending has further fuelled the quantities of credit in their economies while debasing their currencies and driving natural rates of interest higher still.

Can central banks repeat their interest rate suppression policies and rescue the credit bubble from imploding once more? 

Last time, it required dollar rates at zero and euro and yen rates in negative territory. 

Clearly, interest rates can go no lower than on the last cycle to postpone the next credit crisis.

The progressive decline in the rise in rates sufficient to trigger a credit crisis is shown by the upper pecked line in the chart below of the US Fed’s key lending rate. 

Note how the peaks were always followed by an official recession, rescued by yet lower rates.

For the first time in nearly four decades, this line has already been broken significantly. 

Yet so far, it has not triggered a crisis in credit.

But the US and other key governments have accumulated so much debt relative to the sizes of their economies that new and maturing debt can only be financed at higher bond yields. 

Bond yields are already rising again, as the next chart clearly illustrates of the US Treasury 10-year Note, widely regarded as the “risk-free” bond standard from which all financial values are generally referred to.

It seems probable that when this bond yield rises further the entire dollar-based credit bubble will implode.

The authorities are certain to try to stop the credit implosion. 

Instead of lesser forms of credit taking its value from the highest, the situation will be reversed with the higher being destroyed by attempts to rescue the lesser. 

It is a situation which has come about because of misguided government intervention over many decades.

In the distant past, through groupthink commercial banks triggered a credit cycle that was ultimately destructive for their customers and sometimes destructive for them as well. 

But at least it was a natural cycle on a limited scale driven by human fallibility. 

The Austrian economist Joseph Schumpeter even coined a positive phrase for it — creative destruction. 

Government intervention has led us to a far worse all-consuming monster.

In any analysis of the current situation, whether it be inflation expectations or the likelihood of recession, nothing else matters so much as the certainty of the looming credit disaster which eclipses them all.