The Financial Jigsaw – Issue No. 16

My unpublished (100,000 word) book “The Financial Jigsaw”, is being serialised here weekly in 100 Issues by Peter J Underwood, author

Last week we completed looking at the commercial banks, see here for last week’s: Issue 15 We will be looking at banks again in later Issues but now we take a diversion and have a look at how credit and debt work in our consumer economy. These jigsaw pieces fit together with banks and money bringing our reading to date into one collection of matching parts. 

CHAPTER 3

CREDIT and DEBT

“What can be added to the happiness of a man who is in health, out of debt, and has a clear conscience?”
Adam Smith – Economist

“There is no means of avoiding the final collapse of a boom brought about by credit expansion.  The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

 Ludwig Von Mises

In the past, banks rarely made ‘consumer loans’; loans for motor car finance, household goods credit deals, credit cards or personal loans as they do today because there is no good security for these loans. Banks generally offered only short-term commercial loans that were fully covered by the value of the assets being financed and they never had to rely on the good faith of the borrower.

The banks simply facilitated the finance by standing between the buyer and seller. The idea of a 20-30 year or even a 5-10 year loan was anathema to sound banking practice of the past. A building society might grant a 25 year mortgage to one of its members, with a very significant deposit as down payment; that’s because, although it’s an asset class, property is not easily converted into cash quickly and as we have found out property can and does, on occasion, go down in value.

Motor car loans and household goods used hire purchase agreements with high initial deposits, relatively high interest rates and one or two year periods unlike today with five or more years loans, interest free and with many special offers.

The modern consumer and credit

In our modern day, we have been taught and encouraged to purchase all we need by using credit, unlike past generations, who saved up for whatever they needed and paid in cash. Saving requires a certain degree of discipline, deferring gratification was accepted as a lifestyle when shortages were common and personal goods scarce, created by a regular cycle of wars following the industrial revolution in the 18th century.

Today, economies have grown into what has become a ‘consumer society’ where the goal is to ‘out-buy’ our neighbours and display our wealth in a wide range of material form. Some blame the ‘Boomers’, the post war bulge of babies, which became the focus of industrialists and merchants to exploit the emerging market for consumer goods financed by never-ending credit.  The ‘live-now, pay-later’ mantra of the 1950-60s may well have been instigated by the ever-present threat of Nuclear Armageddon, worsened by the cold war, between the Anglo-American Empire and the USSR eastern-bloc countries.

No moral issue is intended here; merely an observation that in general the banks and financial elite exploited the advantages offered by unprecedented economic expansion, full employment and the technological advances of the second half of the 20th century enabled with cheap energy, mainly oil.

The ‘Boomers’ were allowed to gorge themselves on virtually unlimited, easy credit and enjoyed the material delights of excess purchasing power encouraged by the banks loaning out far more than was neither prudent nor responsible.

Acknowledging the degree to which responsibility had been forsaken by the banks, there is even a clause in the UK Consumer Protection (Amendment) Act 2002, which allows for a defence of ‘irresponsible lending’ against a financial institution on the assumption that they should have known beforehand that the borrower would be unlikely to repay the loan.

The principles of personal financial management

A culture has emerged today with the idea that of having to ‘live within ones means’ is unacceptable and even an attack on fundamental ‘human rights’, ignoring of course the concurrent responsibilities. People have learned that they have a right to whatever they want now, with little in the way of responsibility, and as a consequence there are inadequate general ‘saving’ levels and poor provision for pensions in later life.

Many people are led to believe that the modern ‘high finance ethic’ is not just normal, but essential for society to function today, and they are probably right. Gigantic banks have become big business that requires big credit to make big profits, generally without considering the adverse effects on an individual’s lifestyle, and often causing extreme distress within families and work places.

The genuine way to become wealthy is by producing more than you consume, and saving the difference.  This is a principle which has persisted since time began but has been distorted by the owners of wealth who have instituted financial systems to prey on the fragilities of human nature.

Credit comes in many ‘forms’ (pun intended) and contains hidden pitfalls for the unwary and those unaware of the devious and cunning strategies used by bankers and financiers to lure the financially uninformed into excessive payments and penalties.  Part 2 of my book describes how personal money management can mitigate the worst effects of debt and will be published following completion of this Part 1.  Here, in Part 1, we examine how national, regional, local government and financial institutions have also been entrapped in the odious results of excessive debt and irresponsible credit management.

Around 20% of the UK economy (GDP) is financial in nature. It is real madness that politicians and the financial oligarchy are spending trillions of dollars bundling, swapping, repackaging and trading imaginary money using only promises to pay. As we have discovered money is essentially a medium of exchange but in our economy it has become a store of ‘virtual’ wealth; it becomes problematic when ‘money’ forms the basis of a gigantic industry doing deals between themselves just to book imaginary, paper profits.

The general nature of debt

We might ask: “What is the nature of debt?” A common definition is: “Debt is future consumption denied.” It is the opposite of: ‘delaying gratification’. But debt is not only about consumption.  We have already witnessed, in the Issues about ‘money’, how production and economic development needs to be financed by offering credit to the producers before they receive their income; this is the very nature of commerce and is at the heart of any economy no matter what political system is used.

When you take on debt it should of itself create an income stream that services the debt and repays the principle and interest; when it fails to do this it becomes negative for economic growth. Consumers rarely see the difference between borrowings to consume and borrowing to invest, because most of us do not invest borrowed money, we use various means to extend our consumption through loans.

Granted we recognise a house as an investment these days but in reality a house is just somewhere to live and strictly should be regarded primarily as a home.  We also ‘invest’ in pension schemes, stock markets and other financial vehicles designed to grow our asset base but not usually with borrowed money but rather with savings.

Governments however have no money of their own and they do not produce anything either. They raise finance mainly through taxation and, in theory, redistribute it throughout the economy but can raise much more than just tax income.  They do this by issuing IOUs (government bonds or gilts) through the commercial banking system and use these funds to expand government spending, invest in infrastructure, welfare and politicians’ pet projects otherwise known as boondoggles: wasted, trivial make-work projects.

Governments ought to balance their expenditure against tax income and bonds issued but they rarely do.  Politicians are as much, if not more, susceptible to over-borrowing and over-spending than individuals. The gap or total accumulated deficit in government spending is known as the ‘National Debt’ and will be discussed in future Issues describing how government raises funds, manages its budgets, finances and the workings of government bond markets.

The mechanics of borrowing money

Credit is offered by banks and financial institutions for individuals to take on the debt. The price of debt is interest and the target national interest rate (the base rate or LIBOR) is set by the central bank but is always at the mercy of financial markets which determine the actual rate of interest by trading government bonds on a daily basis in the bond markets.  These are massive markets with billions and trillions traded each day.

In normal times the Treasury issues bonds to the market where the primary dealers (major commercial banks) buy the bonds and hold them on their balance sheet gaining interest payments from the Treasury in return.  The primary dealers use their existing money to purchase these bonds and therefore there is no increase in the money supply. The workings of these markets will be covered in future Issues.

A primary function of the Bank of England (BoE), the UK central bank, is to keep interest rates in line with their target rate (0.5% in 2018), control inflation and unemployment; generally adding to economic stability.  The higher the demand for bonds the higher is their price and therefore the lower the interest rate.  If demand falls, as happened in 2008, the BoE has to purchase these bonds to keep the interest rate low and this is the basis of Quantitative Easing (QE) when markets collapsed in 2008 and investors became nervous about increased risk in the bond market.

When QE is in operation the central bank borrows money from the commercial banks who create loans which are placed in their ‘reserve assets’ account as opposed to their normal asset account when normal loans are made. This causes an increase in the money supply and has been going on around the world ever since the 2008 crisis.

The central bank then buys treasury bonds and mortgage-backed securities (MBS) with this new money. The government spends this money into the economy to stimulate growth, which generally does not create inflation because government spending is disinflationary in the main.  The central bank keeps the bonds on their books and receives interest from the treasury.

The Fed has been reducing their holdings of treasuries ever since 2014 by reversing QE – known as quantitative tightening (QT) although QE has been continued mainly by the ECB and BoJ.  We have yet to experience the full effects as QT plays out, but currently a stronger US dollar has resulted in pressure on emerging market economies (EMs), especially Turkey and Argentina.

Because government bonds are unlikely to default they are considered risk-free and represent the lowest rate of interest achievable within any economy.  However, governments have been known to default at regular intervals and bondholders have suffered losses as a consequence; an example of which happened recently in Greece. 

To be continued next Saturday

Author: Austrian Peter

Peter J. Underwood is a retired international accountant and qualified humanistic counsellor living in Bruton, UK, with his wife, Yvonne. He pursued a career as an entrepreneur and business consultant, having founded several successful businesses in the UK and South Africa His latest Substack blog describes the African concept of Ubuntu - a system of localised community support using a gift economy model. View all posts by Austrian Peter