Hudson On The United States' Financial Quandary: ZIRP's Only Exit Path Is A Crash
Interest-bearing debt grows exponentially, in an upsweep. The non-financial economy of production and consumption grows more slowly as income is diverted to carry the debt overhead.
Abstract
Interest-bearing debt grows exponentially, in an upsweep. The non-financial economy of production and consumption grows more slowly as income is diverted to carry the debt overhead. A crash occurs when a large part of the economy cannot pay its scheduled debt service. That point arrived for the U.S. economy in 2008, but was minimized by a bank bailout, followed by a 14-year boom as the Federal Reserve increased bank liquidity by its Zero Interest-Rate Policy (ZIRP). Flooding the capital markets with easy credit quintupled stock prices and engendered the largest bond market boom in U.S. history, but did not revive tangible capital investment, real wages or prosperity for the non-financial economy at large.
Reversing the ZIRP in 2022 caused bond prices to fall and ended the runup of stock market and real estate prices. The great 14-year debt increase faced sharply rising interest charges, and by spring 2023 a number of banks failed, but all their depositors were bailed out by the FDIC and Federal Reserve. The open question is now whether the U.S. economy will face the financial crash that was postponed from 2009 onwards by the vast expansion of debt under ZIRP that has added to the economy’s debt burden.
INTRODUCTION
Throughout history the buildup of debt has tended to outstrip the ability of debtors to pay. Any rate of interest will double what is owed over time (e.g., at 3% the doubling time is almost 25 years, but 14 years at 5%). Paying carrying charges on the rising debt overhead slows the economy and hence its ability to pay. That is the dynamic of debt deflation: rising debt service as a proportion of income. Carrying charges may rise to reflect the growing risk of non-payment as arrears and defaults rise. The non-financial economy of production and consumption grows more slowly, tapering off in an S-curve as income is diverted away from new tangible investment to carry the debt (see graph 1). The crash usually occurs quickly.
Graph 1. Financial Crisis Pattern vs. Business Cycle
Governments may try to inflate their societies out of debt by creating yet more credit to postpone the inevitable crash, by bailing out lenders or debtors – mainly lenders, who have captured control of government policy. But the debt crisis ultimately must be resolved either by transferring property from debtors to creditors or by writing down debts.
The National Income and Product Accounts (NIPA) count the financial sector as producing a product, and adds its interest income and other financial charges to the economy as “earnings,” not subtracting them as rentieroverhead. The rise in financial wealth, “capital gains,” interest and related creditor claims on the economy are held to reflect a productive contribution, not an extractive charge leaving the economy with less to spend on new consumption and investment.
The problem gets worse as this financial extraction grows larger. As credit and debt expanded in the decade leading up to the 2008 junk mortgage crisis, banks found fewer credit-worthy projects available, and turned to less viable loan markets. Banks wrote mortgage loans with rising debt/income and debt/asset ratios. Racial and ethnic minorities were the most overstretched borrowers, falling into payment arrears and defaulting. Real estate prices crashed, causing the market value of bad mortgage loans to fall below what many banks owed their depositors.
There is nothing “natural” or inevitable about how such bank insolvency and negative equity will be resolved. The solution always is political. At issue is who will absorb the loss: depositors, indebted borrowers, bank bondholders and stockholders, or the government via the Federal Deposit Insurance Corporation (FDIC) and Federal Reserve bailouts?
Less often asked is who will be the winners. Since 2009 it has been America’s biggest banks and the wealthiest One Percent – the very parties whose greed and short-sighted policies caused the crash. Having been deemed “systemically important,” meaning Too Big To Jail (TBTJ, sometimes cleaned up to read Too Big To Fail, TBTF), they were rescued. And today (2023), that special status is making them the beneficiaries of a flight to safety in the wake of the FDIC’s decision following the collapse of Silicon Valley Bank that even large depositors should not lose a penny, no matter how poorly their banks have coped with the Fed’s policy of rising interest rates that have reduced the market value of their banks’ assets, aggravated by falling post-Covid demand for office space lowering commercial rents and leading to mortgage defaults. Once again, this time by protecting depositors, the Federal Reserve and Treasury are trying to save the economy’s debt overhead from crashing and wiping out the nominal bank loans and other financial assets that cannot be paid.
The usual result of a crash is a wave of foreclosures transferring property from debtors to creditors, but leading banks also may become insolvent as their debtors default. That means that their bondholders lose and counterparties cannot be paid.
The 2008 crash saw an estimated eight to ten million over-mortgaged home buyers lose their homes, but the banks were bailed out by the Federal Reserve and Treasury. Instead of the economy’s long buildup of debt being written down, the Federal Reserve increased bank liquidity by its Zero Interest-Rate Policy (ZIRP). This provided banks with enough liquidity to help the economy “borrow its way out of debt” by using low-interest credit to buy real estate, stocks and bonds yielding higher rates of return.
The 14-year boom resulting from this debt leveraging featured an innovation in the economy’s ability to sustain growth in its debt overhead: Debt service was paid not only out of current income but largely out of asset-price gains – “capital” gains, meaning finance-capital gains engineered by fintech, financial technology. Lowering interest rates created opportunities to borrow to buy real estate, stocks and bonds yielding a higher return. This arbitrage quintupled stock prices and created the largest bond market boom in U.S. history, as well as fueling a real-estate boom marked especially by private capital firms as absentee owners of rental properties. But tangible capital investment did not recover, nor did real wages and prosperity for the non-financial economy at large.
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