Friday, February 10, 2006

The Poetry Of Finance

Bill Bonner is an enjoyable read when it comes to macroeconomics. Here's a good piece.


Whither goes the money? Are bad debts written off balance sheets as easily as they were once written on them? Does the money just go up to money heaven, back into the "thin air" from whence the Fed first drew it out?

We were wondering yesterday about the debt bubble. Can debt levels continue to rise forever? And what happens when a debtor cannot pay? No harm done, right?

Our head aches and our knees wobble at the thought of it. Even without thinking, we know it can't be so. Nature has her limits, her penalties and her dirty tricks. In debt, as in dollars, quality and quantity vary inversely. The more debt a man takes on, the more he has to struggle to keep up with it. The quality of his IOU declines. "Will he really be able to make good on his commitments?" lenders ask themselves.

Logically, if not consistently, lenders demand higher rates of interest. Higher rates increase the weight of debt throughout the economy. A man who must borrow to continue living in the style to which he has become accustomed must shoulder more debt at higher rates – making him even less able to pay. At the margin, debtors begin to buckle at the knees. Credits go bad. Bankruptcy courts and workout companies start hiring extra hands. That is what we see happening in Britain and America today.

But, apart from the overburdened lender, is anyone really worse off? The credit may have been created "out of thin air" by central banks...doesn't it vanish just as painlessly? Alas, no.

When a lender doles out a million pounds to a borrower, both of them now feel they have money to burn. Imagine next that the borrower takes an extravagant vacation around the world. The money does not vanish into thin air. Instead, it goes into travel expenses: jet fuel, swanky hotel rooms, pricey bar tabs. It goes not up to heaven, but down to earth, where it is used up, and vanishes forever, like a lover's last kiss or a smoked cigarette. And it does not vanish without a trace. You are left with a bitter aftertaste and the burnt-out stubs.

First, the borrower goes broke. Then, when the lender goes to collect, he finds that he is broke, too. And somewhere in Sri Lanka or San Martin is a hotel proprietor standing in front of a brand new wing of rooms. He wonders what's happened to his free-spending customers. What happened to the sound of ice cubes at cocktail hour and the smell of foie gras at lunch? He worries about how he'll pay the mortgage he took out to pay for his new addition.

As the credit cycle continues to turn down, there are fewer people with money in their pockets, and more capital investments that don't really make sense anymore. In short, the money doesn't ascend into money heaven at all. Instead, it becomes a steel ball and chain clamped to the ankles of investors, businessmen and they'll drag around for years. Not only have the borrower and the lender no more money to spend, but now the hotel owner has thrown away his money on that suite of luxury rooms that no one wants. He'll either have to eat into his own income or capital to keep the thing going...or go bust, too.

Fraud begets fraud...swindle begets swindle...error begets error and the whole cycle soon becomes woebegotten. In America today, the Fed's phony new money – created out of thin air – feeds phony house price increases that turns into phony consumer demand that coaxes businessmen in China to make bad capital investments. When the cycle tops, almost everyone everywhere will feel the pain, because the funny money drew out real resources – oil, labor, steel – that might have been put to better use.

Don't get us wrong; we love the Fed as much as everyone else. In the Soviet Union, resources were misallocated by force. In the Fed's empire, they are misallocated by fraud. This is undoubtedly a big improvement; for one thing, it is much more entertaining.

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