The Big-Picture Economy, Part 3: Scarcity, Risk and Debt
  (September 25, 2013)

When skimming and speculation are more profitable than actually increasing the production of goods and services, the discipline and incentives of a market economy are distorted to the point of no return.

In the natural order of a market economy, income and credit are scarce. Income must be earned, and is thus limited by the hours of the day, capital, competition, ingenuity and luck. Credit is scarce because the pool of savings (capital) available to be loaned out at interest is limited, as is the income available to service debt.

This intrinsic scarcity of income and credit generates capitalism's inherent discipline: capital must be saved by sacrificing consumption, scarce capital must be placed at risk to earn a return, and capital that is lent to borrowers (i.e. credit) must earn a return commensurate to the risks of default and alternative uses of the money.

The natural order has been completely upended in our state/crony-capitalist economy. The Federal Reserve's Zero Interest Rate Policy (ZIRP) and easy credit have destroyed capitalism's inherent discipline and incentivized the destructive forces of speculation, leverage and debt.

We need to distinguish between income earned from generating goods and services and unearned income skimmed from government giveaways and central-bank enabled carry trades. Consider the investment banks that, thanks to the Fed's manipulation, can borrow billions of dollars at near-zero interest and then use the money to buy non-U.S. bonds paying 3.5%. This is a carry trade, as the cost of carrying the debt is much smaller than the yield on the foreign bonds.

In an unmanipulated market economy, the cost of borrowing money would generally be 1.5% above inflation for very low-risk situations. That suggests the interest rate if the Fed ceased its intervention would be around 3.5% to 4%.

How many currently profitable carry trades would vanish if investment banks had to pay 4% to borrow money in the U.S.? How much risk would speculators have to take on to skim higher-yield trades?

The Fed's ZIRP is a blatant gifting of billions of dollars in low-risk carry trades to large banks, speculators and financiers. The Fed might as well write a check and send it to the bankers--ZIRP and easy credit are the equivalent of a free-money check.

On the lower end of the economic spectrum, low rates and abundant government-backed credit enable marginal borrowers to load up on debt that they would not qualify to borrow in unmanipulated markets. This incentivization of marginal borrowers increases risks of defaults and systemic crashes, which tend to be triggered by marginal-debt defaults.

In effect, The Fed's ZIRP and easy credit have leveraged up systemic risk and moral hazard. Moral hazard describes the difference between those who risk losing money in a speculation and those with no risk of loss. Those with very limited risk--for example, Too Big to Fail (TBTF) banks backstopped by the Fed or FHA home buyers putting down 3% cash on a home--will act quite differently from those who risk losing their all their capital if the bet goes bad.

Put another way: if all your losses at the casino are covered by the Fed, while any winnings are yours to keep, you will gamble big and gamble often. After all, why not? The losses are shifted to someone else while you get to keep any gains.

Abundant, easy credit incentivizes systemic speculation, leverage and risk. If you're issuing mortgages guaranteed by the U.S. government, there is no need to be too risk-averse: originate a mortgage for anyone with a pulse and skim the fat origination fee. If the borrower defaults, who cares? You skimmed your fee, and all losses are shifted to the taxpayers.

When skimming and speculation are more profitable than actually increasing the production of goods and services, the discipline and incentives of a market economy are distorted to the point of no return. That is the U.S. economy in a nutshell.

The only way to restore natural market discipline is to let the cost of credit rise to a market-discovered price, force all speculators to absorb the losses resulting from their bad bets, and let the risk of losses discipline lenders to adjust loan portfolios and interest rates to reflect the risks of rising rates and defaults.

Scarcity of credit is the source of sound risk assessment and the discipline of aligning interest rates to risk and inflation. Manipulating rates to near-zero and opening the credit floodgates have incentivized everything sound economic policy avoids: moral hazard, speculation, leverage and reliance on marginal credit expansion for profits and "growth."

"Growth" that depends on manipulated interest rates and easy credit is a sand castle awaiting the rising tide; its destruction is assured.

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