Friday, August 15, 2008

The Vicious Circle of Shrinking Capital

The standard line in the financial media is that interest rates are set to drop in the U.S. and will remain low for the foreseeable future. Huh? Based on what source of capital available for lending?

Let's start with the basics. Money has to come from somewhere before it can be borrowed. There are only two sources for money to lend: either it has been saved in the real world from a surplus of income over expenses, or it has been created out of thin air by leverage in a banking system.

Recall that leverage is what enabled the housing/credit bubble. As required reserves shrank to 1%, that allowed U.S. banks to lend $100 million for every $1 million held in cash. Leverage in investment banks is running anywhere from 30-to-1 to 60-to-1, or perhaps much higher (who can tell with so many "assets" held off balance sheet?).

But even leverage requires some actual capital. And let's not forget that the big buyers of U.S. debt--China and the Gulf Oil exporters--have been using actual surplus capital, i.e. cash, not leveraged funny-money, to buy U.S. Treasuries, mortgages, etc.

Some readers have suggested, "but can't the government just print up a trillion dollars?" While no expert, from what I gather the Federal government does not print up a trillion dollars and then spend it. It basically prints up Treasury bonds which are sold on the open market and the proceeds (the cash someone exchanged for the future promise of pathetic returns, i.e. the bonds) are then spent. This is "deficit spending"--spending more than you rake in from tax revenues, and filling the gap with borrowed money, not printed money.

States like California are egregious addicts of the same method of spending more than you take in: the state attempts to fund every infrastructure project from toilets in state parks to fixing the crumbling water-management system with bonds, i.e. the promise of future pathetic returns on capital exchanged for actual cash.

Bottom line: all deficit spending and all private borrowing are ultimately dependent on surplus capital and leverage based on low risk and rising assets.

But guess what's receding / shrinking / vanishing faster than a summer spray of water in Death Valley? Global surpluses, global assets and global leverage.

Here's what's happening to the global pool of capital on which all this future borrowing is dependent.

1. As the global consumer economies plummet into a deep, prolonged recession, Asian exporters find their surpluses (profits) dry up and then turn into losses: losses first of profits, then of jobs, then of the savings of those millions who lost their jobs, then of the asset base of lending (factories, real estate, etc. which all crash in value as losses mount) and as fear rises, of risk-free leverage.

2. Resource-based economies (Australia, all oil exporters, etc.) will be hit with lower prices for commodities as demand for manufactured goods shrinks. Governments will still be funding infrastructure projects, but with tax revenues falling like anvils dropped from the Leaning Tower of Pisa, they will be doing so via deficit spending, i.e. by competing with private sector borrowers for the shrinking pool of capital available for lending.

Recall that governments gain popular approval by spending lavishly. Cutting spending is political suicide everywhere, so governments from Saudi Arabia to the U.S. will maintain spending at all costs, insuring stupendous rises in deficit spending. i.e. government borrowing private capital.

In May I wrote Oil: One Last Head-Fake? in which I made the case for this thesis:

What I am suggesting is a gigantic head-fake in which global recession causes oil demand and price to plummet for a brief period. This will feed a resurgent complacency about Peak Oil, setting the world up for an unprecedented shock when the global economy and demand recovers.

While I expected the head-fake in 2009, it appears to be under way now. The primary consequence which everyone seems to be missing is the massive reduction in the global surplus of capital available to borrow. Do you reckon that all the oil exporters are going to slash their domestic spending as their oil incomes are slashed? Of course not; what vanishes is not their spending but the surpluses which have been misallocated to U.S. Treasuries and mortgages.

3. As risk is finally recognized, leverage shrinks just as assets on which leverage was based decline in value. Recall that leverage is always based on rising assets: as your capital base of assets rises, you can always leverage more debt. But when that reverses and your assets decline--in this case, real estate, stocks, commodities and all private debt instruments like mortgages and corporate paper--then the leverage turns into an asset-eating monster.
Assets have to be sold to raise capital or pay down debt, and in a classic vicious circle the rampant selling of assets drives down the market value of those assets, causing more selling as margin calls/debt/leverage gets called in.

As losses mount, the ability to create money from leverage is lost. What happens instead is banks are selling off assets to raise capital and stave off insolvency, feeding the cycle of ever-lower asset prices. The same is true of individuals, who are turning in leased autos, selling jewelry and second homes, etc. to lower their debt/stave off insolvency.

4. Another trend nobody seems to notice is the iron grip of demographics. I recently read that Saudi Arabia is building desalinization capacity (to turn salt water into fresh water) on such a vast scale for its exploding population that the system will require up to a million barrels of oil a day to operate.

That's a million barrels of oil that the Saudis won't be able to sell for cash, and millions of dollars which will no longer be available to fund/buy U.S. debt (Treasuries, mortgages, etc.)

As I have written here many times, all nations are facing unprecedented demands to pay for rising populations and rising expectations. Global aging is a reality, and just as the global pool of capital goes into a massive decline, the demand for deficit spending to pay for elders' pensions and medical care is exploding.

Everyone expecting permanent declines in the cost (in purchasing power, regardless of whether you use currency or gold as a measure) of what I call the FEW resources (food, energy and water) is going to be disappointed, for they forgot to consider that the population of human beings expecting/demanding Western-style abundances of fresh water, meat and energy has doubled in the past 20 years from roughly 1 billion (North America, Japan and Western Europe) to 2 billion (rising middle classes in Eastern Europe, Russia, the Middle East, China, Southeast Asia and India).

Poor people don't require vast amounts of water, food and energy, nor do they have the political wherewithal to demand it. As populations with rising incomes and just as importantly, rising expectations have doubled, so too have demands on governments to provide the infrastructure and services.

Meanwhile, back in the Lands of Unfunded Liabilities, i.e. the U.S., Japan and Western Europe, the demand for capital via deficit spending is rising along with the expenses promised to retiring Baby Boomers. And don't think this is only a Western problem; China too has made unfunded promises to its retiring generation.

5. While some foresee massive capital accumulation in the U.S. from rising personal savings, I see trends which limit that capital growth: paying down debt doesn't create one cent of capital. As millions lose their jobs, that knocks out the critical prop beneath saving money. As FEW costs stay high, a greater percentage of income must be spent on necessities. As governments face staggering deficits, taxes are raised (if not directly, then through "junk fees" and assessments), further reducing consumers' net income available for savings.

Medical costs are being shoved back onto the consumer as well. All those glorious savings can vanish in a week of critical care. Frugality is about survival and solvency, not about piling up trillions in new capital our dear government can then borrow at 3%.

6. Here in the U.S., the infrastructure is falling apart. A new energy complex must be built which will cost trillions of dollars. Simply put: the demands for private capital are simply stupendous, yet the pool of global capital is shrinking in a vicious circle which will lead to ever smaller surpluses available for lending.

Where is the pool of rising assets and surpluses from which we can all draw trillions in borrowing? The pool is rapidly being drained by asset depreciation, falling commodity incomes, collapsing leverage and job/income losses, just as demands for borrowing, both public (government) and private are set to explode.

That's a recipe for rising interest rates for decades to come. Sure, maybe the Fed will tinker with their thermostat, lowering the Fed Funds rate to 1% in the next few months; but to think that the Fed tinkering with their little spray bottle can control the global tides of recession, capital destruction and demographic demand is absurd to the point of fantasy. In the long run, rates will rise, higher and over a longer time span than the financial punditry can even imagine.

The cheap, seemingly endless supply of surplus capital available for lending is gone and won't be coming back.

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