Guest post from Karl Denninger at Market-ticker.org:
It’s really not very complicated.
If there are negative real rates of interest, defined as the cost of borrowing is less than actual inflation (not what some government wonk claims) then I can trivially run a cash furnace — literally — and show good “earnings” for as long as that continues.
Why?
Think about it. I can borrow $1 million tomorrow, at a rate of interest of let’s say, 1%. This was not hard not long ago, was it?
Ok, so I must post up $10,000 a year in interest (1% of $1 million.) Fine. The true rate of inflation is 5%. I make a product and lose 1% on every unit I sell, but the price goes up by 5% a year (inflation.) I can pay the interest, sell the product at a loss and claim a 3% net margin!
This assumes I don’t lever anything, which of course I will do. If I “turn the crank” 10 times I now can claim a 30% return.
In truth I lost 20% (2% times each turn of the leverage crank) but that’s in real terms and all financial statements are in today’s dollars, that is, nominal terms.
Everyone in the society is forced by said inflation to subsidize my actions. That is, I never actually made any profit; I stole the money from you, your neighbor and everyone else. I’m not the only one doing it either; everyone in business is doing it and you’re getting robbed blind.
The problem with this paradigm, which is what we’ve done for the last 30+ years, is that the ratchet job keeps getting bigger because it has to; inflation is a compound function and further, everyone wants more and more profit and therefore more turns of the crank. You, as a consumer, are forced to eat this — right up until you can’t.
So the real estate agent, for example, has to have a reasonable and pretty-new vehicle to drive customers around in. The 10+ year old Camry or Mazda with 200,000 miles on it and a few dings and interior wear will not do. But that nice Tahoe LT that was $36,000 in 2002 is now over $70,000 in equivalent trim, a clean double.
The house she’s showing? It doubled twice in that period of time; what was a $100,000 home is now $400,000. You’d think this is all good because she gets paid a commission as a percentage, but you’d be wrong because her costs have gone up faster than the income did. In particular food, energy and health care have all skyrocketed in cost. Health care you can avoid if you’re both wise and lucky, but food and energy — not so much. In addition since the value of everything in “nominal dollars” has gone up so have insurance costs. The insurance companies love this since that ratchet drives their profits higher and, being a regulated industry with a 10% profit cap that’s the only way to make their business grow!
As the squeeze continues there’s no way out. Reality is that a median income must be able to buy a median house or eventually you run out of people moving from one place that’s higher cost to somewhere that’s lower, and when you do the sales stop. If the median personal income in a given area is $50,000 then the median house can’t realistically sell for more than three times that, and this assumes the real estate taxes are rational.
The only way to put a stop to this spiral is for real interest rates to be positive across the curve. That enforces discipline because time has value and thus if you want to do it “now” rather than accumulating capital and doing it later you must pay for that election instead of getting paid. It instantly stops all the cash furnace games because now there’s no way to make money doing it; if you can’t actually turn an operating profit on your operations you go bankrupt.
Let’s be clear about this: In a negative rate environment every business in the nation that borrows money forces you to pay for their borrowing, and thus for their operations, irrespective of whether you personally consume their good or service.
You may not recognize this but it is true and as a result the larger the economy gets in such an environment they more you get screwed.
Stopping the expansion does not solve the problem because at the present price level goods and services are not affordable by the median income on a median level without you too sinking into that hole. The providers of said goods and services can’t pay for the things necessary to provide them; the plumber, HVAC dude or electrician needs a truck for his tools and supplies, the realtor needs a vehicle suitable to haul a couple or family of four around looking at houses and the salon owner needs to have a place to put their chair and plug in their clippers, never mind that you need a place to live where you can pay for it with the wages you can earn. Each “living unit” in the economy (e.g. single person, family, etc.) must be able to provide, with their capacity to earn, a reasonable and decent place to live, power for the lights and refer, food and similar.
The last two decades of this crap has essentially forced everyone to play this game themselves lest the average person not be able to do so. Yes, people like myself can make it work otherwise, and so can a few others — but most cannot. You can’t leave things alone in this configuration because those “most” are utterly necessary or your hair does not get cut, your plumbing, power and HVAC do not get fixed, you have no fuel for your vehicle because the people making it can’t afford to live on their incomes and similar.
The premise that people should “own nothing and eat bugs” is preposterous; they won’t do that and, at the same time, show up to fix your A/C unit when its 110F out or your heat when its twenty below zero!
Withdrawing liquidity until the rate of interest across the curve is higher than the true rate of inflation will collapse every single one of those cash furnace firms that cannot actually turn an operating profit without stealing something from everyone in society. Most of them will collapse. Some can in fact make money, but nowhere near as much. Their stock prices will go down materially to reflect this new reality where earnings are actually earned instead of stolen.
Think about the simple transaction of moving from one house to another. You may think a housing bubble and rising prices are good. You’re wrong. If you own a house, sell it and buy another house in a bubble you made nothing. In fact you lost doing this, particularly if you bought it before the bubble occurred, because you are likely over the IRS tax exemption cap on the alleged “gains” and thus must pay taxes on what is in fact a lateral move which did not benefit you in real terms at all. Since you must have a place to live there is no way for you to personally win.
Your heirs win if you die while owning such a bubble house for the obvious reason: They get a nice windfall they didn’t work for. But you, personally, are currently being eaten by snakes and worms, so from your point of view that’s worth zero. Further, if you don’t own a house you get it in every hole you have when you want to buy one, which wildly inhibits family unit formation and that, my friends, is serious trouble down the road because without family unit formation and children who is going to pay taxes when you no longer can — say much less wiping your butt?
A personal vehicle is another example. The average new vehicle in 1981 was $8,910. In 2022 it was $48,000 or 5.39 times what it cost in 1981. Yet the median weekly wage has gone from about $300 in 1981 to just over $1,048 (Q2 2022) or 3.49x.
The median single-family home cost about $62,000 in 1981. It was about $390,000 in 2022 an expansion of 6.3x or pretty close to double the advance in median weekly wages.
House prices, in short, need to go back to about a 2003-2004 level — and new car prices must come down by about 40%. These are not the only examples; health care costs are even worse in that they’ve doubled as a percentage of GDP which is in nominal dollars and thus already includes inflation — to bring them back to parity the price must fall by about 75%.
To say that such changes would result in wild-eyed changes in the economy generally is the understatement of the century.
But if we don’t withdraw the excess liquidity until the price level returns to something approaching historical averages as a percentage of incomes, which will be much more than you think as incomes will shrink too, we’re going to go off the cliff and be unable to meet the obligations we claim to be willing and able to support and ultimately our society will collapse.
This has been a known issue and threat for more than 20 years and it has been willfully and intentionally ignored by both sides of the political aisle.
The capacity to keep doing so has expired; Medicare and Medicaid are running an 80% cash deficit right now and last year consumed two trillion dollars, or approximately one dollar in three at the federal level alone. The capacity to fund that will run out within the next two years without ramping up the extraction level even more which just makes the problem worse.
Time’s up.
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