This is a Work in PROCESS
last update 01-May-2009
I’ll put the update date at the top every time I change it.
So here we are, the third month of 2009, still in a world where the monetary orthodoxy has been turned on it’s head. Without boring anyone with the details of what’s happened to date, perhaps we should look at where we go from here.
The “Current Thinking” across the world seems to be that “Debt Deflation” is in full swing, what had value as an asset yesterday may be worthless today. So much for the brilliance of the business community and especially the bankers, the so called “Masters of the Universe”. Many perfectly good businesses are now in debt up to their necks due to the banks telling people that Leverage (debt by any other name) is a good thing. Companies, especially the big corporations have been leveraging themselves up, to you and me, going into debt, because it was seen as a way that profits could be enhanced. I think the idea was that if you borrowed a wodge of money, the debt repayments would be less than what could be earned off the money if it was reinvested. Now, that may work for a while, but there is a significant problem in that the system is a closed system, that is, there are finite boundaries to what can happen. How do you explain a closed system as opposed to an open system?
In an open system, growth would be unrestricted, and any constraints would be overcome by the normal process of supply and demand. Bear in mind that if we start from a baseline of 100 with an AVERAGE of 2.5% growth per year, the growth acts in the same way as Compound Interest on money in a bank. To explain this I have to talk a little maths, and I’ll also make a couple of assumptions. The first is that the Average growth over a long period is constant, in this example 2.5%. I’ll ignore inflation which has the opposite effect to growth because it destroys the value of money and wealth, but that’s a different post. So starting at year one with baseline 100, we ‘grow’ at 2.5%, at the end of the year we we add the growth on to our baseline and we get 102.5%, so growth has made the economy bigger. What happens at the end of year 2this time we ‘grow’ from a baseline of 102.5 (not 100), and we increase by 2.5% of 102.5. That is NOT 105, but 1.05063, not a lot of difference you think, jump forward 10 years. If the Growth was 2.5%on the initial 100 every year, we’d be at a 125 (that’s 10*2.5%), instead we’re at 128, again, at this point, no great shakes, so another 10 years.
Simple growth would take us to 150, compound takes us to 1.639, that’s quite a large gap now, going from 3 percentage points to almost 14 percentage points in the second decade, so lets jump another ten Again, Simple Growth would have us on 175, compound takes us to 209.8, and the growth, against the original 100 baseline now is not 2.5% but 4.8%, Ten more years 40 Years Simple 200 Compound 262 growth 6.55% 50 Years Simple 225 Compound 335.3 growth 8.38% 60 Years Simple 250 Compound 429.2 growth 10.73% 70 Years Simple 275 Compound 550.0 Growth 13.7% Hang on — look at the figures the compound growth rate now means that we are ‘GROWING’ at over 13% a year, and the Growth has meant that, being a compound growth we are at DOUBLE where we would be if it was simple growth. Lets do a few more 80 Years Simple 300 Compound 703.4 Growth 17.6% 90 Years Simple 325 Compound 900.4 Growth 22.5% 100 Years Simple 350 Compound 1152.6 Growth 28.8% lets skip a few, lets jump to 160 Years 160 Years Simple 500 Compound 5071 Growth 126.8% So in 160 years we end up with a growth of over 50 times our start and an annual growth Rate of 126% If plotted on a graph, this becomes what is called an exponential graph. you can see that if we take the 300 years plus since the Bank of England was created, we end up with
However, in a closed system, which despite appearances is what we have, constraints can fatally impair a systems ability to cope with changes. A couple of examples may help, both in the area of commodities, the raw materials that make the world a productive place First, the costs involved to extract and transport iron ore from the place it’s mined to the place it’s used. Iron ore is a fairly common mineral, and needs little processing before being loaded onto bulk carriers for transport to the Steelworks of the world where the raw material is turned into usable iron and steel. Until mid 2008 we saw an increase in iron ore costs as demand for the raw ore increased in line with the booming economies of the West and Asia, especially China and India. The costs of transporting that ore, measured on the Baltic Dry Index also increased dramatically, with rates over $100 per tonne at one point.
The costs ACTUALLY involved in transporting the goods hadn’t actually changed, but with the Law of Supply and Demand as the driver, more ore needs shipping than ships that are available, therefore the price goes up. In the longer term, this is counterbalanced by an increase in the amount of available shipping that drives the cost of transport back down. There are however a couple of problems, the first is the time lag between the capacity shortage and the extra capacity coming on line. Any bulk carrier takes up to 3 years from placing the order to being available to work, so we currently have a surge in capacity to match the boom of 2005-6, however, that boom has disappeared, this doesn’t translate into an orderly decline in transport costs, it results in a crash, with the Baltic Dry recently hitting it’s lowest ever level. The shipping owners have gone from Feast to Famine. The problem was that during the feast no one could see famine beyond the horizon, so most carriers have plans in place for future investments that will either have to be drastically curtailed or the business will make little profit, or perhaps large losses from having unused capacity available. That’s just the transportation. The raw material itself, iron ore had also been undergoing a boom with the cost of ore tripling over 8 years. Again, the actual cost of extracting the ore has not tripled, there may be some marginal increases, but most of the extra cost to the buyer comes out as extra profit to the seller. This means that two of the largest companies involved, Rio Tinto and BHP Billiton had market valuations that were extremely high, with corresponding profits. When a company seems a profit train that doesn’t look as if it is ending two things happen, firstly the company gets fat, waste creeps into the system headcount increases, wages increase.
Profits?? They still increase, driven by the excess demand driving prices. But then we hit a tipping point, somewhere in the chain a weakness forms. In this current phase, the weakness is the Consumer. Many people had been fooled into thinking that debt was good, Credit cards were maxed out, mortgages were taken out and equity released from houses, enjoy yourself while you can..This works while interest rates are falling, but nothing can fall forever, at some point in every business cycle the cycle turns. In the up phase of a cycle, interest rates have to go up to prevent inflation.
Now, although I don’t like being a harbinger of doom, I currently do not see an easy way out of the situation I am about to describe below.
As I said in the last substantive paragraph, as the cycle turns, interest rates will have to rise, for savers, that will be welcome news, but for borrowers? Think this through, in the last 10 years in the UK, “Tracker Mortgages” have become the norm. Currently, most people on Trackers are in a position where the repayment interest rate has dropped to between 1.0% and 1.5%, meaning that even if finances are stretched unless both partners lose their jobs then the repayments should be OK.
But, when the cycle turns, the Trackers will do just that, follow the interest rate up, meaning swinging increases in repayments, possibly in a short period. Unless people are still paying their mortgage at their original rate and driving down the amount of capital owed, rather than reducing the payment to survive, the forthcoming interest rate rises will result in incresaed mortgage payments that that will match the previous decrease. If people are finding it hard to repay now, how will they cope with the increases? Any rate rise may not happen for up to three years, but when it does, if you are on a tracker, you are in trouble unless you can extend your mortgage or match the new payments.