In his sagacious text entitled The New Paradigm for financial Markets: The Credit Crisis of 2008 and What it Means, the iconoclast speculator, George Soros, says that: "We are in the midst of the worst financial crisis since the 1930s. In some ways it resembles other crises that have occurred in the last twenty-five years, but there is a profound difference: the current crisis marks the end of an era of credit expansion based on the dollar as the international reserve currency. The periodic crises were part of a larger boom bust process; the current crisis is the culmination of a super-boom that has lasted for more than twenty-five years."
It is important to note that he unequivocally isolates unchecked credit expansion as the source of the unprecedented turmoil that has been roiling financial markets since August of 2007, i.e. he asserts that exponential credit expansion - which was a quintessential feature of capital markets during the last 25 years - is inextricably linked to the parlous financial condition the global economy currently finds itself in. Underlying the aggressive credit expansion that propelled the 25 year super-boom, was the revered and almost sacred Keynesian paradigm of macro-economic development; which asserts that aggregate demand has to be boosted through expansionary (policy) interventions, to alleviate an economy of recessionary pressures, which therefore revitalizes the economy, and puts it onto a growth trajectory.
Hence, some of the expansionary interventions that reserve banks (& other monetary authorities) use to assuage an economy of recessionary pressures are interest-rate cuts. When base interest rates are cut/reduced, credit becomes 'more-affordable', which in turn stimulates increased consumption, and leveraged investments by entities within an economy. Ostensibly, this has the consequential effect of stimulating aggregate demand - which results in economic growth, and promotes longterm economic stability.
Whilst it is logical to assume that cutting interest rates would stimulate increased consumption; which would in turn increase aggregate demand; thereby promoting economic stability and growth, empirical evidence discounts the assertion that interest-rate cuts can always be successfully used to stimulate longterm economic stability and growth. In fact, the market turmoil that was endured in 1987, and between 2007-2009 had its origins in the logically sound, but empirically unsound belief that interest-rate cuts can be used to stimulate longterm economic stability and growth. In fact, it can be said that interest rate cuts, whilst they might stabilize the economy in the short term, have a great likelihood of causing longterm instability in an economy with excess capital inflows and savings.
When the aforementioned crises were building-up, we witnessed an exponential growth in debt, caused by a borrowing and leveraging frenzy that was engendered by overly-low interest rates. Otherwise stated, the flood of 'cheap money' in the global economy during the build-up to both crises, fueled leveraged expenditures and investments that misallocated economic resources, which thus set the stage for the current dramatized market turmoil we are witnessing.
Therefore, in this post I'll attempt to illuminate on, using a conceptual model I developed, the dynamics of a crisis originating from unchecked credit expansion.
To be honest, I arrived at the model by pure accident when I was fudging around with a few abstract ideas. I have stripped from the model, the ugly mathematics that seems to put off a lot of people.
The graphical illustration below will be used to explain the dynamics of a crisis originating from unchecked credit expansion:
It is important to note that he unequivocally isolates unchecked credit expansion as the source of the unprecedented turmoil that has been roiling financial markets since August of 2007, i.e. he asserts that exponential credit expansion - which was a quintessential feature of capital markets during the last 25 years - is inextricably linked to the parlous financial condition the global economy currently finds itself in. Underlying the aggressive credit expansion that propelled the 25 year super-boom, was the revered and almost sacred Keynesian paradigm of macro-economic development; which asserts that aggregate demand has to be boosted through expansionary (policy) interventions, to alleviate an economy of recessionary pressures, which therefore revitalizes the economy, and puts it onto a growth trajectory.
Hence, some of the expansionary interventions that reserve banks (& other monetary authorities) use to assuage an economy of recessionary pressures are interest-rate cuts. When base interest rates are cut/reduced, credit becomes 'more-affordable', which in turn stimulates increased consumption, and leveraged investments by entities within an economy. Ostensibly, this has the consequential effect of stimulating aggregate demand - which results in economic growth, and promotes longterm economic stability.
Whilst it is logical to assume that cutting interest rates would stimulate increased consumption; which would in turn increase aggregate demand; thereby promoting economic stability and growth, empirical evidence discounts the assertion that interest-rate cuts can always be successfully used to stimulate longterm economic stability and growth. In fact, the market turmoil that was endured in 1987, and between 2007-2009 had its origins in the logically sound, but empirically unsound belief that interest-rate cuts can be used to stimulate longterm economic stability and growth. In fact, it can be said that interest rate cuts, whilst they might stabilize the economy in the short term, have a great likelihood of causing longterm instability in an economy with excess capital inflows and savings.
When the aforementioned crises were building-up, we witnessed an exponential growth in debt, caused by a borrowing and leveraging frenzy that was engendered by overly-low interest rates. Otherwise stated, the flood of 'cheap money' in the global economy during the build-up to both crises, fueled leveraged expenditures and investments that misallocated economic resources, which thus set the stage for the current dramatized market turmoil we are witnessing.
Therefore, in this post I'll attempt to illuminate on, using a conceptual model I developed, the dynamics of a crisis originating from unchecked credit expansion.
To be honest, I arrived at the model by pure accident when I was fudging around with a few abstract ideas. I have stripped from the model, the ugly mathematics that seems to put off a lot of people.
The graphical illustration below will be used to explain the dynamics of a crisis originating from unchecked credit expansion:
Explanation of the graphical illustration above:
- The illustration depicts the dynamics of an economy under distress owing to rapid credit expansion over time. Rates of change with respect to time (i.e. dx/dt, where x represents any of the six variables under consideration) are represented by the vertical axis, including the rate of change with respect to time of: Debt; Equity, GDP, The Debt-to-Equity ratio, The Base Interest Rate and The Natural Interest Rate. Time is represented by the horizontal axis. In the rest of this post, the phrase 'rate of change' will be used to mean 'rate of change with respect to time'.
- GDP: The rate of change of GDP (dGDP/dt) over time is represented by the lime-green trajectory labeled Z. Between point f and point g, the rate of change of GDP is negligible, although it does register a small net increase. From point g through to point s, the rate of change of GDP starts to register a steady decrease.
- Interest Rate: The rate of change of the base interest rate (di/dt) in the economy over time, i.e. rate of change of the risk-free rate, is represented by the grey/gray trajectory labeled U. The rate of change is somewhat stable - as evidenced by the general flatness of the trajectory - as base interest rates usually change at specific times of year - when monetary authorities announce new rates. On the diagram, an interest-rate downward movement is illustrated by the 'step-down' between points e and q on the grey/gray trajectory.
- Debt: The rate of change of the aggregate debt used by all agents in the economy (dd/dt) over time is represented by navy-blue trajectory labeled X. As evidenced by the trajectory between points a and e, the rate of change of debt usage in the economy grows exponentially, because of the abundance of 'cheap money' in the economy.
- Equity: The rate of change of the aggregate equity used by all agents in the economy (de/dt) over time is represented by red trajectory labeled Y. As evidenced by the negative gradient between points h and t, the rate at which equity is used to finance new activities of agents in the economy is falling. This generally indicates an increasing preference to use debt in the economy.
- Debt-to-Equity Ratio: The rate of change of the debt-to-equity ratio of the aggregated balance sheet of all agents in the economy (dde/dt) over time is represented by pink trajectory labeled W. As you can see from the trajectory between points j and n, the rate is increasing exponentially over time, faster than the rate at which usage of debt is increasing. This is because debt is growing at a fast rate, and equity is also falling at a fast rate, therefore the rate of change of the debt to equity ratio over time becomes steeper than the rate of change of the debt ratio over time for that reason (I shan't go into the mathematics of it).
- Natural Interest Rate: The rate of change of the natural rate of interest (dn/dt) over time is represented by the yellow trajectory labeled V. By the term 'natural rate of interest', I simply mean what the base rate of interest would be if it were left to be determined by the free market forces of supply and demand. As you can see from the trajectory between points p and t', the rate grows fast, but turbulently over time owing to the increasing demand for debt.
...The Dynamics of a credit-induced economic shock
To stimulate economic growth, monetary authorities reduce interests rates, as shown by the step between points e and q on the gray/grey trajectory labeled U. This causes the rate of change of the natural rate of interest to equal the rate of change of the base interest rate, as evidenced by the intersection at point q of the yellow trajectory labeled V and the grey/gray trajectory labeled U. This results in a material increase in GDP, as evidenced by the peak at point g on the green trajectory labeled Z, showing that credit expansion has had a positive impact on economic growth.
After that, the demand for credit grows at an astronomical rate - causing the natural rate of interest to gallop, as evidenced by the sharp increase of gradient between points q and t' on the yellow trajectory labeled V. At the same time, the base interest rate is fixed, meaning that the observed price of credit is cheaper than the perceived price of credit. Therefore, it becomes increasingly more beneficial for agents to finance their activities through debt as opposed to equity, which results in increasing usage of debt capital, as evidenced by exponential increase in the rate of debt usage depicted by the steep trajectory between points b and e on X, and a reduced usage of equity capital, as evidenced by the negative gradient between points i and t.
However, the flood of cheap money is having an adverse effect on economic growth, as evidenced by the steady decline of the rate of change of GDP between points g and e on the trajectory labeled Z. This means that the abundant credit money is increasingly being channeled to economically unproductive uses - a wastage of resources. Which sets the stage for economic collapse, as economic waste is unsustainable in the longterm.
On when the economic collapse will occur: that is tricky. But, it can occur at any point of time within what I term 'the crisis circle', shown by the blue circle in the illustration that connects points r, b, k, i , n, e, t'.
Hoping that you found the model useful.
However, the flood of cheap money is having an adverse effect on economic growth, as evidenced by the steady decline of the rate of change of GDP between points g and e on the trajectory labeled Z. This means that the abundant credit money is increasingly being channeled to economically unproductive uses - a wastage of resources. Which sets the stage for economic collapse, as economic waste is unsustainable in the longterm.
On when the economic collapse will occur: that is tricky. But, it can occur at any point of time within what I term 'the crisis circle', shown by the blue circle in the illustration that connects points r, b, k, i , n, e, t'.
Hoping that you found the model useful.
