The Market Always Goes Up Part 2: Interest and Wealth Inequality
In my previous post on this topic I focused on the general reason for the causes of inflation as well as why rising interest rates can cause inflation during the boom portion of the business cycle . In this post I hope to go into more detail and to discuss how interest on loans contributes towards inflation during the bust portion of the business cycle.
In a normal business cycle, there is a boom and bust. With the bust, there is a reset of prices caused by deflation. For a good example of this refer to the dow jones-gold chart macrotrends.net/1378/dow-to-gold-ratio-100-year-historical-chart. As you can see from this chart during every major recession there was a significant decrease in the price of the dow jones as measured in gold. The chart is sideways and choppy as opposed to the clear uptrend the chart of the dow jones measured in dollars. So it is clear, there is more than the boom-bust cycle that is causing the Dow Jones in nominal terms of dollars to rise over the past century and not have a more drastic reset in prices during recessions. This deflation and reset is actually good because it allows less well-off businesses and individuals to purchase at a discount.
To better understand why this is the case, let's look at what happens during a business cycle. During the boom phase of the cycle, jobs are plentiful, businesses are flourishing, loans are created plentifully, and prices generally rise. Debt payments are handled without hardship for the majority of businesses and individuals during this phase. In the bust phase, demand drops, people lose their jobs, businesses shut down and the economy goes into a recession. While debt payments are handled with ease during the boom phase, during the bust phase money becomes scarce to come by and debt payments can induce hardships for many individuals and businesses causing bankruptcies, foreclosures etc. As debt payments become a greater proportion of individuals and businesses expenditures there is deflation causing the market to drop. So, we can say debt payment or debt destruction is deflationary. This will all be sufficient if there is enough money in the economy to pay off all debts. However, there is not. When you introduce interest to loans, there is an ever-increasing debt payment over time. Any money that could be spent on goods and services to boost the economy is instead used to pay off principal with interest of loans. Mathematically, it is impossible to pay of all the loans with interest because not enough money exists (Remember when banks create a loan they give enough money to pay back the loan but not enough to pay back the loan with interest).
So, while some businesses may be able to pay off their loans with interest there are others who simply cannot and they go into bankruptcy. In fact this mechanism whereby money is being siphoned off from the economy to pay interest on loans causes more defaults than would have otherwise happened without interest. Those defaults and bankruptcies are bad loans and rather than being deflationary by being paid, they still exist in the system or money supply and have an inflationary pressure during a deflationary cycle. The creditor can obtain any collateral to redeem the value of the loan wherever one exists. But, during a bust cycle or recession prices drop more than the value of the loans. For example, During the 08-09 mortgage crisis, banks would lend out enough money to buy a $300 000 home, but when the market crashed that same house was worth half it's initial price. The deflationary/deleveraging cycle that should happen during the bust portion of the business cycle is therefore hampered. The more bad loans there are the less deflation occurs. In fact, there is going to be massive amount of bad loans in the future as student loans are largely unsecured. Now this happens every business cycle, so that the total amount of debt in the economy increases with every business cycle, this is why we see the Dow Jones rising for over more than a century.
The money paid for interest goes back to the lender i.e banks, government etc. That interest money is usually hoarded during the bust phase and not re-circulated money back into the economy. This creates wealth inequality where the top 5% can own 90% of the money. The consumption of that 5% can never equal the consumption of the 95% so that money is not respent into the economy promoting eventual debt destruction.
In Summary, interest on loans promotes inflation through 2 mechanisms. Interest on loans puts pressure on businesses to increase prices causing inflation during the boom phase of the business cycle as discussed in Part 1. And, the payment of interest on loans siphons much needed money from businesses during the bust phase of the business cycle causing more bad loans and less debt destruction (ie less deflation).
In a normal business cycle, there is a boom and bust. With the bust, there is a reset of prices caused by deflation. For a good example of this refer to the dow jones-gold chart macrotrends.net/1378/dow-to-gold-ratio-100-year-historical-chart. As you can see from this chart during every major recession there was a significant decrease in the price of the dow jones as measured in gold. The chart is sideways and choppy as opposed to the clear uptrend the chart of the dow jones measured in dollars. So it is clear, there is more than the boom-bust cycle that is causing the Dow Jones in nominal terms of dollars to rise over the past century and not have a more drastic reset in prices during recessions. This deflation and reset is actually good because it allows less well-off businesses and individuals to purchase at a discount.
To better understand why this is the case, let's look at what happens during a business cycle. During the boom phase of the cycle, jobs are plentiful, businesses are flourishing, loans are created plentifully, and prices generally rise. Debt payments are handled without hardship for the majority of businesses and individuals during this phase. In the bust phase, demand drops, people lose their jobs, businesses shut down and the economy goes into a recession. While debt payments are handled with ease during the boom phase, during the bust phase money becomes scarce to come by and debt payments can induce hardships for many individuals and businesses causing bankruptcies, foreclosures etc. As debt payments become a greater proportion of individuals and businesses expenditures there is deflation causing the market to drop. So, we can say debt payment or debt destruction is deflationary. This will all be sufficient if there is enough money in the economy to pay off all debts. However, there is not. When you introduce interest to loans, there is an ever-increasing debt payment over time. Any money that could be spent on goods and services to boost the economy is instead used to pay off principal with interest of loans. Mathematically, it is impossible to pay of all the loans with interest because not enough money exists (Remember when banks create a loan they give enough money to pay back the loan but not enough to pay back the loan with interest).
So, while some businesses may be able to pay off their loans with interest there are others who simply cannot and they go into bankruptcy. In fact this mechanism whereby money is being siphoned off from the economy to pay interest on loans causes more defaults than would have otherwise happened without interest. Those defaults and bankruptcies are bad loans and rather than being deflationary by being paid, they still exist in the system or money supply and have an inflationary pressure during a deflationary cycle. The creditor can obtain any collateral to redeem the value of the loan wherever one exists. But, during a bust cycle or recession prices drop more than the value of the loans. For example, During the 08-09 mortgage crisis, banks would lend out enough money to buy a $300 000 home, but when the market crashed that same house was worth half it's initial price. The deflationary/deleveraging cycle that should happen during the bust portion of the business cycle is therefore hampered. The more bad loans there are the less deflation occurs. In fact, there is going to be massive amount of bad loans in the future as student loans are largely unsecured. Now this happens every business cycle, so that the total amount of debt in the economy increases with every business cycle, this is why we see the Dow Jones rising for over more than a century.
The money paid for interest goes back to the lender i.e banks, government etc. That interest money is usually hoarded during the bust phase and not re-circulated money back into the economy. This creates wealth inequality where the top 5% can own 90% of the money. The consumption of that 5% can never equal the consumption of the 95% so that money is not respent into the economy promoting eventual debt destruction.
In Summary, interest on loans promotes inflation through 2 mechanisms. Interest on loans puts pressure on businesses to increase prices causing inflation during the boom phase of the business cycle as discussed in Part 1. And, the payment of interest on loans siphons much needed money from businesses during the bust phase of the business cycle causing more bad loans and less debt destruction (ie less deflation).
Note
Some may say that those loans that default are the responsibility of the creditor and remain their liability. But, as we can see from 08' a lot of banks were bailed out. If banks were forced to be on the hook for bad loans that may have caused more deflation than what occurred in 08'. Instead, more debt was created in the form of programs like TARP that ensured the continuous debt accumulation and inflation continue.
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Related publications
Disclaimer
The information and publications are not meant to be, and do not constitute, financial, investment, trading, or other types of advice or recommendations supplied or endorsed by TradingView. Read more in the Terms of Use.