The Inescapable Reason Why the Financial System Will Fail
Authored by Charles Hugh Smith via Peak Prosperity blog,
Modern finance has many complex moving parts, and this complexity masks its inner simplicity.
Let’s break down the core dynamics of the current financial system.
The Core Dynamic of the “Recovery” and Asset Bubbles: Credit
Credit is the foundation of the current financial system, for credit enables consumers to bring consumption forward, that is, buy more stuff today than they could buy with the cash they have on hand, in exchange for promising to pay principal and interest with their future income.
Credit also enables speculators to buy more assets than they otherwise could were they limited to cash on hand.
Buying goods, services and assets with credit appears to be a good thing: consumers get to enjoy more stuff without having to scrimp and save up income, and investors/speculators can reap more income from owning more assets.
But all goods/services and assets are not equal, and all credit is not equal.
There is an opportunity cost to any loan (i.e. credit), as the income that will be devoted to paying principal and interest in the future could have been devoted to some other use or investment.
So borrowing money to purchase a product or an asset now means foregoing some future purchase.
While all products have some sort of payoff, the payoffs are not equal. If I buy five bottles of $100/bottle champagne and throw a party, the payoff is in the heady moments of celebration. If I buy a table saw for $500, that tool has the potential to help me make additional income for years or even decades to come.
If I’m making money with the table saw, I can pay the debt service out of my new earnings.
All assets are not equal, either. Some assets are riskier than others, with a less certain income stream or payoff. Borrowing to buy assets with predictable returns is one thing, buying assets with highly speculative returns is another; regardless of the eventual result of the investment, the borrower still has to pay interest on the debt, even if the speculative investment goes bust.
The basic idea here is the loan is based on collateral, that there is something of value that is anchoring the loan above and beyond the borrower’s ability to pay principal and interest.
The classic example is a house: the lender issues a mortgage based on the market value of the house, i.e. what it can be sold for should the buyer default on the mortgage and the lender has to sell the collateral (the house) underpinning the loan.
The value of the collateral is obviously contingent on the market; the value of the house goes up and down depending on supply and demand, the availability and cost of credit, and so on.
If a lender loans me $500 to buy a new table saw, and I default on the loan, the table saw is the collateral. Unfortunately for the lender, the market value of the used tool is perhaps $250 at best. So the lender loses $250 even after repossessing and selling the collateral.
If the lender loaned me $500 to buy champagne and I default, there is no collateral at all; the loan was based solely on my ability and willingness to pay principal and interest into the future.
When I say that all credit is not equal, I’m referring to the creditworthiness of the borrower.
Lenders make money by issuing credit to borrowers. The incentives are clear: the more credit they issue, the higher their income.
Given this incentive, it’s easy to convince oneself that a marginal borrower is creditworthy, and that a speculative investment is a safe bet.
This is especially true if the government guarantees the loan, for example, a home mortgage. With the government guarantee, there’s no reason not to take a chance on a marginal (risky) borrower buying a marginal (risky) house.
If we take some home mortgages and bundle them into a mortgage-backed security, we can sell the future income stream (i.e. the payments made by the borrowers in the future) as securities that can be sold worldwide to investors. I can make risky loans, skim the fees and pass the risk onto global investors.
All this debt is now considered an asset to investors.
There’s one last feature of credit: liquidity. Liquidity refers to the pool of credit available to refinance or roll over existing debt. If I’m having trouble paying my credit card, for example, and there’s plenty of liquidity in the credit system, I can obtain a larger line of credit and borrow enough to pay my monthly principal and interest on the existing debt.
If I can refinance my existing debt at a lower interest rate, so much the better.
Credit can be issued by private-sector lenders to private-sector borrowers, or by public-sector central banks to private-sector lenders. Central banks can buy public and private debt (government and corporate bonds, mortgages, etc.), effectively transferring debt from the private sector to the public sector.
These are the basic moving pieces of the credit expansion that has fueled both the “recovery” and the reflation of asset valuations, which have now reached historic extremes.
The Current (Flawed) Logic We're Pursuing
In response to the Global Financial Crisis (GFC) of 2008, central banks lowered interest rates to near-zero to boost private-sector lending, and increased liquidity to enable private-sector lenders and borrowers to refinance existing debt and generate new credit.
They also bought assets: government bonds, corporate bonds and in some cases, stocks via ETFs (exchange traded funds).
The goal here was to prop up the collateral underpinning all the debt. If liquidity dried up, consumers and enterprises would default, handing lenders catastrophic losses, as the crisis had crushed the market value of the collateral that lenders would have to sell to recoup their losses.
And so central banks pursued heretofore unprecedented policies aimed at goosing private-sector lending and borrowing while boosting the markets for stocks, bonds and real estate—the collateral that supported all the debt that was at risk of default.
All this low-cost and easily available credit, coupled with the central banks’ public messages that they would “do whatever it takes” to restore credit mechanisms and reflate the private-sector markets for stocks, bonds and real estate, worked: credit expanded and markets recovered, and then soared to new highs.
While these policies accomplished the intended goals, boosting both new credit and asset valuations, they also generated less salutary consequences.
By lowering interest rates and bond yields to near-zero, central banks deprived institutional owners who rely on stable, high-yielding safe investment income—insurers, pension funds, individual retirement accounts, and so on—of exactly what they need: safe, stable, high-yield returns.
In this “do whatever it takes” environment, the only way to earn a high return is to buy risk assets—assets such as stocks and junk bonds that are intrinsically riskier than Treasury bonds and other low-risk investments.
The Stark Conundrum We Face
Central banks are now trapped. If they raise rates to provide low-risk, high-yield returns to institutional owners, they will stifle the “recovery” and the asset bubbles that are dependent on unlimited liquidity and super-low interest rates.
But if they keep yields low, the only way institutional investors can earn the gains they need to survive is to pile into risk assets and hope the current bubbles will loft higher.
This traps the central banks in a strategy of pushing risk assets—already at nose-bleed valuations—ever higher, as any decline would crush the value of the collateral underpinning the titanic mountain of debt the system has created in the past eight years and hand institutional owners losses rather than gains.
This conundrum has pushed the central banks into yet another policy extreme: to mask the rising systemic risk created by asset bubbles, central banks have taken to suppressing measures of volatility—measures than in previous eras would reflect the rising risks of extreme asset bubbles deflating.
A interactive chart with tax implications by taxpayer and deduction type.
7 Ways You're Wasting Your Money That You Don't Think About
Your daily latte habit isn't all that's killing your bank account.
Looking to save up a few bucks? Sure, you could cancel Netflix for a few months and donate plasma for some extra cash, but we've got a better solution: Study your habits. You're probably wasting quite a bit of money, and chances are good that you're not aware of all of your unnecessary spending.
We decided to collect a few of the most common bad habits to see what they really cost. For instance, you probably don't know how much you spend when...
1. Going Out to Eat
American consumers budget more money for restaurants than grocery stores, which makes sense, according to Eddie Yoon of Harvard Business Review—it's easier than ever to avoid cooking, so many people avoid developing cooking skills. If you're looking for a reason to change your eating habits, do the math.
Let's say you spend $10 per meal—a pretty paltry sum for a sit-down restaurant, but we'll assume that you also hit up your favorite fast food chain on occasion.That's $3,650 per year, assuming that you eat out once per day.
But replace those meals with home-cooked meals at an average cost of around $3, and you'll save over $2,500 per year. By the way, you can easily cook meals for $2 per serving or less. Just make sure you're using that food (see our next item).
2. Throwing Food Out Early
Americans waste about 33 million tons of food per year. We're getting worse, too; the average household wastes 50 percent more than a household from the 1970s. If you've got a pretty typical family, you throw away about $2,275 in wasted food every year.
How does that happen? You go to the grocery store, pick out a bunch of fresh produce, then stop by the frozen food aisle and load your cart. At home, you get hungry, so you grab whatever's convenient—and those pizza rolls are much easier to make than eggplant Parmesan.
To avoid wasting food, simply make a list before you go shopping. Plan out your meals in advance, and if you're not able to use something, freeze it. Oh, and don't assume that your food has spoiled simply because it's past its expiration date. Many foods are perfectly fine for days or even weeks after the dates on their labels, especially when properly stored.
If you're staying with us, you've already saved about $4,775. Let's keep it rolling.
3. Setting Your Thermostat
Everyone loves a nice, warm house, but by redefining your perception of "warm," you might be able to save some serious cash. According to the Department of Energy, you can save about 3 percent on your heating bill for each degree (Fahrenheit) you turn down your thermostat during the winter.
Of course, your results will vary depending on the size of your home, the quality of your insulation, and various other factors. Still, by changing your habits, you can save a lot of money while limiting your effect on the environment.
Try turning your thermostat down by about 10 degrees at night—you'll be under the covers, anyway—and check your furnace vents to make sure that they aren't blocked. If you won't be using certain rooms, block them off during the winter.
The average household spent about $2,092 on heating, according to Shrink That Footprint, so if you can turn down the thermostat by just 3 degrees, you'll enjoy about $189 extra per year.
Assuming you're also watching your food consumption, you've saved about $4,964 so far.
4. Doing The Laundry
When you do your laundry, you probably fill up the detergent cap, right? If so, you're likely wasting detergent (and money).
For starters, if you have a high-efficiency washing machine, you're using less water, and an excessive amount of soap won't make anything cleaner—in fact, you'll likely end up with a buildup, which can make your whites appear grey. Carefully read the instructions and try adding less detergent to each load. The one exception: If you've got hard water, you'll likely need the extra soap. Then again, you might not need any brand-name detergents, as white vinegar often works just as well. Simply use about half a cup per average-sized load, and you'll cut detergent out of your budget.
Depending on what you're washing, you can also probably skip the hot water. Cold water can wash most fabrics just as well, and you'll save money on your gas or electric bill. While we're at it, try air-drying your clothes, and you'll save significantly more.
If you wash 400 loads per year, you spend about $608. According to financial blog Money Crashers, implementing these changes could bring that down to $140 per year—a savings of $468.
If you're following all of our tips, your total savings just climbed to $5,432 per year.
5. Buying Certain Cosmetics
The average American woman spends about $8 per day on cosmetics. Yes, that's a ton of money—but you don't need to sacrifice your #flawless appearance in the name of your budget. Instead, simply change where you shop. "You may find yourself turning up your nose at the idea of getting beauty products at the dollar store, but you would be missing a great opportunity to save yourself some money," says Sarah Hollenbeck, personal finance expert from Offers.com. "Many name-brand companies such as E.L.F and NYX can be found in the shelves of your local dollar store for much less than what you would pay for the exact same products anywhere else."
You would be missing a great opportunity to save yourself some money.
You should also avoid splurging on pseudoscientific products that claim to eliminate wrinkles or "restore a youthful glow." Many of those products don't do much of anything.
Talk to your dermatologist and do some research before investing your hard-earned cash in a cosmetic that seems too good to be true.
Depending on how you use makeup, you could save $1,500 per year by cutting your budget in half.
Still, we realize that many of our readers don't wear makeup (or spend $8 per day on cosmetics), so we won't even add these extra savings to our running total.
6. Buying (Admittedly Awesome) Clothes
We know, we know: you needed those chic new pants. You're not alone. Americans spend about 11 percent of their discretionary budgets on apparel and footwear, according to a Wells Fargo analyst, but we often overspend for name brands.
That's not to say that quality clothes aren't worth the money; better garments will last longer, when properly cared for. Still, shopping smarter can pay off. "If you're shopping for brand name clothes, always make sure to check out overstock stores," says Hollenbeck. "These stores have amazing deals on quality clothing, shoes, and accessories, oftentimes with deals as high as 90 percent off."
Another suggestion: Read your clothes' tags. Properly washing and drying your clothes will keep colors and fabrics intact. Oh, and if you don't have one already, get a tailor—there's nothing quite as satisfying as buying a cheap suit or dress off the rack and letting an experienced tailor work some magic. A typical American family spends about $1,800 on apparel, according to the Bureau of Labor Statistics. Keep an eye on your budget and avoid splurging, and you should be able to cut that to around $1,400 for another $400 in savings.
Our running total is now around $5,832.
7. Buying Coffee
Everyone drops by the local coffee shop on occasion, but going every day can be a huge drain on your bank account. Of course, the easiest way to save money on coffee would be to stop drinking it all together.
Starbucks, for instance, recently raised some of its prices, and a simple tall latte now costs a whopping $2.95 at some stores. "Of course, the easiest way to save money on coffee would be to stop drinking it all together," Hollenbeck says. "You could take up a habit like a morning run or yoga session to get the blood pumping in the morning, but for some the idea of giving up their daily cup of joe is impossible." We're definitely in that group. Fortunately, Hollenbeck still has some advice for us. "Consider taking advantage of free coffee around you, such as at work," she says. And for people who enjoy blended coffee drinks, "purchasing some tasty creamer can help liven up a boring cup while helping you spend much less than you would on a daily frap."
Another tip that might seem unusual: When buying coffee, use cash. A 2016 study published in the Journal of Consumer Research showed that people experience more "financial pain" when paying with cash, as opposed to credit or debit—and that this can actually make purchases seem more rewarding.
In other words, you'll spend less on your coffee, and you'll likely enjoy it more than if you'd pulled out your card. "Using cash at the register can help you get a better idea of just how much you are spending on each cup," Hollenbeck says. If you buy three lattes per week, you spend about $460 on coffee each year. Make your coffee at home, and you'll spend $0.18 per cup for an annual total of $28.
Adding It All Up
That brings our final total to $6,264, enough for a modest-but-dependable used car. Yes, that's right; smarter spending just got you a 2006 Acura. (And remember, that's not even counting the approximately $1,500 you could save if you're a particularly voracious cosmetics user.)
The next time you're in a financial crunch, keep that in mind—you've got plenty of money, provided that you're capable of watching (and changing) your spending habits.