Debt Cycles part 2. Long term debt cycle

A warning: This text is long and takes a while to read.

The majority of the long-term debt cycle is largely based on changes in interest rates regulated by the central bank, which make the above-mentioned processes work. Most of it is the sum of changes in short debt cycles. They are mainly based on changes in interest rates regulated by central banks, which reflect the willingness of people and businesses to borrow or borrow money. The short debt cycle will be discussed later. At the end of the cycle, the role of interest rate changes diminishes and the focus is on printing money with the central bank's key interest rates close to zero.

At the beginning of a long debt cycle, the parts of the above equation are much smaller than when the debt bubble bursts in the end. The money supply is often tied to fixed assets held by the central bank. In practice, the amount of debt cannot grow significantly faster than the amount of real assets. This affects the right side of the equation, reducing the amounts on that side. The growth rate of money in circulation and debt remain limiting factors as the money supply is linked to the central bank's fixed assets.

At some point, policymakers will be pressured to increase money supply to improve economic development. This is done by breaking the link between the money supply and the fixed assets. In other words, the amount of money is growing faster than before. The central bank can tighten or loosen monetary policy by regulating interest rates and money supply. The latter is rarely a significant factor. This mostly happens at the end of the cycle.

The long-term debt cycle lasts 60-100 years. In the initial phase, debt and consumption are roughly in balance with money and income. The increase in the money supply allows for an increase in debt, which enables increases in consumption and an increase in wealth. The former allows additional liabilities. Creditors provide additional debt as borrowers ’income, cash flows, and collateral values increase. These increase the willingness of creditors to borrow. Development strengthens itself and the economy grows.

The growth phase lasts most of the cycle. It progresses variably according to short debt cycles. Through the key interest rate, central banks regulate the willingness of creditors and debtors to lend or pay the debt. Total debt is slowly increasing. The peak of the cycle is manifested by high debt levels and / or the failure of monetary policy to generate economic growth. One of the signs of the peak is found in the granting of debt, which focuses more on collateral values than on debtors’ income. Interest rates are close to zero or at zero. Debt service costs are higher than the borrowers' ability to borrow. This reduces consumption. Debt ratios are declining. Too many businesses, households and financial institutions are becoming insolvent. They need to reduce consumption which increases unemployment, reduces people's incomes and increases other problems.

Debt problems are often the sum of many stages. First, the expectations of the general public about large cash flows in the distant future arise. Secondly, expectations arise about the increases in value in the near future and the gains they will bring. Thirdly, the wildest paintings of a glorious future emerge, exploiting the general public and eventually generating the outrageous scams that make money for their developers.

The above development is compounded by the fact that the investments are made by over-indebtedness and future cash flows are not sufficient for debt management costs. The differences between expectations and reality are the greatest when the debt bubble bursts. Prior to this, the positive effects of rising asset prices have been visible and not enough people have understood their unsustainability. Before the bubble bursts, there is usually low inflation and a debt-driven boom. The latter seems more of a boom created by high productivity growth and prudent investment than the absurd euphoria which will be revealed later to the general public. Debt payment begins. Economies can do it in four ways:

1. Austerity
2. Debt reduction
3. Increasing the money supply by lowering interest rates to zero, continuing it with the central bank purchases of bonds as interest rates fall to zero
4. Income transfers

The first two reduce income and consumption. All are necessary, although few are desirable. They also produce less unwanted effects and, when going into excesses, more harm than good. Financial discipline is necessary because there is no extra money. Savings need to be made where they have the least impact on long-term economic growth and quality of life. Excessive savings increase problems. Some economic actors must save. They can be either public or private actors. Without saving, there can be no needed investments in the long run. Some of them can be financed with the central bank´s bond purchases, but not all of them. The reason is that the government usually has too much debt.

Debt write-downs take place through insolvency, debt restructuring and forced asset sales. The latter have the greatest negative effects. Debt restructuring reduces creditors' income because at the same time the prices of assets also decrease, which also means the decreased debt collateral. The ratio of debt to asset values and income is increasing as a result. This leads to forced sales of debts as they are diminishing assets of creditors.

Forced sales lead to the sale of other assets and the payment of bank loans, which reduces the rate of money circulation, which accelerates forced sales, which leads to deflation, i.e. an increase in the value of money if the printing of money does not prevent it. At the same time, paying off debts adds to the problem of paying off debts as they increase as the value of money increases. The value of the business decreases, reducing corporate returns, which in turn reduces production and employment and increases bankruptcies. They lead to pessimism and a lack of confidence which lead to hoarding which reduces the speed of money circulation. The negative spiral feeds itself, shrinking the economy if nothing is done about it. During it, it is difficult to produce sensible indebtedness.

The worst thing that can follow from forced sales is a lack of trust between creditors and debtors. This means that no companies or governments can borrow money. Payment transactions cease to operate and society is paralyzed for hours, days or weeks. Nothing can be bought in stores and people depend on others. At the same time, financial markets are likely to close for longer than regular payments. The former do not happen suddenly but e.g. the stock market is likely to have fallen for weeks or months. The situation has been close before. The lack of confidence was caught up in the days or hours of the previous financial crisis. The situation is recognized by the fact that the prices of all asset classes are falling at the same time. It may not last more than hours and offers the opportunity to buy cheaply when the risks are high.

For this situation, I recommend buying quick-to-eat foods first and taking tap water where it is possible for several days or buy large amounts of water from somewhere. You can then follow which direction the investment prices are going. At the same time, it is worth following the news about the decisions of central banks to put money on the market. If it works, the prices of asset classes will start to rise. The length of the situation depends on how faith returns to the markets.

Printing money is a necessary evil so that the financial system does not collapse and there is no depression. It is needed to break the deflationary cycle, but too much printing can produce bad problems. It is not automatically a good or bad thing. As overshoot, it can cause additional amounts of money to be transferred to other currencies, which will increase the prices of imported products. In addition, it can transfer too much money to inflation-hedged investments. It can produce hyperinflation when the value of money falls sharply. Its risk is greatest when the debts are in other currencies and owned by foreigners, but the income of people and businesses are not. Large economies with their own currencies have the lowest risks, but they can also experience hyperinflation.

The end user and uses of printed money mean a lot. Saving the economic system and increasing the growth of economic activity are the main reasons for the pressure on money printing. The end user can be the state, other public actors, companies and citizens. There are many possible uses: investing in tangible and intangible capital such as infrastructure and know-how, maintaining bankrupt companies by buying their loans, buying other assets, direct consumption, savings, etc. The first use is usually to buy loans, without which the economic system becomes too likely to collapse. Economic activity will increase as asset prices rise and the potential for growth-generating investments will increase as the availability of money improves. The rationality of the state and public actors determines the usefulness of the investment.

Ultimately, the question is whether the benefits of printing money outweigh its less desirable effects. In the beginning, it produces the greatest benefits. The more the operation is utilized, the lower the relative benefit. The result is ever-increasing bond purchases. In the end, the situation may be that the disadvantages outweigh the benefits. The relationship between the disadvantages and the benefits of printing money is impossible to determine no matter what central banks or other financial experts say. One common denominator for central bankers deciding on printing is that they have no idea of the undesirable effects of their actions. They are missing from the models they use. The following list tells about possible side effects:

• New massive revaluations of bonds and other asset classes

• Non-functioning price formation in various assets

• The emergence of an interdependence between priting and the financial markets

• Decreased long-term productivity growth

• The growth of zombie-companies and the favoring of large companies at the expense of small ones

• Moral hazard

• Negative side-effect of rewarding fools

• Increased wealth disparities leading to internal conflicts

Money going into government and corporate bonds naturally raises their prices. They can become insane. Market participants buy bonds so that they can sell them to central banks at a higher price. This will raise prices even further. If central banks buy too many bonds, there will be absurd self-sustaining price increases. In the end, prices are so absurd that bonds are mostly bought only by central banks. This means increasing negative real yields on bonds. At the same time, the prices of other asset classes are rising as some of the printed money flows into their prices. Although the intention is to put money into the real economy, the biggest benefits flow elsewhere, to the wealthy.

Excessive monetary pressure means that the prices of bonds are not determined by the market, but the real price makers are in the central banks. It leads to the markets´ dependence on them. They start making their biggest moves depending on how central banks signal the amounts of printed money or bond sales. The latter is a rarer phenomenon, but it happens when central banks believe they have gone too far. The market may crash if this dependency exists. In that case, the catastrophe is ready to happen if the central banks do not stop selling. It might happen anyway.

When most of the money goes to rising asset class prices, the real economy suffers in the long run. There will be no productivity growth because no sensible investment is made and the money goes to other uses. In the worst case, they go into the survival of companies that should go bankrupt. These companies are unable to make investments but keep themselves alive. Maintaining them is the same as peeing on the leg in the winter frost.

Bond purchases favor large companies because small ones are unable to obtain financing by selling bonds. They finance their growth either with the owner’s assets or with bank loans. Smaller companies are better able to adapt to change, but the benefits to the overall economy diminish when purchases favor the large companies. Few of them are as productive as more efficient small businesses paying more for their loans.

Printing money rewards the wrong kind of risk-taking because fools who buy too expensive assets don’t suffer so easily from their mistakes. They get the reward even if they make mistakes paid for by others. In this case, the others are taxpayers who receive the invoice e.g. as rising costs of living. At the same time, executives who have used the cash flows of their companies either for excessive dividends or to buy their own shares are rewarded. When companies are bankrupt because of these acts, the purchase of bonds in cash will save them. At the same time, company executives will be able to increase their share-based bonuses.

Wealth disparities will increase if money is not distributed to citizens. The printed money is then mostly transferred to the prices of the assets, which can cause internal conflicts. The feeling of injustice is growing, although the majority of the population does not understand why wealth disparities are growing. Printing enriches the already rich more than the ordinary people. The latter relieve their pain through violence or hatred towards the former. If the situation persists, politicians may begin to feel tempted to distribute money directly to citizens. This is one sign that indebtedness is escaping central bank control. As an isolated case, the situation is not bad, but the transition to a continuous distribution of money will destroy the currency.

When citizens receive free money, they can put it for consumption, investment, debt repayment or savings. The desired destination for money is private consumption. In this case, some of the money is forced to be saved because it is the result of a bad economic situation. There is little to reserve for extra consumption. Where the money mostly goes depends on the needs and wants of a large section of the population. Different nations can consume, save, and invest in different ways. In the United States, money is more likely to go to investment than, for example, in Europe. This, too, produces undesirable effects, as unemployment can be a prerequisite for access to money. Not everyone wants to go to work because they can get almost the same money for free. Again, an excessive distribution of money does not make sense.

Over-indebtedness generates deficits in the economies and smaller public actors, regardless of whether money is printed. It can also produce currency escape. Capital can look for better returns abroad. The state can create mechanisms to reduce it. One way may be to restrict or prohibit the transfer of currency by imposing high taxes on currency transfers. Smart money always finds a way to circumvent these restrictions. On the other hand, ordinary citizens cannot do it. This increases wealth disparities and tensions between the rich and the poor.

Tax increases are one way to raise more money for the administration to distribute. They are less popular with the public than printing money because they are better understood. The lower amount transferred from salary to personal account is a signal of higher taxes. The same applies to the taxation of consumption. It is easy to read the tax rate on trade receipts. The same is true when higher taxes are passed on to product prices. If the withdrawals are large, they will lead to tax planning for large capital. Ordinary citizens cannot do it as effectively. People can move out of the country or move to places with lower tax rates. The latter applies to countries that do not have common national taxes. There are numerous tools for tax planning, but the former are perhaps the most important.