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Mr. Practical: Capital and Credit

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How leverage has stacked the system

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What is capital? People sure use that term a lot and seem to know what they are talking about.

But when you listen to most economic discussions, especially among central bankers, there is confusion as to what capital actually is regarding its relationship to credit and debt.

Capital is any input that facilitates growth or expansion in an economy.  Capital is finite at any one time but can grow over time through efficient production.

Liquid capital, or cash, is created when capital in the form of the inputs (technology and commodities) are converted through a production process into consumption.  Cash can then be converted into less liquid capital, such as investments or real estate.

People often confuse capital with debt.  Debt is normally defined as the transfer of liquid capital from creditor to debtor; the debtor uses the capital instead of the consumption or investment the creditor is willing to forgo.

Central banks have altered the definition of debt.  Debt was once created by banks when they lent out deposits, transferring the liquid capital of the depositor to the debtor; the bank, acting as a clearing house, guaranteed the deposit.

The Federal Reserve allows banks to lever that functionality by requiring banks to keep just 10% of the deposit as collateral; ergo, a bank could lend ten times its deposit base.  That was the first step in levering capital up in the economy.  It was and is called fractional banking.

Over the last 30 years, central banks, regulators, and Wall Street have created various methods to increase that leverage even more; in other words, they have taken a modicum of capital and created mountains of debt with it.

In other words, financial engineering creates new and different ways to increase leverage.  

Most of those vehicles are disguised as derivatives.  For example, some stocks allow investors to buy them on margin of 50%: they put up half of the cost and a broker lends them the other half so the investor's capital is levered two-to-one.

Alternatively, through derivatives, they can buy an SP500 futures contract and only put up 5% in capital and the broker will lend them the other 95%, so the investor's capital is levered twenty to one!

The derivatives market has a notional value of ~$1 quadrillion (one thousand trillions; pause to let the enormity of that number sink in); this provides a glimmer of the risk and leverage embedded in the derivatives markets, and by extension the stock and commodity markets.

The system imploded under this debt in 2008 because there was not enough income being generated to pay back interest and principal.  Central banks and governments responded by adding $60 trillion of fresh global debt to reflate the bubble.
How is that working?

Well, we're now seeing negative interest rates (NIRP) in Europe and Asia and many think they are coming to the U.S.  Negative interest rates mean savers are now being charged to keep their money at the bank; there now is a cost to holding cash in a savings account.

This is not natural and has revolting consequences.  If you buy an Italian government bond you actually have to pay them interest to lend them money.  This is ridiculous on its face but especially since Italy is bankrupt. The only reason it is possible is that the central bank of Europe is buying them up to that price.

And why is this happening?

The bubble is fraying.  It is about to pop again for all of the new debt created since 2008; that debt is even less productive than the previous debt and generates even less income to pay it back.

Bureaucrats can either lever capital or re-distribute it.  It seems they are having trouble levering it any further so negative rates are an attempt to re-distribute capital.  All of the savings in liquid capital within the banks must be chased out to buy  increasingly risky assets like stocks and houses to stimulate the economy.

This is like Dr. Frankenstein raising the dead.  If all the savings are chased out of banks, what is left for investment for the future?  

Savers can take their money out of the bank and hold it in cash in their basement if the negative rate gets too high; that is unless they make cash illegal like they are trying to do in Sweden.  

If they make cash illegal and combine that with negative rates, you are essentially renting your money-and if you don't spend it, it will eventually go away.  This is theft.

What will savers have left over to retire on?  What happens when risky asset prices go down, which is likely to happen when all those savers need to reconvert their assets into cash to live.

The answer is the government.  The government will eventually be the only entity that can make investments, not from capital but from taxing whatever is left in savings.

The Federal Reserve is so invested in their flawed methods they probably will never stop; it will take Congressional action.  Congressmen need to be educated and informed and then forced by their constituents to get the central bank under control.

Europe is already cooked and can't turn back.  This cycle will eventually result in socialism if not worse in the U.S.

We may already be too late.
No positions in stocks mentioned.
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