Banks and credit

[Matty_UK]

The last 20 years or so capitalism has been maintained through an expansion of credit, preventing an underconsumption crisis. Obviously, you can't expand credit forever, as demonstrated by the sub prime market crisis.

Just wondering if someone can exactly explain to me how and why you can't indefinately run the economy on imaginary money that banks are owed but don't have?

[Lynx]

Faith?

[Matty_UK]

Originally posted by [email protected] 01, 2008 06:24 pm
Faith?
Explain?

[Lynx]

Originally posted by Matty_UK+January 01, 2008 02:30 pm--> (Matty_UK @ January 01, 2008 02:30 pm)
[email protected] 01, 2008 06:24 pm
Faith?
Explain? [/b]
Money is divorced from the 'value' of tangible assets (buildings, factories, infrastructure, skilled workforce). The value of investments within the stock market is partially based upon the concept of money making money (debt, equity, leveraging, etc). But ultimately it depends on the willingness of investors to believe in the 'paper value' of their investments. Thus, faith. This is not an explanation, but an interpretation of what appears to be a house of cards built on expectations.

If the house collapses, the tangible assets remain intact, allowing for the re-establishment of the whole capitalist process from scratch. Of course, not everyone will be starting from scratch, the elite always find a way to land on top of the rubble.

[peaccenicked]

Money is a social relationship it represents exchange value, being social it only there by public consensus. The movement of money to money' without commodoites is at the bedrock of short term speculation without regard for the consequence. Socialism begins as a consensus on the direct distibution of goods based on human need, there maybe initially tokens involved with scarcer goods but the basic human needs such as housing, food, transport,health care will be supplied for free.

[BobKKKindle$]

Just wondering if someone can exactly explain to me how and why you can't indefinately run the economy on imaginary money that banks are owed but don't have?

When you take out a loan, you incur debt which expands over time, depending on the interest rate. If the government were to increase the interest rate, perhaps is response to inflationary pressures or in order to change the value of the currency, the debt burden would rapidly expand and so those who had previously taken out loans would be forced to reduce their consumption expenditure and possibly file for bankruptcy. Alternatively, the value of an asset used to cover borrowing may decrease, placing consumers in a similar position - as occurred with the recent mortgage crisis.

If a bank loans out more it has in deposits, and finds that the loans cannot be paid back and, at the same time, those who have made deposits try and withdraw their money, the bank will also be forced to close down because it will have a net account deficit. If this occurs on a wide enough scale, it can cause the entire economy to collapse, as it will no longer be possible for firms to finance the purchase of capital equipment.

[gilhyle]

Actually you can keep expanding credit for ever - as long as the credit advanced leads to an expansion in the forces of production. Credit operates like a commodity. There is a credit cycle where the volumes of credit expands and contracts and the price of credit varies.

The situation is complicated by the manipulation of the price of credit by the state and the manipulation of the credit cycle by regulation.

The expansion of credit is not a sign of capitalism in crises, it is the basic mechanism of growth in the capitalist economy.

[Floyce White]

Credit, and money in general, is a form of property. Property is the relation of violence between people.

The system of fictitious capital is the current method of administering capital. It gradually augmented the state-management system (also known as "Keynesianism") beginning in the mid-1960s, and now has superseded the former system.

Credit can expand indefinitely--as long as the creditors agree to continue issuing debt, and agree to not call in each others' debts (or write them off). Debtors merely need to take out more loans to make the minimum (interest) payments.

[Die Neue Zeit]

Actually you can keep expanding credit for ever - as long as the credit advanced leads to an expansion in the forces of production. Credit operates like a commodity. There is a credit cycle where the volumes of credit expands and contracts and the price of credit varies.

The situation is complicated by the manipulation of the price of credit by the state and the manipulation of the credit cycle by regulation.

The expansion of credit is not a sign of capitalism in crises, it is the basic mechanism of growth in the capitalist economy.

On the one hand, it seems disheartening at first. On the other hand, this is exactly the kind of phenomenon I was referring to in my "Stamocap" thread (credit taking the form of "leverage" re. pyramidal holdings).

That last remark of yours needs further discussion in my Research and Online Classes thread ("Question on America's debt levels"), because debt is growing disproportionately to the economy and to national income. Is this disproportion what you're referring to in your "as long as" qualification above?

[gilhyle]

Under capitalism proportionality is determined by the market. If you can invest and get a return sufficient to service the debt then the credit cycle will continue. Debt will grow 'disproportionately' under the kind of neo - Keynesian policies the Fed has pursued for years now. But disproportionality is not a yes or no condition. Credit expansion can justify itself after the fact - sometimes by events that were unrelated to the assessment of the credit decisions. The anarchy of capitalism sometimes works in its favour. Thus something can be disproportionate at the time of issue and later prove sustainable.

Thats not to underestimate the capacity for capitalism in its current phase for significant credit-based asset price inflation. This is undoubtedly caused by the weakening of credit regulation - linked to taking credit off-balance sheet the banks' b/s and thus out of the regulatory framework.

[Lynx]

Credit is supposed to be temporary, even when it expands on a current account basis. Whatever happened to "no free lunch" ??

[gilhyle]

Credit is supposed to be temporary, even when it expands on a current account basis. Whatever happened to "no free lunch" ??

Credit was temporary in the 18th century. Since the development of the joint stock company in the early 19 century, the supply of capital via credit, not just for working capital, but for fixed capital investment to leverage equity capital has been a permanent feature of capitalism. There has never been a day, even in the depths of the 1929 recession when all the credit for capital investment was unwound. This is fundamental to capitalism

[Lynx]

Credit was temporary in the 18th century. Since the development of the joint stock company in the early 19 century, the supply of capital via credit, not just for working capital, but for fixed capital investment to leverage equity capital has been a permanent feature of capitalism. There has never been a day, even in the depths of the 1929 recession when all the credit for capital investment was unwound. This is fundamental to capitalism
1. I'm still getting the message that not all loans get called in at the same time, but all loans do get called in, eventually. Credit always exists, but the transactions themselves are not permanent.

2. Why do we need leveraging?

3. Is Wall Street designed to function as a casino?

[ComradeRed]

Just wondering if someone can exactly explain to me how and why you can't indefinately run the economy on imaginary money that banks are owed but don't have? Try explaining why you can run an economy indefinitely on imaginary money...then you'll get your answer ;)

[Die Neue Zeit]

1. I'm still getting the message that not all loans get called in at the same time, but all loans do get called in, eventually. Credit always exists, but the transactions themselves are not permanent.

2. Why do we need leveraging?

3. Is Wall Street designed to function as a casino?

I can answer your question regarding financial leverage (http://en.wikipedia.org/wiki/Leverage_(finance)#Financial_leverage): it has to do with return on equity.

If a company has only equity capital, they'll get X% ROE. However, if they incur debt, there is the potential to get X+N% ROE, because the denominator (investment) pertains only to equity capital.

Of course, that company will then have to consider the times-interest-earned ratio, or "interest coverage ratio" (some measure of income, usually EBIT, divided by interest expense).



Further down in the wiki, things get more complicated with the leverage effects associated with "derivatives" (options and futures contracts). Fortunately, finance courses provide stats tables when dealing with "derivative" calculations.

[gilhyle]

1. I'm still getting the message that not all loans get called in at the same time, but all loans do get called in, eventually. Credit always exists, but the transactions themselves are not permanent.

2. Why do we need leveraging?

3. Is Wall Street designed to function as a casino?

On 1. Yes all loans get called in in the end but by the time they do they have been replaced by others, usually on an expanded scale.

On 2, Yes as Jacob says from the firms point of view leveraging increases the returns to equity, but looking at it from the macro-economic point of view, leveraging faciliates the intensified integration of society's assets into the capitalist economy. Think of Africa where so much of the assets of society are unused most of the time and exist outside the money economy and the credit system - unavailable as security, no finance raised on the back of them. An integratl part of the development of capitalism is increasingly mobilising the assets of society through the finance system

On 3., no Wall Street does not operate like a Casino. But it is possible to make money on Wall Street using the same strategies that will make you money in a Casino (although you would get thrown out of the Casino (or worse) for using them) and Wall Street encourages you to use them.

[Die Neue Zeit]

On 2, Yes as Jacob says from the firms point of view leveraging increases the returns to equity, but looking at it from the macro-economic point of view, leveraging faciliates the intensified integration of society's assets into the capitalist economy. Think of Africa where so much of the assets of society are unused most of the time and exist outside the money economy and the credit system - unavailable as security, no finance raised on the back of them. An integral part of the development of capitalism is increasingly mobilising the assets of society through the finance system

Ah, securitization, no?

This is happening in the world of micro-credit now, where eBay's microcredit subsidiary, MicroPlace (http://en.wikipedia.org/wiki/Microplace), is issuing microfinance securities to retail investors.


On 3., no Wall Street does not operate like a Casino. But it is possible to make money on Wall Street using the same strategies that will make you money in a Casino (although you would get thrown out of the Casino (or worse) for using them) and Wall Street encourages you to use them.

Are you alluding to the history and studies of the efficient market hypothesis? ;)

[Lynx]

By equity you mean stock?

[Die Neue Zeit]

^^^ Most measures of corporate equity give the sum of common stock and retained earnings. I think preferred stock is included, too, in spite of the fact that most end-of-chapter textbook "problems" and "exercises" ignore preferred stock.

Then there's the accounting problem of redeemable preferred stock, which in GAAP is reported as either a liability ("debt") or in between the liability and equity sections of the balance sheet, depending on which GAAP is applicable (international or US).

[gilhyle]

The word stock is an old term still sometimes used in confusingly contradictory situations. Sometimes it means shares, sometimes (e.g. 'stocks and shares') it is revealed to have been a broader term.

FOr our purposes, by stock, in essence, is meant profit-participating shares. There are also shares that earn a fixed return (sometimes preference shares) and 'mezzanine finance' in various forms which do not rank pari passu with other non-secured creditors. Instead it ranks behind those 'ordinary' creditors in a liquidation but before the shareholders. But ignore all that complication, the key point of principle is the distinction between a financial instrument which allows you a share in the profit and one which gives you a fixed rate of return/repayment. THe former goes up if the profits go up, the latter does not.

[Lynx]

The term equity was used, which, in the context of real estate, is that part of value which is owned. Thus, a homeowner has equity (market value of property - mortgage debt).

Why do businesses issue stock? If they need to incur debt, is it not preferable to borrow from a bank or issue bonds?

[Die Neue Zeit]

1) Credit ratings (even in corporate finance, I remember a formulaic calculation wherein too much financial leverage isn't good, and this has to do with risk / standard deviation);
2) The declaration of dividends isn't obligatory on the part of companies (hence lots of companies putting their earnings back into capital investments); and
3) If a company goes belly-up, stockholders are at the bottom of the pecking order in terms of getting their money back (even those holding redeemable preferred stock play second fiddle to holders of the company's mortgaged debt, other bondholders, etc.).

[gilhyle]

The term equity was used, which, in the context of real estate, is that part of value which is owned. Thus, a homeowner has equity (market value of property - mortgage debt).

Why do businesses issue stock? If they need to incur debt, is it not preferable to borrow from a bank or issue bonds?

When raising new funds, the choice is one between

a) taking on debt and the cost of servicing debt and holding the equity shareholdings steady - in which case the existing shareholders get more profit if the funds can be used profitably, and

b) getting more shareholders in, in which case there is no funding cost in the P&L but profits have to be divided between more people.

Option a) tends to get used by preference, but option b) is used if a venture is more uncertain or if banks are unwilling to lend more.

[Die Neue Zeit]

^^^ Indeed. The after-tax cost of debt is lower than the after-tax cost of equity (the expected rates of return by various investors) in the bigger picture known as "cost of capital (http://en.wikipedia.org/wiki/Cost_of_capital)" because of the risk premium (http://en.wikipedia.org/wiki/Risk_premium#Finance).

[Lynx]

Thus it is preferable to take on debt the conventional way and only take on shareholders as a last resort. The Thomson Financial league tables (http://en.wikipedia.org/wiki/Thomson_Financial_league_tables) show that global debt issuance exceeds equity issuance with a 90 to 10 margin.

There are examples of companies going public, then returning to private status.

If I were a business owner, I would prefer to:
a) retain control (debt over equity)
b) use internal financing (http://en.wikipedia.org/wiki/Internal_financing)
c) be debt free

[Die Neue Zeit]

FYI, hence the less-glamorized bond market trading: the daily volumes for bond exchange centers are much larger than those of stock exchanges.

[Lynx]

That might explain why dividend income is less heavily taxed?
Historically, which investment has been more profitable - stocks or bonds?

Edit: the pecking-order theory (http://en.wikipedia.org/wiki/Pecking_Order_Theory) is a model which makes sense to me

[Die Neue Zeit]

^^^ I've read textbook stuff on the pecking order theory. Thanks for that FYI.

Now, dividend income is less heavily taxed because there is an increased risk premium associated with it (namely, no guarantees whatsoever on regular payments, even if the company is in great shape).

Just a question in turn: why aren't you taking up finance as your university study (your desire to learn this stuff at a level beyond that of most posters here)? :confused:

[Lynx]

^^^ I've read textbook stuff on the pecking order theory. Thanks for that FYI.

Now, dividend income is less heavily taxed because there is an increased risk premium associated with it (namely, no guarantees whatsoever on regular payments, even if the company is in great shape).
They wish to encourage riskier investments... and I assume these are economically beneficial investments, hence deserving of a tax credit. But it seems to me people choose riskier investments out of greed.


Just a question in turn: why aren't you taking up finance as your university study (your desire to learn this stuff at a level beyond that of most posters here)? :confused:It is too late for me to attend university, but hopefully not too late to learn more about economics. I believe the understanding of markets is an important 'meat and potatoes' issue. Communism will have to provide a functioning economic system.

[Die Neue Zeit]

^^^ It's NEVER too late to go into business school and at least earn an undergraduate recognition (be it a certificate, diploma, or "undergraduate degree").

[gilhyle]

T
Historically, which investment has been more profitable - stocks or bonds?

Edit: the pecking-order theory (http://en.wikipedia.org/wiki/Pecking_Order_Theory) is a model which makes sense to me

A good way to answer this question is to go back to the 1950s. At that time Pension funds and insurance companies invested predominantly in bonds in the belief that the very low risk more than compensated for the lower rate of return.

On a related example, many aristocrats who had cashed in large land holdings in the late 19th and early 20th centuries also invested in bonds. beieving that the low risk and acceptable nominal rate of return was acceptable.

However, what was not taken sufficiently into account was inflation. The only bonds that take inflation into account are a minor type of index linked bond issued by some states in the 1970s but which never really took off. Leaving them aside, inflation is the key long term problem for bonds.

Understanding this a famous UK actuary (whose name escapes me) argued in the early 50s that equities would always be the better long term investment. THis argument was generally accepted in US and UK investment markets and 20th century statistics generally support this view.
Thus the answer to your question is equities.

HOWEVER, the statistics are usually done retrospectively, assuming the chosen equities survive. The superiority of equities is not so great if you assume a significant investment in companies that actually went bust. Even so, on balance, any assumption of a significant level of inflation means that equities continue to come out on top.

Why this is, therefore, goes to the very heart of capitalism and to the point that as an anarchic form of economic development it is constantly subject to disproportionalities between supply and demand - hence inflation.

[Lynx]

But isn't inflation less of a concern, thanks to monetary policy?
If I earn 4% interest on a term deposit with an annual inflation rate of 1% then the net growth is 3%. This was the basic calculation we were supposed to do. Back in the days of high interest rates/high inflation, you could get a term deposit above 10% (was once at 16%). Of course, if inflation was equal or higher than the rate of return, your were losing money.
In Canada, a number of changes caused the average person to move their investments from the bank to Bay Street. The government eliminated the $1000 interest income deduction; and they deregulated the banking industry so that banks could offer their customers convenient packaged investments into the market.
I'm willing to agree that equity investments make more than parking your money in the bank. That certainly is the case today. And I believe Wall Street investors have done better than those of us who placed our nest eggs in real estate.
The basic motivation hasn't changed: finding ways to make money from money. It might be useful to say that people invest their money in certain ways because they are unaware of alternatives. Invent a new type of 'investment' with a slightly more attractive rate of return and you might snag new customers. Even the old Pyramid/Ponzi schemes still do the trick.

This is bringing me back to a question I have wondered about earlier: Is it possible to have a healthy, yet deflationary economy?

[gilhyle]

I tinkit is extremely difficult to have a healthy but deflationary economy. One of the reasons I suspect the ECB targets an inflation rate of 2% is that there is an argument that an inflation rate of below 2% is actually a deflationary situation because of the way inflation is calculated (I never fully understood the argument).

Deflation penalises the borrower, inflation penalises the lender. Arguably an expanding economy requires that borrowers by rewarded.

The question of real estate versus equity investment is more finely balanced than bonds. I have seen articles argue both that property is as good as equity and that equity is (on balance) better than property.

IT is interesting to see that as inflation has been managed over the last twenty years (on the back of the defeat of the 1970s-80s trade union movement) investment portfolios have tended to move back into bonds and, I think (no figures to hand), increase their investment in property. The problem with that is that the last ten years are sui generis and distort all analyses. But you are right, I think, that the periods of high inflation in the 20th century exaggerated the advantages of equities.....if that is what you are saying.

[Lynx]

I tinkit is extremely difficult to have a healthy but deflationary economy. One of the reasons I suspect the ECB targets an inflation rate of 2% is that there is an argument that an inflation rate of below 2% is actually a deflationary situation because of the way inflation is calculated (I never fully understood the argument).

Deflation penalises the borrower, inflation penalises the lender. Arguably an expanding economy requires that borrowers by rewarded.
Can you explain in more detail what constitutes an expanding economy?


The question of real estate versus equity investment is more finely balanced than bonds. I have seen articles argue both that property is as good as equity and that equity is (on balance) better than property.

IT is interesting to see that as inflation has been managed over the last twenty years (on the back of the defeat of the 1970s-80s trade union movement) investment portfolios have tended to move back into bonds and, I think (no figures to hand), increase their investment in property. The problem with that is that the last ten years are sui generis and distort all analyses. But you are right, I think, that the periods of high inflation in the 20th century exaggerated the advantages of equities.....if that is what you are saying.
Yes, with regard to conditions that existed 'then' versus conditions that exist now. I remember being happy with high interest rates, because I had no debt and lots of savings.