9 thoughts on “A Falling Interest Rate Destroys Capital”
slothrop
I came to this characterization of our (non)monetary system after reading your interesting work and wondered if you could comment.How "deflation" of debt leads to hyperinflation. In our system, debt is essentially demand for credit-money. Hyperinflation occurs when the demand for the currency (credit-money) collapses.Therefore debt collapse=hyperinflation.Debt is a claim future earnings, but the credits in the system remain. Only one side of the monetary unit collapses, and so the credits will be free to bid up something else, like real things (oil/gold/silver.)This may seem rather obvious or perhaps simplistic, but I’ve never heard anyone put it this way. Do you think it is an accurate characterization?
Yes, Much better.Your gold backwardation thesis is one of the most insightful, well-reasoned arguments I’ve ever read on anything.It’s got me thinking about the world differently. Bravo.
Hi Keith, I’ve been reading Antal Fekete since 2004; I’m glad to find others as impressed by his thinking as I am. Since his popular essays make uneven reading, I’ve tried to check his facts against historical records. If anything they confirmed even further that Fekete’s genius is his Austrian modeling of the things bankers once took for granted. Perhaps you could help me locate a Fekete essay I recall but can’t now locate…In it he offers a (third) definition of in/de-flation based on flows between commodities and financial markets. I’ve been converting his .pdf site into .mobi and as I look at the mass of great economics thinking there, I wonder if anyone is editing his prolific works? I certainly be up for a project like that – the world needs to grasp these truthful insights and Fekete himself seems to make too many enemies for this to happen spontaneously.Keep spreading the word! – Nice to find your blog, I’ll be back…
Keith,Great Insightful article. 2 Questions. Are you familiar now that the Investment Banks now mark their own debt up or down on a quarterly basis, and the change flows thru their Income statement. It’s called DVA – Debt Value Adjustment. Once a company decides to account this way, they cannot reverse. Most banks opted to do this in 2009, when their falling bond prices created DVA which added to their Revenue. Very counterintuitive. Is this rule a step in the right direction for balance sheets to reflect what you are saying. Because, it their bonds go up in price, negative income flows thru the Income Statement, hurting the Book Value. Funny they have discretion over which of their own bonds they subject this measure tohttp://www.bloomberg.com/news/2010-07-11/bank-earnings-depending-on-debt-writedown-abomination-in-latest-forecast.htmlI’ll save my other question for the next post.http://www.wikinvest.com/wiki/Debt_Valuation_Adjustment
Greg: Fekete defines inflation as the combination of rising prices and rising interest rates, i.e. when money is flowing out of bonds and into commodities. And deflation is when money is flowing out of commodities and into bonds. I agree with the phenomenon (I am working on a paper that delves into this) but I prefer to define inflation and deflation in terms of counterfeit credit (I have a paper on this site about that).Please contact me by email. My email address is my last name dot my first name at gmail dot com. I would love to discuss a project to compile Fekete’s works and other related stuff!Peterruh: I have read several articles on how some banks are using this and what a large proportion of their "earnings" come from this. I would bet money that if the market price of their bonds begins to rise in earnest, they will somehow get an exception and stop using DVA accounting. The Rule of Law is decaying, if not collapsing.anonemiss: I agree that the debtor gets relief in the form of free capital when the rate of interest rises after he has borrowed. I do not agree that this capital is created ex nihilo. At best, it is a zero-sum game of transferring capital in this case from the saver (bond buyer) to the debtor (bond issuer). But it’s worse than that, because a persistent rising interest rate will push one marginal enterprise after another out of business.
What about callable bonds? The destruction of capital would be much less (even after taking into consideration call premiums and transaction costs in selling a new bond issue in order to refinance the debt). Also, wouldn’t companies have a huge incentive to postpone taking on debt if a falling interest rate environment destroyed capital? If this incentive does exist, it isn’t apparent by they way companies manage their borrowing. Instead of seeing companies postpone new debt issues, we see constant refinancing of not only consumer but also corporate debt at lower and lower interest rates. Also, your thesis seems to contradict a basic principle of corporate finance. . .that lower costs of capital are good. The stock market certainly likes falling interest rates, and not just because it makes stocks a relatively more attractive investment than bonds, but also because a lower cost of borrowing is good for a growing business.
oilfieldfoodie: In the case of a callable bond, then obviously the issuer can get out of it if the rate of interest falls sufficiently far. This means that the bond buyers are either incurring the risk of loss of transaction costs such as fees, commissions, legal fees, and the bid-ask spread in case the bond is called. Or else the bond buyers are hedging by buying some sort of interest rate derivative (the quadrillion dollar interest rate derivatives tower is a whole ‘nother discussion).To the corporation, the calculus is that a project which does not make sense at 6% becomes profitable at 5%. So they borrow at 5%.I am not contradicting the idea that a lower cost of capital is good. I am saying that once *you* borrow at a fixed rate, *your competitor* can borrow at a lower cost and that this is bad for you. It is good for your competitor. Until the rate falls further and then *his competitor* can borrow.Also, one must distinguish between a *low* cost of borrowing vs. a *falling* cost of borrowing.
Keith Weiner Economics 
I came to this characterization of our (non)monetary system after reading your interesting work and wondered if you could comment.How "deflation" of debt leads to hyperinflation. In our system, debt is essentially demand for credit-money. Hyperinflation occurs when the demand for the currency (credit-money) collapses.Therefore debt collapse=hyperinflation.Debt is a claim future earnings, but the credits in the system remain. Only one side of the monetary unit collapses, and so the credits will be free to bid up something else, like real things (oil/gold/silver.)This may seem rather obvious or perhaps simplistic, but I’ve never heard anyone put it this way. Do you think it is an accurate characterization?
I don’t see how debt is demand for something.The way I look at it, it’s not about the quantity of things. What happens to a bond when the debtor is about to default? There is no bid. The entire monetary system is based on debt, and as it heads into default it will go no bid. I wrote a paper on how I think it will play out: http://keithweiner.posterous.com/when-gold-backwardation-becomes-permanentI have a different definition of inflation and deflation than most people. I make my case for my definitions here: http://keithweiner.posterous.com/inflation-an-expansion-of-counterfeit-credit
Yes, Much better.Your gold backwardation thesis is one of the most insightful, well-reasoned arguments I’ve ever read on anything.It’s got me thinking about the world differently. Bravo.
Hi Keith, I’ve been reading Antal Fekete since 2004; I’m glad to find others as impressed by his thinking as I am. Since his popular essays make uneven reading, I’ve tried to check his facts against historical records. If anything they confirmed even further that Fekete’s genius is his Austrian modeling of the things bankers once took for granted. Perhaps you could help me locate a Fekete essay I recall but can’t now locate…In it he offers a (third) definition of in/de-flation based on flows between commodities and financial markets. I’ve been converting his .pdf site into .mobi and as I look at the mass of great economics thinking there, I wonder if anyone is editing his prolific works? I certainly be up for a project like that – the world needs to grasp these truthful insights and Fekete himself seems to make too many enemies for this to happen spontaneously.Keep spreading the word! – Nice to find your blog, I’ll be back…
Keith,Great Insightful article. 2 Questions. Are you familiar now that the Investment Banks now mark their own debt up or down on a quarterly basis, and the change flows thru their Income statement. It’s called DVA – Debt Value Adjustment. Once a company decides to account this way, they cannot reverse. Most banks opted to do this in 2009, when their falling bond prices created DVA which added to their Revenue. Very counterintuitive. Is this rule a step in the right direction for balance sheets to reflect what you are saying. Because, it their bonds go up in price, negative income flows thru the Income Statement, hurting the Book Value. Funny they have discretion over which of their own bonds they subject this measure tohttp://www.bloomberg.com/news/2010-07-11/bank-earnings-depending-on-debt-writedown-abomination-in-latest-forecast.htmlI’ll save my other question for the next post.http://www.wikinvest.com/wiki/Debt_Valuation_Adjustment
Very good examples. If falling interest rates destroy capital then rising interest rates will create capital, see my blog post: <a href="http://appliedphilosophy.wordpress.com/2008/11/03/a-liquidation-example/">A Liquidation Example</a> for a real life example of this.
Greg: Fekete defines inflation as the combination of rising prices and rising interest rates, i.e. when money is flowing out of bonds and into commodities. And deflation is when money is flowing out of commodities and into bonds. I agree with the phenomenon (I am working on a paper that delves into this) but I prefer to define inflation and deflation in terms of counterfeit credit (I have a paper on this site about that).Please contact me by email. My email address is my last name dot my first name at gmail dot com. I would love to discuss a project to compile Fekete’s works and other related stuff!Peterruh: I have read several articles on how some banks are using this and what a large proportion of their "earnings" come from this. I would bet money that if the market price of their bonds begins to rise in earnest, they will somehow get an exception and stop using DVA accounting. The Rule of Law is decaying, if not collapsing.anonemiss: I agree that the debtor gets relief in the form of free capital when the rate of interest rises after he has borrowed. I do not agree that this capital is created ex nihilo. At best, it is a zero-sum game of transferring capital in this case from the saver (bond buyer) to the debtor (bond issuer). But it’s worse than that, because a persistent rising interest rate will push one marginal enterprise after another out of business.
What about callable bonds? The destruction of capital would be much less (even after taking into consideration call premiums and transaction costs in selling a new bond issue in order to refinance the debt). Also, wouldn’t companies have a huge incentive to postpone taking on debt if a falling interest rate environment destroyed capital? If this incentive does exist, it isn’t apparent by they way companies manage their borrowing. Instead of seeing companies postpone new debt issues, we see constant refinancing of not only consumer but also corporate debt at lower and lower interest rates. Also, your thesis seems to contradict a basic principle of corporate finance. . .that lower costs of capital are good. The stock market certainly likes falling interest rates, and not just because it makes stocks a relatively more attractive investment than bonds, but also because a lower cost of borrowing is good for a growing business.
oilfieldfoodie: In the case of a callable bond, then obviously the issuer can get out of it if the rate of interest falls sufficiently far. This means that the bond buyers are either incurring the risk of loss of transaction costs such as fees, commissions, legal fees, and the bid-ask spread in case the bond is called. Or else the bond buyers are hedging by buying some sort of interest rate derivative (the quadrillion dollar interest rate derivatives tower is a whole ‘nother discussion).To the corporation, the calculus is that a project which does not make sense at 6% becomes profitable at 5%. So they borrow at 5%.I am not contradicting the idea that a lower cost of capital is good. I am saying that once *you* borrow at a fixed rate, *your competitor* can borrow at a lower cost and that this is bad for you. It is good for your competitor. Until the rate falls further and then *his competitor* can borrow.Also, one must distinguish between a *low* cost of borrowing vs. a *falling* cost of borrowing.