Musings of a Fintech: Short Term Borrowing Growth Trap

If you want to learn about growth, neoclassical models, such as Solow-Swan , can a good starting point. You should also read about the Chicago School of thought. I’m not an economist. I’m a quantitative analyst, bond structurer turned entrepreneur. I usually take all the above and throw it out the window. Partly due to laziness but also from the endless arguments between economic camps – how come they both win the Nobel prizes but still can’t agree on a single item. However the following just seems to make sense to me

For me, growth is a function of population, inflation, innovation and enterprise, random processes and interest rates. This is in some undefined and ever-changing format.

We can roughly forecast population and eliminate random processes through averaging (not always the best thing). Inflation, even if poorly calculated (not including property) can be estimated and removed. Innovation is also random. This leaves me with interest rates and the focus of this article.

I fundamentally believe each person has the capacity to maintain a level of debt, and for arguments sake I will assume this is 30% of gross pay (or approximately 50% of net pay). This is a maximum level that I believe to be stable, any higher and the borrower will default with almost certainty. This isn’t a recommendation.

An interest rate reduction by a central bank, is, therefore an increase in the ability to service new debt if the old debt’s interest rates are floating liabilities (we move further away from my chosen limit). Fixed debt just takes longer to re-price as it matures (or is prepaid, depending on call options). Lower interest rates also suggest, often, that inflation might increase in the future – pulling forward consumption before prices increase. The natural incentive is put in place for people to spend today.

The Reflation Trade:

After the near-collapse of the financial system in 2008, many investors got on the reflation trade: monetary policy aimed to increase the prices of financial assets to not only spur bail-out bank balance sheets but to lower long-term interest rates to increase investment and consumption. This worked well and only really stopped in the US when the Federal Reserve raised rates in December. Japan, the UK and the ECB are still in an easing mode and Australia has more potential scope to cut rates than increase them.

In short this has several impacts:

You borrow to buy assets, the price increases. The obvious asset class is property but this also included in investment and consumption. Interestingly, there has been deflationary pressure at the same time as asset price increases (remember, property is not included in inflation, except for interest rate dependent debt servicing in some countries). Deflationary pressure comes in many forms but an increase in the supply of products and innovation have been factors (innovation including digital products and manufacturing processes). Also remember that inflation has a downward bias as the technology level increases (if the megapixels on a camera double, that is counted as a form of deflation).

Why is the US ahead of the curve?

Firstly, they were more aggressive and much earlier in monetary policy. Assets reflated much faster and some of the financial crisis damage was repaid quicker (e.g. bank balance sheets). In many ways, the US has a better balanced economy, with global tech businesses mostly being based there.

In my mind there is another reason: the consumer can borrow for 25 years with certainty and flexibility.

You can get a 25-year mortgage at a fixed (and very low) rate and still have the ability to refinance even lower or repay when you see fit. This allows the consumer to have greater confidence in their expenditure.

In the rest of the world, this doesn’t happen. You can fix for 5 or perhaps 10 years maximum in many countries but are unable to prepay without hefty fees. The result is that the consumer is then stuck on short-term floating debt and knows they cannot borrow to capacity as they need to be aware of potential interest rate increases (but this actually stops them happening, the fear is the important factor here). Animal spirits cannot occur.

Borrowing from the future?

In short, interest rate declines and locking in long-term low rates is borrowing from the future. This is the whole point: whilst we are low on innovation, population growth or something else random, we need a stimulus as a steady growth rate is better than unstable volatile swings.

Lehman versus Layman:

Interestingly, US banks failed not from their dodgy sub-prime assets directly. It was the short term borrowing that led to their downfall (i.e liquidity). Yes, liquidity was due to shitty assets but the short term borrowing was the reason. It appears the US has learned – albeit it was easier due to the structure of their consumer debt markets.

The rest of the world has passed on the short-term borrowing risk straight to the public.

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