While there is no starting-pistol that tells us the final phase of the credit cycle leading into the next credit crisis has actually begun, nearly all the signs point to it being the case for the US economy.

There are differences from previous cycles, but they can be explained. Over the last thirty-five years, non-mortgage consumer debt has been an increasing factor, as has the general drift from manufacturing to the provision of services. To whom the banks owe deposit money has changed from almost entirely consumers with savings and small businesses’ cash balances to a greater proportion of purely financial businesses. 

The absence, so far, of price inflation to match the expansion of US bank credit since the last credit crisis is in large measure explained by the ownership of cash. Of the institutions and businesses, we know from figures released by the Federal Reserve Bank of New York that of the $12.8 trillion of cash, deposits and checking accounts in the banking system, foreigners (overwhelmingly financial institutions) have cash deposits of $4.217 trillion.^[i]

This is hot money, created by bank credit, but not spent and therefore not driving up consumer prices. This is an example of why the evolution of bank customers on the liabilities side of the banks’ balance sheets affect how the credit cycle should be read, the likely duration of the final pre-crisis phase estimated, and how the crisis itself will unfold. Furthermore, having created the credit cycle through its suppression of interest rates, the Fed lacks the theoretical knowledge to understand the extent of the problem it has both created and oversees.

This article examines these dynamics and concludes that the duration of this final phase of the credit cycle may be considerably shorter than most people expect, and is likely to be driven more by financial than economic considerations.

Interest rates do not control credit demand

We start by looking at why central banks cannot control inflation by managing interest rates. Last week, the Bank of England raised its base lending rate by a quarter of a per cent to three-quarters of a per cent. In its statement, the Bank stated that its “Monetary Policy Committee sets monetary policy to meet the 2% inflation target and in a way that helps sustain growth and unemployment.” In this, the Bank’s monetary policy is little different from the other major central banks, particularly that of the American Fed.

There are multiple links in the supposed chain between changes in interest rates and the 2% inflation target, but essentially the Bank must be assuming that an interest rate is the price of borrowing money. If that was so, you would expect higher interest rates to reduce the growth of bank credit, and lower rates to stimulate it, and if you control the rate of monetary growth, then the quantity theory of money suggests you can influence the rate of price inflation. This is a common assumption in financial markets, which are necessarily in tune with central banks’ monetary policy.

The facts suggest otherwise. The following chart shows what happened in the US between 1970 and 1990, including the time when Paul Volcker, as Chairman of the Fed, jacked up the prime rate to 20% in the early 1980s. The reason for illustrating these decades is that volatility in interest rates were at their most violent, and the effects should be at their most obvious.

If interest rates were money’s “price”, one would expect to see higher rates at least slow down monetary growth, and even make it contract. Lower rates should make money supply growth accelerate. This plainly did not happen, and it has never happened since money became totally fiat. Nor did it happen in the days before money’s purchasing power sank year after year when Gibson’s paradox clearly showed there was no correlation between interest rates and price inflation. This being the case, it is evident that the supposed link between interest rates and bank lending as a means of controlling price inflation has never existed.^[ii]

Gibson’s paradox, whereby interest rates correlated with the general price level and not the rate of price inflation, appears to have altered since the 1970s, because the general price level has simply soared. Measured in gold, the dollar has lost 96.5% of its purchasing power since it was last officially set at $42.22 per ounce. Obviously, a collapse in the purchasing power of money is bound to undermine long-established relationships between the general level of prices and interest rates. While that correlation may no longer be graphically illustrated, the lack of correlation between the rate of changes in the general level of prices (the inflation rate) and interest rates still persists.

Clearly, the basis of monetary policy, particularly the supposed link between the price of money as a means of managing price inflation, is fundamentally flawed. We also know from experience that central banks tinkering with interest rates have failed to prevent recurring credit crises. In other essays, I have demonstrated why this is so, and I won’t repeat the theory here.^[iii] Instead, we need to ask ourselves, if an interest rate is not the price of borrowing money, what is it?

Interest rates reflect time preference

There are, essentially, two approaches to addressing the relationship between interest rates, money and prices. There is the Keynesian, mathematical approach, which is in the tradition of William Stanley Jevons (1835-82). Jevons was one of three economists who proposed a theory of marginal utility as the basis of value in the 1870s. To Jevon’s successors, concluding with Keynes, interest was the charge imposed by savers on borrowers. It, therefore, followed as Keynes argued:

“Thus, the rate of interest at any time, being the reward for parting with liquidity, is a measure of the unwillingness of those who possess money to part with their liquid control over it.”^[iv]

In other words, Keynes was saying interest is the price of money demanded by savers, but as we have seen in the chart above, changes in interest rates do not lead to changes in the quantity of money, so it cannot be right.

The other approach was that of Carl Menger, founder of the Austrian School, who argued that marginal prices were set subjectively by human action. Menger also noted that we all value actual possession more than a future possession of the same satisfaction. But the production of better and more desirable goods involves time and investment in the means of production. Therefore, as Menger pointed out if a manufacturer wants money up front in order to be able to deliver a product in, say, six months’ time, he will only get it at a discounted value. This is because parting with money means we have to defer our own possession of goods. It is the deferment of ownership of goods that is the issue, not money itself.

The root of time preference is that if we are to forego the enjoyment of goods, we will only do so on in accordance with our assessment of their future value, allowing for the deferment of utility and the uncertainties of promised possession. We think of money as being fully fungible into all goods, and therefore representative of our desire for them. On this basis, we might be prepared to part with $98 today on the promise of $100 in six months’ time. This can be expressed in one of two ways. We can either say the present value of $100 in six-months’ time is $98, or we can say it represents an annualized rate of interest of 4.08%. The rate of interest is an expression of the time preference of the certainty of possessing money today, over only having it in six months’ time.

This is not the same as assuming interest is the price of money. Money is not goods, it is merely the bridge between our labour and our consumption. Parting with money for a period of time is actually deferring the benefit of the immediate possession of goods. Of course, there are some goods for which we will readily defer ownership, and there are some for which we will only reluctantly defer actual possession. Therefore, the time-preference of money is a catch-all general representation of what we can buy today but deferred for an agreed period of time, which will be differently assessed by each of us. It is rightfully set between individual savers and borrowers.

Obviously, time preference can only originate in the minds of lenders and borrowers of money, which makes it impossible for the state to intervene without unintended economic consequences. Time preference exists regardless of interest rate policy. Accordingly, the management of interest rates by policymakers, who believe they are managing the price of money, is rather like asking a blind man to drive you home from the party.

Time preference also evolves over the credit cycle to reflect expectations of the likely purchasing power of money over time. If the rate of price inflation picks up and there is a general expectation it will increase further, then this is the same as saying the purchasing power of money will decline. Therefore, the present value of future money will be less, which together with the loss of money’s utility will translate into yet higher interest rates. This is a late-cycle phenomenon because the previously increased quantity of money will be progressively undermining its purchasing power and expectations that the trend will continue and likely accelerate become more firmly entrenched in peoples’ assessment of their own personal time preferences.

Therefore, it is public perceptions embodied in time-preference which drive interest rates, not monetary policy, and this becomes increasingly apparent late in the credit cycle when central banks always find themselves on the back foot.