Amassing Unproductive Debt

Last week, we discussed the marginal productivity of debt. This is how much each newly-borrowed dollar adds to GDP. And ever since the interest rate began its falling trend in 1981, marginal productivity of debt has tightly correlated with interest. The lower the interest rate, the less productive additional borrowing has in fact become.

 

Left: the first IKEA store located in Älmhult in Sweden, near the residence of the company’s founder (nowadays the store is a museum); right: a Task Rabbit car. Given the valuations at which TaskRabbit was able to raise funds recently, it is a good bet IKEA paid a small fortune to take it over (waiting for the QE-induced bubble to burst may have been cheaper). [PT]

 

Let’s look at a recent event: the Ikea acquisition of TaskRabbit. You might wonder, why does a home goods company need to own a freelance labor company? Superficially, it seems to makes sense. Ikea products notoriously come in flat packs, but consumers don’t want to fuss with all the little parts. They just want finished furniture. Ikea has been using TaskRabbit to hire people to assemble it in their homes.

Isn’t this like that caricature of the billionaire who buys, say, the Planters Peanut company because he likes to eat salted nuts? Ikea could be a customer of TaskRabbit, hiring its temporary workers as needed, without owning the company. In fact, it had been doing that for years.

The acquisition price was not disclosed, however, we can guess that it was high. TaskRabbit was a Silicon Valley darling with a bright future. Its value proposition is right for this economy. It had raised $50 million, presumably at rich valuation multiples.

How much would Ikea be willing to pay? We don’t know how many dollars TaskRabbit was earning, so we will have to pass on total price. However, we can ask how much Ikea would be willing to pay for each dollar of earnings. There are two metrics to help answer this question.

One, Ikea can compare to the price that its own investors are willing to pay for a dollar of Ikea earnings. If it can buy a dollar of earnings via TaskRabbit for less than the market pays for a dollar of Ikea earnings, then it’s a good deal. Ikea is not publicly traded (but we suspect management has an accurate internal estimate of enterprise value).

Two, Ikea can compare the return on its investment to the cost of borrowing. If it expects to earn 5% on its investment for example, but borrows at 3%, then it’s a good deal.

The price to earnings of a large company, and its cost of credit, are both related to the prevailing rate of interest. As interest falls, price to earnings rises and cost of credit falls. So a falling interest rate, all else being equal, creates the opportunity for such acquisitions.

This fuels a process of capital destruction that we have written about extensively (see Keith’s series on Yield Purchasing Power). With Ikea we don’t know the company’s debt or cost of borrowing. But typically, acquisitions are funded by borrowing. The debt of the acquirer replaces the equity of management and investors of the acquired. Total debt goes up, but production does not increase.

And the exquisite madness of this is that it makes sense! By every principle of rational business management, these deals should be done. If you can borrow at 3%, then you can pay perhaps up to 20 or 25 times earnings to make acquisitions. If you can borrow at 1%, then you may pay up to around 50 times earnings, or a bit more.

This process, of course, makes billionaires out of the founders of many a start-up and makes the venture capital firms and their investors a lot, too. The source of their profits is the debt, borrowed by the acquirer. They may spend their profit and consume it.

The more the rate of interest falls, the more fuel is added to accelerate this consumption process.

 

Giving in to Temptation

We don’t want to drill any deeper into this here. Instead, let’s move on to address the question we left from last week: why is the marginal productivity of debt after 2010 at a higher level than before the crisis, despite interest rates that continued their inexorable collapse?

In the Theory of Interest and Prices Part I, I state:

 

“These processes and forces [that lead to the formation of the bid and ask prices of credit] are nonlinear. They are also not static, not scalar, not stateless, and not contiguous.”

 

The question last week was a bit unfair, in that these five ideas were embedded in how it was framed. We showed a graph showing falling interest and falling marginal productivity of debt. And asked why the discontinuity in the correlation post-2010?

We think the key idea that explains the post-2010 situation is: people are stateful. What does this mean? It means they have internal state. Their behavior is not a simple function of quantity of money or interest rates.

For example, they have balance sheets. A business with low debt to equity has plenty of capacity to borrow to buy more assets. However, we know that in 2010, asset values were way down compared to 2007, but of course the debt persists. Therefore, the capacity to borrow was reduced.

Stateful also refers to the fact that people have memory. What could people possibly have been remembering in 2010? It’s a real head-scratcher…

Sarcasm aside, the major corporations in 2010 or 2012 had less appetite to borrow to buy the TaskRabbits of the day. No matter that the cost of credit was lower than it had been pre-crisis, their assessment of the risk was much higher.

Deals like the Ikea acquisition of TaskRabbit are a sign that the temptation to buy earnings with dirt cheap credit once again outweighs the fear of a liquidity crisis or a crash of asset prices. Besides, if your company is the only one not partaking in the Fed’s largesse, and all your competitors are, then you will certainly lose out.

 

Has the Trend in Interest Rates Reversed?

We are aware that many believe that interest rates have reversed course. That they will go back to normal. We wonder where, on a line that has been falling for 36 years, is the normal point? Yes, rates have ticked up a bit recently. So let’s just show interest rates for the period 1981-present to put this perspective.

 

10-year treasury yield 1981 – today. There is no sign of a major trend change just yet. That would change if market-based price inflation expectations of were to increase or if doubts about the Treasury’s creditworthiness were to arise. Both appear highly unlikely at the moment, but as a caveat to this one should perhaps keep in mind that such things always appear to be highly unlikely at turning points. The future is ultimately unknowable, but the fact remains that at this juncture no major trend change is in evidence. [PT] – click to enlarge.

 

Do you see the alarm bells, the red flags, the warning signs that this trend has reversed and interest is about to begin heading up in a serious way? Do you see the clear point where the bottom was put in, and the reversal occurred? We don’t.

Nor does the junk bond market. Here is a graph of the spread between junk and Treasury bonds.

 

US junk bond spreads over treasuries based on the BofA Merrill Lynch US high yield Master II Index. As an aside to this: the spread of euro are junk bonds over treasuries is currently zero. Even in today’s central bank-created financial theater this one stands out. It is interesting that US high yield spreads are not yet at or below the 2007 trough – this could turn out to be  a meaningful divergence. As a brief remark to what follows below: social time preference, i.e., the originary interest rate, is not measurable. We are not sure how one is supposed to know what it is, apart from guessing. Moreover, gross market rates not only reflect risk premiums in addition to the natural rate, but also a price (“inflation”) premium. The latter can conceivably become negative (in fact, we know that this occasionally happens from observing market-based expectations of future CPI rates). [PT] – click to enlarge.

 

We started the chart in 2007 to show several important features: the all-time low, the incredible spike during the crisis, the mini spikes in 2011 and 2016, and the present trend. We are currently near the all-time low (3.48% today compared to 2.41% in June 2007).

This graph really shows a measure of risk perception. It is germane to our discussion of rates, because issuers of junk bonds are already on shaky ground. If their cost rises (as in rising interest rates), they are likely to default. In a true rising interest environment, junk issuers are headed to default en masse. Right now, the market is predicting the opposite result.

 

Maginot Line

We, of course, have a reason to think interest rates are not in a rising trend but a falling trend. Central banks exist to enable more government (and crony) borrowing. They seek to push down the interest rate. However, the market is bigger than even the biggest central bank.

In my theory of interest and prices, I ask what happens if the interest rate is pushed down below marginal time preference. Governments can pass legislation, but they cannot repeal economic or natural law (just ask King Canute). They can try to push interest down, but they cannot control how people will react.

Normally, interest is greater than time preference. That’s because people don’t lend, if they don’t get the compensation they want. However, with irredeemable paper currency, central banks can push interest rates below time preference. They can cause this spread to invert, with impunity. Or so they believe (if they are even aware of the Austrian concept of marginal time preference at all).

This inversion causes the rising cycle of interest and prices. The symptoms should be quickly recognizable to anyone familiar with the gold bug argument: the quantity of money is increasing, and prices are rising commensurately. Interest rates rise to compensate lenders for declining purchasing power.

We dub this theory the Maginot Monetary Theory. The Maginot Line was an attempt to fight WWII based on an understanding of WWI. And the Maginot Monetary Theory is an attempt to deal with today’s falling cycle based on a (superficial) understanding of the rising cycle of 1947 through 1981.

The cause of that rising cycle was interest below time preference. Interest, of course, was moving up. That might almost have set things right. Unfortunately, time preference was rising also. This cycle kept iterating until 1981, when interest spiked and finally got above time preference.

Since then, interest has certainly remained above time preference. That spread has been normalized. However, interest is also above marginal productivity. Not the marginal productivity of debt that we showed in the graph last week, but the rate of return on capital of the marginal business. So long as this spread is inverted, interest falls (and this puts downward pressure on prices).

One informal proof of this is to watch the marginal use of debt go into nonproductive uses, such as acquisitions of businesses that are only superficially synergistic to the corporation. When interest rates pause, borrowing becomes more anemic and GDP slows down, until the next shot of juice obtained by the next drop in interest.

In order for interest rates to go into a durable rising trend, the marginal productivity of capital would have to rise above interest and then marginal time preference would have to rise above interest also. With profit margins under continued pressure, and with debt levels rising everywhere, we don’t see how either of these conditions could be met.

 

Advantage of the Gold Standard

The main advantage of the gold standard is not static prices, which is neither possible nor desirable. It is that the rate of interest cannot be manipulated like what has been done since 1981. If time preference is violated, savers can just withdraw their gold and put it under the mattress. The preference of the savers has real teeth, as it ought to.

In the gold standard, the savers are empowered as the stewards of capital. They do not allow it to be consumed as it is today. This is why Monetary Metals is working to reestablish the market for gold interest.

We have one postscript to add to our long series on the unsoundness of bitcoin and the money-out-of-thin-air madness known as forking. A new bitcoin fork is planned. Bitcoin gold combines all the virtues brand recognition of gold with all the stability speculative upside of bitcoin.

 

Charts by Monetary Metals, St. Louis Fed

 

Chart and image captions by PT

 

Dr. Keith Weiner is the president of the Gold Standard Institute USA, and CEO of Monetary Metals. Keith is a leading authority in the areas of gold, money, and credit and has made important contributions to the development of trading techniques founded upon the analysis of bid-ask spreads. Keith is a sought after speaker and regularly writes on economics. He is an Objectivist, and has his PhD from the New Austrian School of Economics. He lives with his wife near Phoenix, Arizona.

 

 

 

Emigrate While You Can... Learn More

 


 

 
 

Dear Readers!

You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.

   

Bitcoin address: 12vB2LeWQNjWh59tyfWw23ySqJ9kTfJifA

   
 

Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • Is the Canary in the Gold Mine Coming to Life Again?
      A Chirp from the Deep Level Mines Back in late 2015 and early 2016, we wrote about a leading indicator for gold stocks, namely the sub-sector of marginal - and hence highly leveraged to the gold price - South African gold stocks. Our example du jour at the time was Harmony Gold (HMY) (see “Marginal Producer Takes Off” and “The Canary in the Gold Mine” for the details).   Mining engineer equipped with bio-sensor Photo credit: Hulton Archive   As we write these...
  • Fed Credit and the US Money Supply – The Liquidity Drain Accelerates
      Federal Reserve Credit Contracts Further We last wrote in July about the beginning contraction in outstanding Fed credit, repatriation inflows, reverse repos, and commercial and industrial lending growth, and how the interplay between these drivers has affected the growth rate of the true broad US money supply TMS-2 (the details can be seen here: “The Liquidity Drain Becomes Serious” and “A Scramble for Capital”).   The Fed has clearly changed course under Jerome Powell...
  • The Gold Standard: Protector of Individual Liberty and Economic Prosperity
      A Piece of Paper Alone Cannot Secure Liberty The idea of a constitution and/or written legislation to secure individual rights so beloved by conservatives and among many libertarians has proven to be a myth. The US Constitution and all those that have been written and ratified in its wake throughout the world have done little to protect individual liberties or keep a check on State largesse.   Sound money vs. a piece of paper – which is the better guarantor of liberty?...
  • Fed President Kashkari Hears Voices – Are They Lying?
      Orchestrated Larceny The government continues its approach towards full meltdown. The stock market does too. But when it comes down to it, these are mere distractions from the bigger breakdown that is bearing down upon us.   Prosperity imbalance illustrated. The hoi-polloi may be getting restless. [PT]   Average working stiffs have little time or inclination to contemplate gibberish from the Fed. They are too worn out from running in place all day to make much...
  • Are Credit Spreads Still a Leading Indicator for the Stock Market?
      A Well-Established Tradition Seemingly out of the blue, equities suffered a few bad hair days recently. As regular readers know, we have long argued that one should expect corrections in the form of mini-crashes to strike with very little advance warning, due to issues related to market structure and the unique post “QE” environment. Credit spreads are traditionally a fairly reliable early warning indicator for stocks and the economy (and incidentally for gold as well). Here is a...
  • US Stocks and Bonds Get Clocked in Tandem
      A Surprise Rout in the Bond Market At the time of writing, the stock market is recovering from a fairly steep (by recent standards) intraday sell-off. We have no idea where it will close, but we would argue that even a recovery into the close won't alter the status of today's action – it is a typical warning shot. Here is what makes the sell-off unique:   30 year bond and 10-year note yields have broken out from a lengthy consolidation pattern. This has actually surprised us, as...
  • Switzerland, Model of Freedom & Wealth Moving East – Interviews with Claudio Grass
      Sarah Westall Interviews Claudio Grass Last month our friend Claudio Grass, roving Mises Institute Ambassador and a Switzerland-based investment advisor specializing in precious metals, was interviewed by Sarah Westall for her Business Game Changers channel.   Sarah Westall and Claudio Grass   There are two interviews, both of which are probably of interest to our readers. The first one focuses on Switzerland with its unique, well-developed system of  direct...
  • Choking On the Salt of Debt
      Life After ZIRP Roughly three years ago, after traversing between Los Angeles and San Francisco via the expansive San Joaquin Valley, we penned the article, Salting the Economy to Death.  At the time, the monetary order was approach peak ZIRP.   Our boy ZIRP has passed away. Mr. 2.2% effective has taken his place in the meantime. [PT]   We found the absurdity of zero bound interest rates to have parallels to the absurdity of hundreds upon hundreds of miles of...
  • Exaggerated Economic Growth of the Third World
      Exciting Visions of a Bright Future Fund Managers, economists and politicians agree on the exciting future they see in the Third World. According to them, the engine of the world’s economic growth has moved from the West to what were once the poverty-stricken societies of the Third World. They feel mushy about the rapid increase in the size of the Middle Class in the Third World, and how poverty is becoming history.   GDP of India vs. UK in 2016 – crossing...
  • How Dangerous is the Month of October?
      A Month with a Bad Reputation A certain degree of nervousness tends to suffuse global financial markets when the month of October approaches. The memories of sharp slumps that happened in this month in the past – often wiping out the profits of an entire year in a single day – are apt to induce fear. However, if one disregards outliers such as 1987 or 2008, October generally delivers an acceptable performance.   The road to October... not much happens at first - until it...
  • Yield Curve Compression - Precious Metals Supply and Demand
      Hammering the Spread The price of gold fell nine bucks last week. However, the price of silver shot up 33 cents. Our central planners of credit (i.e., the Fed) raised short-term interest rates, and threatened to do it again in December. Meanwhile, the stock market continues to act as if investors do not understand the concepts of marginal debtor, zombie corporation, and net present value.   The Federal Reserve – carefully inching forward to Bustville   People...
  • Miraculous Credit Spreads - Precious Metals Supply and Demand
      Running From “Risk-Free” to Not So Risk-Free Debt  The price of gold blipped $13 last week, while the price of silver was unchanged. Speaking of interest rates and central planning by central banks, we note that in mid-2016, a correction (counter-trend move to the main trend) began in 10-year bond yields.   10-year treasury note yield vs. 10-year German Bund yield over the past decade [PT]   It occurred at the same time in the Swiss government bond and the...

Support Acting Man

Item Guides

Austrian Theory and Investment

j9TJzzN

The Review Insider

Archive

Dog Blow

350x200

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

Realtime Charts

 

Gold in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Gold in EUR:

[Most Recent Quotes from www.kitco.com]

 


 

Silver in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Platinum in USD:

[Most Recent Quotes from www.kitco.com]

 


 

USD - Index:

[Most Recent USD from www.kitco.com]

 

Mish Talk

 
Buy Silver Now!
 
Buy Gold Now!
 

Oilprice.com