Staring Down the Barrel of Bad Debt

In today’s Markets and Money we take up where we left off yesterday. That is, thinking about how refusing to write-off or restructure bad-debt, and monetising it instead, only creates bigger problems in the future.

Debt monetisation by central banks creates major problems. Think about the real economy…the thing made up of people going about their business making individual decisions. And think about the massive explosion of credit in the past 40 years (relative to the size of economic growth).

In 2008 all the credit/debt chickens came home to roost. Once the credit bubble burst, the evaporation of credit turned hundreds of billions of debt ‘bad’. Many marginal borrowers could no longer service their debt.

Before a recovery can kick in, you normally see bad debt written off, balance sheets cleaned up and investors taking a hit. While that has happened to a certain extent, there is a huge amount of bad debt sitting in the system…slowly rotting away.

Actually, much of the bad debt is now sitting on central bank balance sheets around the world. For example, mortgage debt in the US, Greek and Spanish government bonds, and who knows what else on the ECB’s balance sheet.

Instead of writing it down or restructuring it, central banks turn this debt into ‘money’. When the banks and money managers get their hands on this new cash, they want to invest it ‘safely’. So they buy government bonds.

What they are actually doing is giving money to the government, at a very low long term interest rate. The government largely ‘consumes’ this money. They have to. Their job, apparently, is to prop up the economy in a time of weak private sector growth.

So we have a cycle where central banks monetise poor private sector investments and outstanding government debt (like when the Fed buys US Treasuries) and the money flows right back to the government and is then consumed.

Pushing a large portion of the world’s capital flows into government coffers, where it is used for consumption rather than investment, is not a way to build a sustainable economic recovery. It is a way to provide the illusion that people have money and are spending it…but’s that’s all it is, an illusion.

It’s an illusion built on debt monetisation and market manipulation. Capitalism’s only real voice broadcasts itself via the channel of interest rates. A high cost of money or credit is capitalism’s way of saying people are starting to save and deferring consumption. Businesses respond to this behaviour by using these savings (via a properly functioning banking system) to invest and take advantage of an increase in future consumption.

On the other hand, low interest rates is the capitalist system saying people have plentiful savings (which is why the cost of money is so low) and are now in consumption mode. Businesses aren’t so keen to invest for the future with these price signals.

Of course, this explanation doesn’t make sense. To say that in a debt-soaked system savings are plentiful sounds absurd. But that’s exactly the signal central banks send when they monetise debt – which effectively pumps more ‘savings’ into the financial system.

Bernanke and Co. muffled capitalism, took it around the back, and shot it years ago. The price signals the system throws off are now useless. That’s why banks don’t lend their massive excess reserves. There’s no demand for loans. It’s why the financial markets are a casino with ‘savings’ punted on all sorts of bizarre short term strategies.

You know as well as we do that this won’t work out well. But can you resist the false signals of the market for long enough not to become a victim?


Greg Canavan
for Markets and Money

From the Archives…

When the Trickle Becomes a Flood
10-08-2012 – Greg Canavan

What Central Planners Can Never Know
09-08-2012 – Bill Bonner

The Central Bank Big Bazooka in Theory and Practice
08-08-2012 – Bill Bonner

In Thrall to the Iron Fist
07-08-2012 – Dan Denning

Cracks in the Foundation
06-08-2012 – Dan Denning

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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2 Comments on "Staring Down the Barrel of Bad Debt"

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Earl mardle
Resisting the false signals is very simple. I am sure that, in some casino, poker players and blackjack players are sending, receiving and interpreting signals that will enrich some, impoverish most and provide a guaranteed return only to the bank. I do not hear those signals and, if I do accidentally overhear them, I ignore them because I am not in the game. Not wholly true of the financial market since I cannot avoid being inside the field of play. But I spend most of my waking hours on one overall target, to disconnect as many of my personal dependencies… Read more »
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