The “consumer economy” has been rolling along for quite a few years, now. Consumption has become so important to the overall economy that we have effectively “pulled out all the stops” to make sure this growth continues. The most pernicious of these has been consumer finance. The demands of sustaining the financial system have created a Ponzi scheme whose scope can scarcely be imagined. It is the nature of Ponzi schemes to have an exhaustion point, where the mechanism that keeps them afloat collapses. We are near that point.
First some distinctions around debt. Debt has two principal uses: Leveraging investment and leveraging consumption. Investment returns are enhanced when the return to equity is enhanced with the lower (and less risky) returns earned by the bank. This is a rational system, where the debt load can be managed, hopefully with wise attention to term, exposure to unexpected events and other elements of risk. The investment or business generates wealth which pays for both debt and equity. Leverage can be overdone, certainly, but it is fundamentally a rational and objective activity. The amount of leverage is inherently limited by the scope and extent of productive enterprise.
Leveraging consumption is an entirely different matter. Consumption produces both tangible and intangible returns, but rarely does it produce earnings that can be used to pay off debt. Those earnings have to come from wealth generating activities unrelated to the debt. In our model, the link between the purpose of creating debt (largely an intangible), and its payment, is severed. A surplus must come from somewhere to cover the interest required by the lender; for a homeowner, their wages. But without the essential linkage, the amount of leverage is not directly limited. If a greater intangible benefit can be sold, debt can be increased. The only limit is the amount of surplus earnings, which is in turn limited by wealth-generating activity.
The total debt load can be increased with stagnant wages if interest rates are reduced. But decreasing rates increases demand, which forces asset prices higher, requiring yet further interest rate reductions if the greater associated debt is to be serviced. Lower mortgage rates do the trick, to a point. It’s not the cost of the house, it’s the “cost of ownership,” which is relatively low with a 4% mortgage. This is a positive feedback loop, where prices require rate decreases, which increases prices, etc., akin to Ponzi spiral.
The incentive to keep this process going is great. Finance is incentivized based on the number of transactions (through front-end fees), and the only way to support continuing transactions is to make them ever cheaper to the consumer. But at some point, there is not enough surplus earnings (which have to come from somewhere else) to support the trend – especially with stagnant wages and wealth-generating activities moving to other countries. We are close to that point.
This method of keeping consumption going has been pushed with ever greater effort for at least the past 20 years. Lower and lower rates, with greater and greater asset prices, cause us to think we were doing great – and some were. The financial meltdown might have been a wake-up call, but now we are officially expecting a return to the consumption finance model. But, unless we manage to come up with new and widespread sources of wealth generation, the system has to stop, because consumption and asset prices cannot continue to increase without cheaper and cheaper debt. Zero rates are just around the corner, and are a hard limit on this process. We cannot go much further.
As we sit now, virtually all the surplus wealth has been removed from the system. We think that continuing to do so will constitute “economic activity.” It does not. Only in a Ponzi universe, and we know that those have to end.