4,000-Year-Old Economics

These days, our economic landscape sometimes seems hopelessly complex.

Trade — the buying and selling of goods and services — between individuals, companies, and countries seems simple enough. But then there are things like interest rate swaps, collateralized debt obligations (CDOs), venture capitalism, taxes and tariffs, concerns about wealth distribution… It’s enough to make you think the world of finance has spun off its axis.

Complex derivatives like swaps and CDOs are often blamed for the financial crisis of 2008-09. Banks were taking baskets of mortgage loans, slicing them into chunks (called tranches), and then selling them off as bonds (known as securitization).

The person (or bank or fund or whatever) who bought these mortgage securities would then collect the loan payments and profit from the interest rates on the mortgages within the security. These mortgage securities could even be used as collateral for other transactions.

And the entity that created and sold the mortgage security had, in effect, just lowered its liabilities and could then make new loans.

If you’ve ever owned a home, you’ve probably been notified that the bank that originated your loan had sold it to another bank or investment firm. There are several public companies that do this, like former Wealth Advisory portfolio stock Annaly Capital and current portfolio stock Capstead Mortgage.

These mortgage securities get blamed for the financial crisis, maybe because they are difficult to understand or because they spread risk in ways that may not be obvious at first. But collateralized debt obligations are not a new thing at all. In fact, the idea of selling debt to another goes back as far as 4,000 years…

The Flintstones of Finance

Last weekend, the New York Times published a fascinating article about a book that will be published later this year called Ancient Kanesh.

Kanesh is an ancient Turkish city. About 10 years ago, archeologists discovered tens of thousands of stone tablets where traders and business people had recorded the details of their business dealings.

It’s taken a while to sort through all that information, but the results are fascinating. The New York Times reported:

The traders of Kanesh used financial tools that were remarkably similar to checks, bonds and joint-stock companies. They had something like venture-capital firms that created diversified portfolios of risky trades. And they even had structured financial products: People would buy outstanding debt, sell it to others and use it as collateral to finance new businesses.

The article goes on to say that the Kanesh economy transformed from a simple trading economy to one built on financial speculation. It becomes a bubble that pops:

After the financial collapse, there is a period of incessant lawsuits, as a central government in Assur desperately tries to come up with new regulations and ways of holding wrongdoers accountable (though there never seems to be agreement on who the wrongdoers are, exactly). The entire trading system enters a deep recession lasting more than a decade. The traders eventually adopt simpler, more stringent rules, and trade grows again.

Sound familiar? It should. The modern economy is very similar…

Boom/Bust Psychology

Of course, boom/bust cycles are how economies work. Some would argue that boom/bust cycles are a consequence of fiat money or central banks or too much debt. And they are right to an extent.

I prefer to think of boom/bust cycles as a natural consequence of human psychology.

Say you’re a farmer and there’s huge demand for corn. You’re going to keep growing as much corn as you can so you can make more money. Maybe you lease or buy more land to grow more corn. Others will do the same until there is more corn supply than demand and prices fall.

Then you can’t afford the lease or the land payments, are forced to sell, and less corn gets grown, allowing prices to recover.

It’s pretty rare for a farmer to choose to grow less corn and make less money just to keep supply and demand in balance because you can’t count on your competition to do the same. (OPEC may be one of the few examples of competing producers cooperating to control supply and demand. So long as there wasn’t much competition, OPEC worked. But the organization is falling apart now that the U.S. has emerged as a major oil producer.)

Anyway, back to the point here. It’s an important aspect of the boom/bust cycle that you get the bust part. The people/companies that made poor investments in expanding production have to get crushed so that production can fall and the cycle can start anew.

That was supposed to happen in 2008-09. Companies that invested poorly needed to fail. But they didn’t because of central bank intervention. The bust was cut short. Trillions of stimulus dollars flooded the market. Bad loans were guaranteed. Interest rates were slashed to make money as cheap as possible. And all that cheap money covered up the fact that demand wasn’t really rising.

So here we are in a world with too much production and not enough demand. What happens next?

The Fed’s Mistake

Central banks like to try to manage economies. They cut interest rates when growth slows to make money for investment cheap to encourage growth, and they raise interest rates when investment seems to be getting out of hand.

Some of what the U.S. Federal Reserve did in response to the financial crisis was correct; some was not. Right now is probably not the time to get into specifics.

In a nutshell, the Fed’s biggest mistake was attempting to encourage demand when the real problem was too much supply. Or maybe I should say the Fed did too much to encourage demand, because some action was appropriate…

In any event, we have a world with too much supply and central banks with very little wiggle room to help spur demand. And even if the Fed did have some wiggle room, what is anyone supposed to do about the supply and demand imbalances that China has created?

Even after the financial crisis, we still haven’t seen the “bust” that changes the world’s supply and demand dynamics. But the strong U.S. dollar (and higher U.S. interest rates) might do the trick.

A stronger dollar means imports are cheaper. That, in turn, means the exporters who send goods to the U.S. are getting paid less. So export countries will see their trade balance weaken and reserves go down.

When reserves fall, exporters have a more difficult time paying down their debt. And this is where rising U.S. interest rates can really do some damage…

Much of the debt in the world today is dollar denominated. That’s because lenders were more willing to buy bonds that were denominated in a stable currency like the U.S. dollar. And borrowers could sell their bonds at lower rates for the same reason.

So what happens when the value of the dollar rises and borrowers have to pay their debt in dollars? They have to buy dollars with weaker local currency, which means they get fewer dollars in exchange. This is how you end up with currency crises and defaults.

I can’t say we’re going to see a decade-long recession like the one that gripped Kanesh. But the conditions are certainly present…

Until next time,

Until next time,

Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.