‘Obvious Things’ And Credit, The Four-Letter Word

“Obvious things can still matter,” Morgan Stanley’s Andrew Sheets reckoned, in a well-written note dated August 15.

It’s true. The tricky part, though, is reestablishing the line between truth and lies. After all, if that line is too blurry, the word “obvious” has no meaning. It’s “obvious” that the Earth is round. Just not to flat-earthers. But I digress. Already. As is my wont.

For his part, Sheets was making a simple point about debtors and creditors in a world defined by the lowest interest rates in 5,000 years. The figure (below, from BofA) is of questionable utility, but it works as “eye candy.”

“Obviously,” it’s a great time to borrow money. Sheets cited record low corporate bond yields across the pond and the cheapest borrowing costs in more than a half-century for US companies. And then there’s mortgage rates, which are still parked near all-time lows.

From there, he made a number of points with the potential to boil the blood of central bank critics and various hard money crusaders. For example, Sheets wrote that, “When debt funds an asset (capex, infrastructure, a house), it’s likely that the asset’s value, at a minimum, rises with inflation [which] is why deflation is so bad and self-reinforcing.”

When rational actors expect the price of the things they’d like to buy to keep falling in perpetuity, they’ll be disincentivized to fund such expenditures with debt. That, in turn, can lead to a decelerating credit impulse, which then feeds into the deflationary quagmire, creating a self-fulfilling prophecy.

It’s easy to lose track of the fact that credit, as a concept, is indispensable. This is yet another in the (very long, and constantly expanding) list of reasons why I don’t trouble myself with the musings of various “professional” traders or “name brand” hedge fund managers or charlatans peddling click bait and absurdly overpriced “newsletters.” Most of those folks, almost as a rule, simply don’t know what they’re talking about in a kind of general sense. They know a lot about a little. For most people, it’s vastly preferable to know a little about a lot. Below, find an extended quote from Yuval Harari on credit:

Many cultures concluded that making bundles of money was sinful. As Jesus said, “It is easier for a camel to pass through the eye of a needle than for a rich man to enter into the kingdom of God” (Matthew 19:24). If the pie is static, and I have a big part of it, then I must have taken somebody else’s slice. The rich were obliged to do penance for their evil deeds by giving some of their surplus wealth to charity.

If the global pie stayed the same size, there was no margin for credit. Credit is the difference between today’s pie and tomorrow’s pie. If the pie stays the same, why extend credit? It would be an unacceptable risk unless you believed that the baker or king asking for your money might be able to steal a slice from a competitor. So it was hard to get a loan in the pre-modern world, and when you got one it was usually small, short-term, and subject to high interest rates. Upstart entrepreneurs thus found it difficult to open new bakeries and great kings who wanted to build palaces or wage wars had no choice but to raise the necessary funds through high taxes and tariffs. That was fine for kings (as long as their subjects remained docile), but a scullery maid who had a great idea for a bakery and wanted to move up in the world generally could only dream of wealth while scrubbing down the royal kitchen’s floors.

It was lose-lose. Because credit was limited, people had trouble financing new businesses. Because there were few new businesses, the economy did not grow. Because it did not grow, people assumed it never would, and those who had capital were leery of extending credit. The expectation of stagnation fulfilled itself.

Over the last 500 years the idea of progress convinced people to put more and more trust in the future. This trust created credit; credit brought real economic growth; and growth strengthened the trust in the future and opened the way for even more credit. It didn’t happen overnight—the economy behaved more like a roller coaster than a balloon. But over the long run, with the bumps evened out, the general direction was unmistakable. Today, there is so much credit in the world that governments, business corporations, and private individuals easily obtain large, long-term and low-interest loans that far exceed current income.

There you go. Conceptualized correctly (where “correctly” just means accurately), credit is a byproduct of faith in the future. Today, the term “credit” often carries a negative connotation because it’s interchangeable with the term “debt.” But everyday discourse around markets and economics is just as hopelessly poisoned as our political discourse. Which is what tends to happen when multitudes of people who, at best, know a lot about a little, and at worst know almost nothing about anything, gather in digital public squares (e.g., Twitter) to revel in being dumb together.

In his August 15 note, Morgan’s Sheets wrote that the deflationary mindset “may have been a fear for much of the last decade, when austerity and secular stagnation ruled the roost and it may have been the fear just 15 months ago, with the arrival of COVID-19, but it’s not today.” He cited higher inflation expectations, noting that “this is new, and improves the economics of borrowing materially.” “Coupled with the inflation picture, the outlook for nominal growth – the key metric for nominal borrowing – is simply much better,” he added.

He then asked if there’s a need to borrow (emphasis in the original). Here again, we risk succumbing to a self-fulfilling prophecy. Subpar growth discourages investment. But what does underinvestment lead to? Well, subpar growth. And around we go, in direct contradiction to the very innovation (credit) that opened the door to modernity some 500 years ago.

Happily, Sheets concluded by alluding to the desirability (indeed, the necessity) of borrowing to save humanity. He cited the IPCC report and noted that “combating climate change will require enormous investment.” In another passage that’s sure to rankle some folks, Sheets wrote that “the economics of investment have improved dramatically, with the cost of wind and solar power declining by 70% and 89%, respectively, in the last decade.”

The read-through is that never has the case for borrowing to finance critical investment been more economical.