Currency Debasement (Part 3) – The Consequences and Pitfalls of Money Creation

INTRODUCTION

This third article builds on the foundations set in the first two, showing how continued currency debasement is impacting asset prices, such as houses, and how it can lead to social inequalities and economic disturbances. The fourth and final article will demonstrate how Central Banks are largely culpable for these disturbances, showing how their money creation has led to today’s financial and social imbalances. It will conclude with a thought about democracy, given that Central Bankers are not elected officials, and yet have such an important say over our economic future.

“Currency” was defined in the first article as bank notes and coins, money in deposit accounts and short-term investments, all of which can be readily used to buy goods or services. The amount of currency in circulation has increased by gargantuan amounts over the last 55 years – this is a global phenomenon. Examples showed that more money is today required to buy a clock, or an egg sandwich compared to 1 or 10 years ago – this is because money, or currency, has been debased.

The proper way to define inflation is to calculate the change in money required to buy the same good or service over a period of time. If you need £5.50 to buy an egg and cress sandwich today, which cost £5.00 a year ago, then you need 10% more money today – that 10% is the inflation rate of that particular sandwich.

Governments, Central Banks and journalists refer to “Consumer Price Inflation” (CPI) when discussing inflation. This is defined as the change in money required to buy a fixed basket of goods and services over time. However, I highlighted that there is also “Asset Price Inflation” (API), which displays the change in money required to buy more expensive items, such as a house, classic car, stocks and shares or artwork. In general, API has increased far more than CPI over time.

The second article showed how currency, or money, has actually been created over time. Money was initially created by commercial banks as they offered loans to their customers to buy goods or services. These “buyers” then acquired goods or services from “sellers”, who then deposited their money at Banks. Bank balance sheets swelled, and currency in circulation boomed.

Banks reduced the pace of money creation after the Great Financial Crisis (GFC) in 2008 - the growth rate since then has been very low compared to previous decades. So Central Banks stepped in and started creating money, spending it to buy existing government bonds off the population. The population then used this new money to buy new bonds issued by governments, who in turn ended up spending more money. Thanks to this process, called Quantitative Easing, governments managed to substantially increase their borrowings without upsetting financial markets and became more indebted.

The money created by commercial banks started off in Billions, which then became Trillions. Central Banks created further Trillions. By creating so much money, Commercial Banks AND Central banks have caused currencies to debase. This article will now explain how this money creation has impacted Asset Price inflation, caused societal inequalities and also serious economic disturbances. Let’s dive in…..

1.       CURRENCY DEBASEMENT AND ASSET PRICE INFLATION

Politicians frequently blame the “housing problem” on a lack of enough houses. But hang on a second, whilst the number of homeless people has risen, there are not hundreds of thousands of people sleeping rough in every town and city. In the UK, the charity Shelter estimates that there are 350,000 homeless people in England, but “only” 3,900 sleeping rough on any given night.

So, there are enough properties to house people – building more will not resolve the issue. The problems are simply that the existing housing stock is just too expensive and people living in them do not own the properties in which they are living. Thus, the housing problem is actually an “affordability problem”, not one of not enough properties. If a further 300,000 homes are built and are unaffordable, then the housing problem will remain. So, how did we get to this “affordability” problem?

To understand house price trends and the rising unaffordability problem, you have to be aware of the development of the mortgage market over the last 50 years. In the last article on money creation, I showed how house prices could not rise if there was no possibility of obtaining a mortgage. This is a crucial concept - if you can only buy a house with your savings, then the total amount of savings is the maximum amount that you can use to purchase a home.

Therefore, if you have savings of £50,000, the price of the house that you can buy is capped at £50,000. IF, however, you can obtain a mortgage, say for £50,000, then you can now buy the same home for a maximum of £100,000.

It used to be very difficult to obtain a mortgage loan from a bank (or building society), and if you could get such a loan, the terms of the loan were restrictive and very conservative compared to today’s offerings. 

When I bought my first flat in 1987, NatWest would only lend me 2 ½ times my salary, and for a maximum 65% of the value of my house. Earning £15,000 a year, I could thus borrow £37,500 (2.5x salary), and that mortgage could only represent 65% of the value of the house. That meant that I could only buy a house for a maximum of £57,700, and in order to do so, I had to find a deposit of £20,500 (35% of the house’s value). Indeed, that is what I did when I bought my 2-bedroom flat in Wandsworth.

Over the last 35 years bank regulators have permitted banks to dramatically loosen their lending standards. Banks were allowed to offer mortgages with higher multiples of salaries AND permit buyers to purchase homes with lower deposits. At their most reckless point, before the GFC in 2008, banks were lending MORE than houses were worth (i.e. no deposit was required) and up to 5 times people’s salaries. Using my own example, under these new lending conditions I would have been able to buy a property for £75,000, 30% higher (£17,300) than the price I had purchased my flat for.

Not having to find a deposit (or having to only find a small deposit) and the availability of loans at high salary multiples led to a rush of people to borrow huge sums to buy homes, as suddenly they could “afford” to get on the housing ladder. The same happened in the US and more recently in Sweden, Canada, Australia and other developed counties.

There was a third issue that improved affordability - the cost of servicing the mortgage debt declined significantly. Because Central Banks cut interest rates throughout the 1990s and 2000s, the cost of repaying mortgages declined. At the same time, some banks offered “interest only” mortgages, not requiring any of the actual loan to be repaid. This further reduced the cost of servicing mortgages (See Appendix for examples). If the cost of servicing a mortgage was lower, people could take out bigger mortgages and buy even more expensive homes.

A final issue was that banking regulators fell asleep at the wheel. They allowed banks to self-regulate and do what they wanted. They lent recklessly….with consequences that are discussed later.

So, the loosening of lending standards, cheaper mortgage servicing AND sleeping banking regulators all led to one thing – a gargantuan increase in mortgage debt and a resulting increase in house prices. This increase in loans meant that currency was being debased - my two-bedroom flat in Wandsworth could no longer be bought for £57,700, as people with access to more (and loosely termed) loans could now bid it for £75,000.

The charts below show the increase in outstanding mortgages in the UK and USA, as well as the increase in UK and US house prices since 1993. There are similar charts of increasing mortgages and house prices for Japan during the 1980s, and more recently for Sweden, Canada and Australia.  Note the immediate period after the GFC, between 2008 and 2014, when mortgage debt did not grow - house prices remained fairly stagnant.

The above charts demonstrate the link between Currency Debasement (through money creation) and UK house Asset Price Inflation. An average house that was worth £ 90,000 in 1998 was suddenly worth £ 210,000 in 2008, i.e. 133% more money was required to buy the house in 2008 compared to 1998.

It is worth noting that not all countries have seen similar trends – Italian households have traditionally been very conservative with respect to borrowing money. As a result, their house prices did not rise much between 1980 to 2008 as Italian bank mortgage growth did not rise like it did in the UK and US.

High Asset Price Inflation has not been confined to houses. As householders could buy more and different goods on credit, those goods have also seen significant API. 40 years ago, people bought cars with savings, now the majority are purchased with loans or via leases - the same goes for mobile phones, televisions etc. And speculators in stock markets buy shares with loans. What would the price of goods be if people could not borrow money to buy them? Much, but much lower. I hope it’s now clear that if debt had not grown as it has, the price of Assets, be they houses, stocks and shares, cars or mobile phones would be much lower (and far fewer would have been purchased).

A final thought about API. As mentioned in the first article, Central Banks are mandated by their governments to maintain a low level of Consumer Price Inflation (CPI), i.e. the change in money required to buy a basket of goods and services over a period of time. They have no mandate on API - and yet the last three recessions (ex-pandemic) have been due to debt fueled housing and stock market bubbles…… This will be discussed in the final article.

2.       PROBLEMS ARISING FROM ASSET PRICE INFLATION: i) DETERIORATING AFFORDABILITY

The deteriorating affordability of UK houses can be seen in the chart below, which again shows the rise in the average UK house price (in Blue) and confronts it with the rise in the average UK salary over time (in Black). The Red line shows the ratio of house prices to salaries, which is a measure of housing affordability. A couple of observations:

• House Prices (API) have risen far more than the increase in Salaries.

• This is because Salaries tend to rise with CPI and not API.

• Thus, the faster rise in House prices (API) compared to Salary increases (CPI) makes houses less affordable.

The red line shows how an average house used to be worth between 4 and 6 times the average salary between 1970 and 2000 (Green Box). The explosion of mortgage credit growth and ensuing currency debasement means that houses now tend to cost between 7 and 8 times the average salary (Red Box). This highlights the deterioration of housing affordability. 

Clearly the deterioration in affordability does not impact the population equally. People who bought houses before 2000 will have purchased them when they were more affordable (~4.5x salary, rather than today’s ~7.5x salary) and will have repaid large parts of the loans. At the other end of the scale, because banks now offer mortgages to 3 - 4 times salaries, people starting their careers today will not be able to buy homes worth 7.5x their salaries unless they find huge deposits…….see Appendix.

The above chart summarises the developing inequality in housing, which is probably the most important inequality for politicians to address. The same charts can be seen in many countries where there has been vast currency debasement. And this inequality does not stop at housing – the same goes for savings. In the US, for example, the richest 5% of Americans own two thirds of the wealth - again, the roots of this can be found in currency debasement. 

I have hopefully demonstrated that the housing problem is one of affordability, and how this has arisen from currency debasement stemming from the increase in mortgage debt and the loosening of credit standards, not from a lack of available houses. But why do these affordability issues persist? Why don’t “the authorities” do something about it, rather than simple offer (frequently broken) promises of new building? It comes down to monetary and fiscal polies that have currency debasement at the heart of them, which will be discussed in the next and conclusing article. Now it’s time to understand the more extreme problems that occur when too much money is created – banking crises.

3.       PROBLEMS ARISING FROM ASSET PRICE INFLATION: i) BANKING CRISIS

Excepting the petrocurrency crisis and dotcom bubble, almost all recent financial problems have occurred due to banks undertaking irresponsible real estate bank lending, i.e. banks extending loans and mortgages to people and businesses to buy homes or commercial real estate, which they could then not afford to service or repay.

The 1980s US Savings and Loans (US banks specialized in mortgages) crisis stemmed from interest rate mismanagement of their vastly inflated mortgage loan books. The Japanese stock market and real estate bubble was inflated on leverage, the early 1990s Scandi and (mini) UK banking crisis was rooted in residential estate markets and of course the mother of all crises was the Great Financial Crisis of 2008, when the debt fueled US real estate bubble popped. As an aside, the 1920s US economic boom, that culminated in the Wall Street 1929 crash and great depression, started with land speculation in Florida.

So how does a banking crisis develop and how does it impact Asset Price Inflation and the economy at large? It’s really just a simple and easy to explain accounting issue (that banking regulators regularly fail to grasp).

Cast your memory back to the example in the second article, when the commercial bank on the island made a £2,000 loan to Albert so he could buy Charlie’s home for £12,000 (instead of £10,000):

• The bank’s Assets increased by £2,000, which was the Loan it made to Albert

• The bank received a corresponding extra £2,000 Deposit from Charlie when he sold his house (for £12,000 rather than £10,000), so the bank’s Liabilities increased by £2,000 (as Charlie could demand this £2,000 back at any time).

Now imagine this occurring on a truly massive scale. As an example, the chart below shows the extraordinary growth of the loans made by the main 5 Spanish commercial banks to Spanish households. In a mere 7 years between 2002 and 2009:

• their Customer Loans ballooned by € 980bn (290%)

• their Deposits increased by € 670bn, with the shortfall of funding being met by the banks borrowing € 310bn from financial markets.

Money was created on a massive scale. Unsurprisingly, Spanish house prices increased by 55% in this period of loan growth. And during this period, because of the readily available credit, there was a huge construction boom as building companies borrowed money to build many new buildings.

Just like in other periods of massive currency and money expansion, there was a misallocation of capital during this period: in their aggressive competition against each other to lend more and more, Spanish banks offered loans to people and businesses who eventually would not be able to service or repay their loans.

Suddenly in 2006, when the European Central Bank modestly increased interest rates, some mortgage holders could no longer afford to service their mortgage loans, which forced them to sell their properties. And just as suddenly, because mortgages were less affordable as the interest cost had risen, there weren’t enough new buyers, just when more and more newly built properties came onto the market. The result was that Spanish property prices plummeted by 35% in 5 years (note how money creation, or customer loans, stopped growing in 2008 in the above chart).

In accounting terms, the consequence of the rise and fall in the house prices was devastating for families with mortgages. The example below demonstrates the financial impact and consequences of a rise and then fall in house prices on a family. Imagine that:

• a family has €15,000 in savings

• they purchase a house for €100,000 before the peak in house prices, with a €10,000 deposit and a large €90,000 mortgage (their savings therefore reduced to €5,000)

• there was a subsequent 20% appreciation in their house price……..

• followed by a 35% decline in the value of their house

The family in a short space of time went from being worth € 15,000 to € 35,000 as the house appreciated in value, to suddenly being worth a NEGATIVE €7,000 (this is called “negative equity”).

The bank now has a potential problem if the family can no longer pay the mortgage. It granted the family a €90,000 mortgage that was secured (or “Collateralized”) on a property worth € 100,000 – in finance speak, this was a 90% “Loan to Value” – so the bank’s loan was “overcollateralized. If the family could no longer repay the loan, the bank could sell the house for €100,000 and recoup its €90,000 loan, as the collateral (i.e. the house) was worth more than the loan. The balance of €10,000 would be paid back to the family.

However, following the decline in house prices, the loan became “undercollateralized” as the house was now only “worth” £78,000. If the bank now takes possession of the house and sells it, the bank will take a € 12,000 loss. The crucial issue is very simple: Whilst asset prices (e.g. a house), can go up and down, the value of the loan (e.g. a mortgage) can ONLY decline if it is repaid.

When people or businesses cannot service and thus default on their bank loans, banks have to choose between 2 actions which have very different consequences on the asset prices (houses) that serve as collateral for their loans:

1.       The bank bankrupts the homeowner or business and takes ownership of the collateral (e.g. the house against which the defaulted mortgage was secured). This action leads to the bank having to sell the house on the open market and register a loss, which will be the difference between the sell price of the house and the outstanding value of the loan (in the above example €12,000). A vicious circle can then develop, where more parties start selling houses into an already weak housing market, which further depresses house prices. This can cause more homeowners to go bankrupt and increase the bank’s losses as the value of their collateral (i.e. houses) declines further. As the number of loans decreases, there is a CONTRACTION of the money supply and a REDUCTION of asset prices, API goes negative, which can lead to the risk of an economic depression (this is what occurred during the 1930s).

2.       The bank can restructure the loan so that there is no bankruptcy. This is called “Evergreening”, where the bank restructures a clearly non-performing loan, by extending the maturity profile and perhaps extending an interest and principal repayment holiday for a period of time. In this case, the bank does not have to sell the collateral, and the action might stabilize house prices. In reality, however, the banks finances will be stressed so that it will not be able to make new loans, resulting in no new money being created, leading to a slow decline in asset prices (this is what happened in Japan between 1990 and 2011 as Japanese banks did not register their losses and “clean up” their balance sheets)

IF the increase in money lent over time has been relatively small, and there has only been a small misallocation of capital, then banks can manage the losses as they have internal reserves (called provisions) against any increases in non-performing loans. It is estimated that the Spanish banking industry lost €138bn to cover bad debts, equivalent to 13% of Spanish GDP. They required a €41bn bailout from the EU.

When lending has instead been on a vast scale and banks do not have necessary provisions, then a banking crisis occurs as the public becomes concerned that the cumulative banking losses threaten to bankrupt the banking system itself:  

1)       Bank shareholders and bondholders get worried about their investments and sell their bank shares and bank bonds. In the Spanish bank chart on Page 4, the “Equity” is the Net Worth of the bank that represents the bank’s cushion that can absorb losses. When investors become concerned that the losses will exceed that cushion, and that the bank cannot withstand large losses, shareholders start selling their bank shares and investors who lent the bank money (bondholders) start selling their bonds. The chart below shows the decline of the US Bank equity index (black) and deterioration in Citibank credit bonds (red) during the GFC. They lost 80% and almost 100% of their value respectively, before bouncing back (which is covered in the final article).

2)       Bank customers withdraw their deposits. If people and businesses who have deposited their savings at a bank lose confidence in the bank, then they will go to the bank and withdraw their savings and deposits so they can put them into a safer bank or buy “safe” government bonds. This is called a “run on the bank”. During the GFC newspapers reported long lines of queuing bank customers waiting to withdraw their savings.

Because a bank lends for a long term (mortgages can be for 10 to 30 years) and deposits are short term (you can withdraw your cash immediately), a bank will run out of cash and go “bankrupt” if its investors sell equity and bonds and customers withdraw their savings. If this happens to the whole banking sector, money supply contracts, asset values decline, and the reverse of currency debasement occurs. Economies slip into a recession - this is exactly what caused the Japanese prolonged recession in the 1990s, the 1992 UK and the 2008 global recessions.

The DotCom crisis was different – however substitute houses with internet stocks and replace bank lending with people’s savings, and to some extent margin debt (borrowing to buy debt). The result was the same – asset prices collapsed when the bubble popped, and money supply contracted.

4.       THE CONSEQUENCES OF A BANKING CRISIS

All major banking crises are followed by an economic recession. The scope of these articles is to explain currency debasement, so the consequences of a banking crisis will focus on what happens to the trends in currency growth/contraction.  

a) Money contracts (i.e. the opposite of Currency Debasement): If people default on bank loans, or banks “evergreen” and hide their non-performing loans, then the amount of money (or Currency) contracts which causes prices to decline – this is called deflation. In such an environment:

• New bank lending is curtailed because bank balance sheets are stressed and weakened.

• Householders save more and reduce their debt, deleveraging in the process

Therefore, because bank balance sheets contract and the currency in circulation reduces, the value of assets decline and API turns negative. Suddenly you need less money to buy the same house! Cast back to the charts on page 3 that show the link between mortgage growth and house prices.

This is exactly what occurred in Japan after their debt fueled asset bubble burst in the early 90s, in the US and UK post GFC, and also in Ireland and Spain after their respective banking crises in the early 2010s (chart below). In each of these circumstances, API turned from very positive to very negative as bank credit growth declined.

A deleveraging and reduction in the growth of private sector credit does not only impact the housing sector. It also causes

• very low CPI as personal consumption declines - suddenly there are too many goods available to be sold

• negative API (stock markets decline or crash, art and classic car values decline etc.)

  
  

b) Government finances deteriorate substantially: When households and businesses reduce their debt, save more and consume less, a recession ensues, leading to a rise in unemployment and a decline in business profits.

Unfortunately, this means that a government receives less tax receipts, just as it has a requirement to spend more on unemployment and social security benefits. Therefore, as a general rule, Governments see a large increase in their budget deficits when a recession starts, and so they need to raise substantial amounts of extra debt.

The chart below shows the increase in Japanese debt after their asset bubble burst in 2000, that brought a banking crisis, and also for the USA and UK after the GFC and their respective banking crises.

Following a banking and financial crisis, the size of the

1. money contraction

2. decline in Asset Price Inflation

3. recession and

4. increase in government debt

   
   

will invariably depend on the amount of money created in the run up to the recession. The more money created, the larger the consequential downfall. The 1980s money creation in Japan was so large it caused 20 years of poor Japanese economic growth and very low inflation, which was dubbed the “Lost Generation”. It also brought a huge increase in government borrowing – see green line in chart above. The money created in the 2000s was so vast it caused the Great Financial Crisis and huge government borrowing, that then required an extraordinary intervention by Central banks around the world to create new money (the QE described in the last article, and which will be discussed in the next and final article).

CONCLUSION

This article has shown how Asset Price Inflation is driven by the growth in the debt that is used to purchase that asset (e.g. mortgage for houses). My apartment in Wandsworth is still exactly the same apartment, but over time the money required to buy it has increased because people now have access to ever increasing amounts of debt.

Because salaries rise in line with CPI, and CPI has risen at a snail’s pace compared to the rise in API, the ratio of house prices to salaries has risen, rendering houses less affordable. This has led to population inequalities - it’s important to realise that it’s the pace of credit creation, or currency debasement, that has driven the house API and reduced housing affordability.

The other problem of currency debasement arises when there is excessive credit creation. This can lead to people not being able to service mortgages when interest rates rise, which can then lead to banks’ loans becoming non-performing, which causes bank losses. This can as a minimum stop bank lending (which reverses currency debasement), or at worst lead to a banking crisis as bank investors sell their bank equity and bonds and depositors withdraw their savings.

A banking crisis leads to a contraction of the currency as households and businesses pay down debt and save money. This leads to negative API and invariably a recession, which necessitates large government borrowing to counter less tax receipts and higher spending requirements on unemployment and social security benefits.

The next and concluding article will demonstrate what happens when a government suddenly needs to borrow a significant amount of money, and how Central Banks around the world have created vast amounts of money to part fund these borrowings and thus avert a likely prolonged economic depression.

It will also argue that this intervention, the QT explained in the second article, has caused further societal inequalities whilst not resolving the underlying debt issue, in effect just “kicking the problem can down the road”. This will explain the rise in nationalism (e.g. extreme political parties and trade tariffs) and raise questions about whether democracy is really alive given that currency debasement and its consequences have been driven by unelected Central Bankers.

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APPENDIX – House price affordability

The table shows average house prices, average salaries, and typical mortgage conditions in different years. This shows how

• loosening of mortgage standards (i.e. allowing people to borrow higher percentages of the value of the home, requiring only interest to be paid, and extending the duration of the loan) and

• lower interest rates

reduced mortgage costs (as a percentage of salaries) despite large house price increases.

However, the requirement for higher deposit requirements has now made housing very unaffordable compared to 30 years ago.

DATA SOURCES – full details available on request

BBG for Market prices and Inflation Data

BIS, Government statistical websites and central banks for debt data