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The Financial System Limit, by David Kauders

“Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”

― John Maynard Keynes



This book argues that stimulating economies to escape recession is a short-term policy that brings longer-term problems not foreseen by policy-makers or the public. Far from maintaining comfortable living standards, the established practice of credit expansion, by various means, is causing slow economic decline and deepening the world;’s debt problems.

I first introduced the concept of the financial system limit in my book The Greatest Crash: How contradictory policies are sinking the global economy, published in 2011. The concept, which will be explored in Chapter 1, says that credit cannot be created ad infinitum. Then in 2013, in privately circulated material, I suggested that the global economy is now dictated by a new economic cycle created by central banks.

Although extensive economic statistics are published by governments and international bodies, I could find none that answered this question: why are interest rates paid by borrowers significantly higher than interest rates offered to depositors? I will explain how this scenario evolved and how positive real interest rates influence the financial system limit and the central banking economic cycle.

This book offers ideas for consideration, rather than an analytic exposition with spreadsheets and models. The discussion is in four parts:

  1. Radical thoughts (Chapters 1 to 3), describing the financial bind the world faces.

  2. Academic theory and case studies (Chapters 4 to 6).

  3. Review of existing proposals and their limitations (Chapters 7 and 8).

  4. Economic impact of the pandemic (Chapters 9 and 10), showing the depth of the debt problem.

There has been much debate between central bankers, particularly in Europe, about whether to continue with policies of stimulus or to adopt sound money in an attempt to cease inflating ailing economies. This book shows that both sides of the argument are wrong. Those promoting monetary and fiscal stimulus as a policy objective have slowly led the world into economic lethargy, from which there is no easy escape. Disciples of the opposing policy, sound money, have a point but it is not the cure for all the ills outlined in the three concepts at the core of this book.

The world was already drifting towards a global recession prior to the arrival of coronavirus. Nonetheless, every politician and official working to secure our financial future needs to understand the theories presented here. These concepts explain why economic growth was globally substandard and economies sluggish before the pandemic occurred. Superficially attractive financial remedies neither work in the long-term, nor help economic recovery.

David Kauders

(a founder member of Kauders Portfolio Management AG)

Zug, Switzerland, June 2020




1 The financial system limit

When someone borrows money to put food on the table, they are in financial difficulty. When they have no hope of even paying the mounting interest bill, let alone repaying their debt, they are bust. This can also happen to a country, when so many people are in financial difficulty that there is no hope of the indebted population honouring its debts even if some people within it are debt-free. In this situation the said country has reached its financial system limit. Neither action by the individual, nor policy change by the authorities, can work off the debt because too much is being spent on paying interest. The underlying problem will manifest itself in many ways: curtailed business activity; inability of consumers to keep spending; falling prices of assets that were propped up by easy credit; almost continual recession with only brief flashes of recovery. The financial system limit of any society is the debt level at which repayment ceases to be viable.

It is customary for economic statisticians to define highly indebted countries according to their government debt levels. However, for the purposes of this book, it is total debt that matters. Total debt is the sum of government debt, corporate plus banking system debt and personal debt. Personal debt itself consists of overdrafts, bank loans, mortgages and credit card debt.

Of the 36 current members of the Organisation for Economic Co-operation and Development (OECD), 28 feature in a list of countries having high levels of personal debt.2 Personal debt is a developed-country problem. Prosperity has been bought, literally, on credit.

We have become used to central banks being able to conjure recoveries out of recessions. Each time a downturn has occurred, it has been swept away but downturns became deeper as the natural economic cycles of the past were augmented by policy-driven cycles. For example, in the United Kingdom, according to the Office for National Statistics, GDP fell by 4.2% in 2009, whereas in 1991 it only fell by 1.1%. In GDP terms, the dot com “bust” was represented by a lower growth rate.3

Serious financial and business journals have carried many reports and opinions about how central banks need to find new ways to counteract the recession that is unfolding around the world. The fashionable proposal is to use fiscal policy (that is, tax cuts and increased government expenditure) to stimulate economic activity. Such a policy can have no lasting benefit, for three reasons:

  1. stimulating economic activity needs increased credit, but banks will not lend to bad risks just because governments have changed accounting rules for bank capital and bad debts;

  2. tax cuts and/or increased government spending cause government deficits to rise. One could describe this as paying Peter now, to rob Paul in a few years time. This will lead the world into deflation.

  3. new money raised by governments through borrowing will incur low positive real interest rates at the outset, but turn into high positive real interest rates when general price levels fall.

Over the past quarter of a century, rates paid to depositors have collapsed, yet rates paid by borrowers have stayed comparatively high. Figure 1 contrasts three-month US Treasury Bill rates (a proxy for interest paid to depositors) with the average cost of US credit card debt including financing charges:4

Figure 1: Paying more to the banking system

Comparing paid and earned interest rates in this way reveals how expensive credit is. From 1993 to 2001, the difference between the two rates was around 9%. In 2003, in the wake of the dot com crash, deposit rates hit new lows, with Treasury Bills only paying 0.81%. But at the same time, credit-card borrowers were paying around 14.7% on average, so the difference had risen to 13.9%. The credit crunch subsequently drove Treasury Bills down to nil yield but a few months later credit card rates were climbing, with the difference, as at December 2019, at around 15.4%.

Debt repayment has a real cost because inflation is so low. When real interest rates are positive and rates paid by borrowers exceed the inflation rate, borrowing consumes financial resources. For example, when inflation is 1% and credit-card borrowing costs 13%, the real rate of interest is 12%. Prior to the era of monetary management by central banks, real interest rates were usually 2% to 3%.

Symptoms of debt problems caused by excessive interest costs vary by country. In many cases, they can be measured directly by statistics such as consumer loan defaults. In Britain, food bank use is an indirect measure of debt problems.

Following the 1987 stock market crash, the credit floodgates were opened wide to encourage more borrowing. When continuing that policy proved ineffective after the millennium boom and bust, quantitative easing was invented to push credit into the Japanese economy. This was later copied by other central banks although the methodology is now seen as ineffective. Instead of contriving ever more extreme measures to expand credit, why not ask what is preventing continued economic growth?

It is impossible for debt to expand to infinity because the cost of servicing it would then also be infinite. The financial system limit is determined by the cost of borrowing. It is best defined as the proportion of economic output spent on interest on total debt, above which that debt can no longer be repaid in full.

A logical proof

Existence of the financial system limit can be proved by logic:

1. Postulate that it does not exist and therefore debt can expand to infinity.

2. No matter how low interest rates charged to borrowers may go, any percentage of infinity is itself infinity. Therefore if debt can expand to infinity, interest paid must also expand to infinity.

3. Interest has to be defrayed from what is earned. Earnings can only be achieved by selling goods or services at a price others can afford. Therefore paying infinite interest requires trading an infinite supply of goods and services.

4. But an infinite supply of goods and services for sale can only be achieved if resources of people and nature are themselves infinite.

5. Since the supply of raw materials is finite and an infinite population could not feed itself, the proposition that debt can expand to infinity cannot be true.

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