If you read the business pages with any sort of regularity, you’ve undoubtedly heard the term debt. Apparently, we have lots of it. So maybe it’s time to look into the causes of this problem and start a discussion about money. First off, it has three sources.
Wages
The first is called wages. It’s the paycheque-to-paycheque funding that sustains life. That’s why a strong economy is so important—people need jobs. And it’s not just for psychological purposes, employment provides a means to get by.
Wage-money comes from multiple sources, all in a cycle. Consumers buy goods, companies make and sell those goods, and employees get paid. Those employees then become the consumers who restart the cycle. Make sense? Money supply resulting from wages then shrinks or grows based on the vibrancy of the economy. When robust, money supply grows. If the cycle slows down, it shrinks.
Loans
A second source of money comes by way of lending. This article describes the marginal reserve banking system and how institutions evaluate risk. Suffice it to say when interest rates are low, business and people borrow more—thereby expanding the supply of money. Same can be said about other forms of debt, like credit cards.
Central banks worry about this phenomenon. If they feel more money could help the system, they’ll lower rates to give borrowing a boost. But if they feel the economy is running hot, they’ll raise them in order to combat inflation. Inflation usually comes from a strong economy running too long and can be controlled by making borrowing tight. Shrink the money supply, shrink the inflationary effect. At least, that was the old rule.
Central banks
Central banks like the Bank of Canada do two things. They control interest and print money. In the past, their primary focus was on inflation. When things looked good, they’d keep rates low; but once inflation reared its ugly head, rates would go back up. The opposite can also be said. When the economy is suffering (meaning prices are also low), central banks lower rates to provide stimulus. But something has changed over the past few years. Something investors should know.
Central bankers are no longer using interest to control the money supply. They’re creating and destroying on their own—and this could be a game changer. Because so much currency has been printed since the crisis of ‘08 (23 trillion worldwide), central bankers have obtained an influence that doesn’t involve touching rates. Specifically, they used to use interest to encourage / discourage personal and commercial lending, now they just put more money in and out of the system. Yes, they’ve always put money in and out of the system but not like this. Current dollar values are through the roof and that’s why this could be a game changer
The point
Ask any Australian bartender and they’ll tell you economics is always changing. Commerce has become increasingly international and ceases to stay still. Senior investors are (by definition) open to new dynamics and if places like the Fed are controlling inflation more by putting money in and out of the system, then interest rates may continue to stay low. And if rates stay low, there’s less of a chance the market will crash (i.e., long tail risk).
The old theory professed that during a downturn, central banks would lower rates to stimulate the economy. Then once everyone is back up and working, raise them. They did this for two reasons: one to combat inflation and another so they could do it again. Old time believers felt this method was best but now that central banks have created so much money there may be a better way. One that allows for rates to stay low.
If the international objective is to move to a new paradigm, you can feel comfortable about investments like real estate and stocks. At least from an interest perspective they won’t get killed by rising rates. Business and government still have to worry about debt but this explains why news agencies have stopped talking about long tail. And why my returns average around 6% when everyone else is getting 30.