by Karl Denninger, Market-Ticker:
I’ve had people in the so-called financial industry, and their captive media, scoff at me when I explain exactly how the so-called “economic growth” we’ve posted up over the last 30 or so years has been a scam — and more-importantly, why it cannot continue.
To recap the reason for all of this (and the ramp in the markets over the same 30 year period) is this:
Rates are at 10%. You can borrow $1 million as long as you can come up with $100,000 in interest every year. Note that the expectation is that you would pay off said bond when it matures, so if you’re going to do that in five years (a 5-year bond, not an amortized loan) you’d need to come up with $1,500,000 — $1 million in principal for the bond 5 years hence and and $500,000 for the five years of interest payments (the latter typically being paid out quarterly.)
But if rates are generally declining on a secular (long-term) basis you can cheat, and this cheating is both very seductive in the short term and extraordinarily destructive over the longer term.
In the short term if the rate of interest declines on a secular basis in five years it looks awfully attractive to roll over that bond instead of pay it off, as the interest rate has gone down. Much more-dangerously, however, it also looks attractive to keep the interest payment the same and borrow however much more you can by writing an even bigger bond!
So let’s assume that in five years the rate of interest is 5% instead of 10%. You have had $500,000 over that five years in sunk interest cost. But now you roll over the debt instead of paying it off, and since you do so at 5% you borrow another million dollars by writing a second bond, both of them five years in duration.
Note what happened here — your original expectation was that you’d have to lay out $1 million to retire the bond. Instead you kept it and added another million to it. This is a net $2 million you can spend that you otherwise would not be able to; an utterly enormous “windfall” that appears to literally come from the sky.
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