To buy or not to buy a house, all the aspects to be considered

In current environment, there are some really good reasons to buy a house but also really good ones not to. I will first give a macro-economic panorama of the situation, and the impact on real estate.

Please note that my knowledge of real estate market is mostly limited to Japan and France, where I have in the past bought/sold properties and still hold some. This is nevertheless sufficient to give some important insight at the macro-economic level.

The macro view of the real estate market:

  • Rate are super low today, this is a fact. It may still last a bit, but there will definitely be a limit to that. What most realtors never tell you though is that low rate means high purchase price, meaning it is not a good time to buy when rates are low:

Indeed the Real Estate market, like other market, is driven mostly by supply and demand. Demand is related to the demographics in a given area, although demographics can evolve, such evolution is usually really slow, baring mass immigration. As a result, we can assume the need for shelter is constant on not too long periods of time. If demand is constant, then the buyers pool is. Higher rate or lower rate has no big impact on the portion or earning someone can pay for shelter (should not be more than 30% of net income for most middle class family).

If interest rates decrease, for a given property at a given price, the installment value per month would decrease, that would result in more people being able to afford the said property (people with insufficient income to buy the property if the rates had remained the same would become able to do so), increasing demand and mechanically the price. Alternatively, should the rates be super low like today and start increasing, should the property price remain as high as now, the pool of families being able to afford the monthly installment on a given property would decrease, resulting in slower sells at first and depressing prices at some point.

The conclusion is that rates being low by historical standard is definitely not a good reason to buy; it just means the price of the property being bought is higher than historical standard, so that the installments remain roughly the same. Should you buy without loan and just savings, it is actually a really bad idea to buy a property in low rates environment, as you do not benefit from locking in those low rates with a loan but would be penalized by the decrease of property price should rates rise after purchase.

On the contrary, buying when rates are really high mean the property being bought is cheap. It is an excellent time to purchase in cash. It is still a good deal when buying with a loan, as even if rates decrease in the future, it is possible to refinance (borrow again at lower rates to pay back the initial loan with the higher rates early), while benefiting from the property price appreciation.

Conclusion: in today’s environment, if considering buying, somebody should definitely consider using a loan, and this loan should absolutely be with fixed rate. Buying with floating rates means that, should rates rise, not only the installments would increase, but also that the property price would decrease, resulting in the worst outcome possible.

The only case where one should consider buying with floating rates instead of fixed rates in current environment is if one can pay back the loan quickly (meaning that the person already has the cash, but choose to invest this separatly cash and buy with a loan instead). Should the rates remains the same, the person get the benefit of lower rates (floating rates are lower than fixed rates for a given period), while still earning some income from the investment. Should rates rise, the person has the option to pay back the loan early. It is nevertheless important to consider in what kind of investment the savings are kept. It should be something relatively liquid (that can be sold easily), and something uncorrelated to the rates movement (if rate increase results in loss on the investment side, it means that the person may end up not being able to buy the property with cash due to the loss) or even better, positively correlated to the rates movement (where rates increase would result in investment gain, an kind of investment really hard to find today for an individual).

  • In some markets, the property prices is extremely high (on top of the rate effect described above), due to other reasons:

In France for example, recent laws (rent control…) and stricter and stricter regulations on the builder side result in a dearth of property being built and therefore a shortage of property. This combined with increasing populations in the cities (both from rural exodus and immigration) result in really high prices.

In major world cities (NY, Paris, London, Toronto, Sydney etc.), there is also an important demand from foreign investors. Such foreign investors increase the overall demand and the property prices in such cities.

In Japan, aside from Tokyo (where there are some foreign investments and rural exodus increasing demand), population is decreasing, and has been decreasing for a while. This results in Japan being one of the cheapest developed market to invest in compared to the median income of the population, if out of Tokyo. Special care needs to be taken though, as, with declining demands; some property may end up really hard to sell/rent in the future. This is expected to continue, as I do not foresee massive immigration to compensate this population decline, and I do not foresee Japanese people having more children in the near future (in any case, it would take 20-30years for those children to become buyers and drive the demand higher).

As can be seen, from a macro standpoint, prices are really high today. Can they go higher? Certainly, if the rate policies and the immigration policies etc. carry on, for example Central Bank implementing Negative Interest Rate Policy (NIRP), but I am not convinced on a 20-30years horizon, which is usually the horizon to purchase a home.

The thing to consider when buying a house:

There are a multitude of aspects to consider before buying a house in current environment, given the really high price-tag today.

  • Real estate is an asset that is extremely non-liquid (cannot be bought or sold easily and cheaply):

Selling a property takes months, especially if the seller wants to get a good price. Transactions also come with hefty costs (real estate agents, legal cost, loan processing fees, etc.), usually around 10% of the property value at purchase time, and another 3% at selling time.

It means, when buying, you need to be quite certain you will keep the property for several years. If, for your career, you expect to have to keep mobile, it may not be a good idea to buy a property, unless:

  • You intend to come back in such property in the future (retirement for example).
  • The property can be rented relatively easily.

As a rule of thumb, you need to stay at the minimum 3 years in a purchased property to breakeven, meaning the savings you would have made on the rent, minus all the costs of owning such property offset the purchase and selling price. In some market with more expensive transaction costs or extremely high prices today, it can be even more than that (something like 5-7 years for Paris for example).

If you need to remain mobile and cannot find a property meeting the above 2 criteria, do not buy to live. Consider buying to rent in an area where you consider retiring and use the income to rent where you need to live. It is not the most efficient, due to tax, management fees etc. but it definitely beats buying and having to sell too early. You do not need to buy a house in which you plan to live in the future, some small investment units could be better. The idea is that once you come back in the area, you can manage those properties by yourself instead of relying on an agent.

  • Real estate is a quite low-return investment:

Real estate is not high return investment (it has nevertheless a big list of other benefits that I will talk about later).

The past 20+ years are absolutely not a good example of real estate’s return. During those 20+ years, interest rate have been decreasing steadily, resulting in important prices increase on the period. This is more an anomaly than the norm. Given the fact it will be difficult for rates to go much lower (crossing fingers here, central bankers are actually considering NIRP, which would increase prices even further), capital gain possibilities are limited at that point.

Real estate costs quite a bit to maintain:

Between the income tax, property tax, building maintenance, coop costs for condos, potential damages by tenants, risk of non-paying tenants, time where the apartment is unoccupied, managements fees etc. the rents earned disappear really fast.

Real estate income is limited:

On average, a property price, if well maintained, track inflation in area with limited population growth. Real estate is not well suited for capital gain historically (the last 20years are an anomaly, the longest decreasing rates period in history). Of course, in a particular area, at a particular time, good capital gain can be made, but it requires deep knowledge of that market, usually the shouldering of extra risk (extra cost to renovate for example, or a bet that a train line will be created in the area in the near future etc.). Such gain expectations should be considered as risky as stock market gain appreciation, combined with a cost of transaction far greater than stock and really poor liquidity. In short do not buy a property for capital gain unless you know what you are doing.

The only potential gain from real estate is therefore on the rental income, either earned if rented to a tenant, or saved, if lived in.

Rental incomes are not high, if properly accounted for:

Let’s assume a 100 000 property, with a gross income of 5% (better than what can be obtained in most major cities when decently located already).

You have to account or provision for a lot of hidden costs:

  • Management company to rent the property, usually 1 month rent to find a tenant and 1 month rent per year (so 1/12th of your income is going to the managing company every year, and if your tenant leaves, you have to pay extra)
  • Assume your tenant changes on average every 2 years, and the management company find a new tenant in 1 month (not optimal, but not bad either).

Over 2 years (24 months of potential rent) you would end up with:

-1 for having the building unoccupied 1 month

-2 for 2 years of management company fees

-1 for the management company to find a new tenant

So 20 months of earned rent over 2 years, 10 months per year instead of 12. Your 5% income is already looking like a 4.16% income.

  • Coop costs for condominium: usually 1.5 months rent per year. For a standalone house, coop costs do not exist, but maintenance costs are a lot higher, so let’s assume it is the same 1.5 of extra maintenance for a single house.
  • Maintenance costs: conservatively, for a condo, ½ month rent per year.

So an extra 2 months of rent gone, before any bad things happen: only earning 3.75% now, before tax.

Then there is the property tax (varies too much from one location/country to another, can be anything between less than 1months rent to 2-3 months rent), let’s be generous and say it is only one month rent. Before income tax, you are already only earning 7 months rent out of 12.

And after that let’s assume a 25% marginal tax rate: 2.2% of net return, before the real risks of real estate investment: bad payers, tenants who damage the property, and regulation forbidding to out a non-paying tenant, along with lawyer costs to recover what is due (a crap-shot depending on the tenant). 2.2% net return with that kind of risk is not particularly appealing, but when thinking about the alternatives (close to 0% bonds rate, extremely expensive stock market today etc.), that may still retain some allure.

A good way to increase the income is to do away with the management company altogether.

It allows for:

  • 3 months of fee saved over 2 years, as described above (2 months of fee + 1 month to find a new tenant).
  • Better control on tenant (you can choose them), potentially avoiding some of the above issues.
  • Potentially less delay between tenants, due to the high motivation for the owner (yourself!) to find a new tenant (a motivation that the real estate company may not share to the same extends). In any case, with the 3 months of fee saved already, even if you find a tenant in 2 months instead of 1, you are still ahead.

Now, doing so is extra work (quite a bit actually), requires that you live close to the property (meaning you are back in the situation where you are less mobile somehow), and other risks (can you find a tenant by yourself? You need to redact a proper rental contract etc.).

In some countries, this direct owner to tenant market is quite developed, so it may not be too hard to pull off (like in France for example), in other markets, on the contrary, most transactions still occur through real estate brokers so it may be harder (Japan is the latter case).

Another risk not covered above is taxation risk: a sharp increase in property tax can a have significant impact on the overall investment. In some countries like the USA; it is a real risk in most states.

Still, real estate has a lot of hidden advantages:

  • Inflation hedge:

Real estate keeps its value, in light of inflation, over long period of time. It means the 2.2% net return considered above can also be considered net of inflation. Should there be inflation, the property value would increase, and the rent value should also increase, albeit with a delay.

In current environment:

  • Bonds and stock are far too expensive (meaning almost guaranteed losers over a significant period of time, especially after inflation).
  • Cash is a guaranteed loss over time (inflation is quite high those days in most countries, whatever our beloved governments say, while rates on short term deposits are at rock bottom). Also a big pile of cash at the bank has other risk, when you consider what happened in Cyprus or Greece recently: bail-in of depositors, capital control etc.

So faced with certain important losses on bond and stock, small losses on cash and money market items (along with confiscation risks), real estate’s 2.2% net of tax and inflation do not seems so bad after all.

  • Efficiency of buying to live:

Buying to live has a lot of extra advantages. It solves several of the issues mentioned above:

  • potential damages by tenants
  • risk of non-paying tenants
  • managements fees
  • time where the apartment is unoccupied

On top of that, usually, buying a property to live in comes with several tax breaks, depending on jurisdictions, such tax breaks are usually not available for investment properties.

Finally, saving on rent is more efficient than renting. Imagine a person has a 25% income tax and has the choice to either buy a property to live, or buy a property, rent it out and rent another one to live. Assume the rent paid and received are the same.

Assume the same funding is used in both cases, meaning no difference between the two solutions. Assume the same maintenance needs for your own property and for the bought to lend property (so I ignore both aspects for the below calculation)

Case1: the person rents its own dwelling and buys an investment property to rent it.

Extra income gross is 100 minus all the various charges related to using a management company explained above (from 5% we went to 4.16% before tax or 1/6th gone for management), as those charges are usually tax deductible, so 100-100/6 = 83.3

Extra income tax: 83.3*0.25 = -20.82

Extra expense for own rent: -100

Total: 83.3-20.82-100 = -37.5

Case2: the person buys its own dwelling.

No extra income (so no tax) and no extra expense, no management company issue, no period without tenant.

Total: 0

The gain is indeed substantial, and the risk lower (no agency risk with the management company, no period without tenant, no “bad” tenant issue…).

  • intangible benefits:

Being the owner of your dwelling comes with serious advantages that cannot be quantified as well:

  • Feeling of belonging with your family or neighbors, the kid school etc.
  • Possibility to remodel, renovate etc. when and how you want.

For some people, those benefits will be the main drive toward buying a property.

You will find here an Excel sheet that can be used for Real estate simulation. It is a lot more detailled than anything I have found on the internet so far, especially on Real estate or Banks websites. It allows for realistic simulations, where not everything will go well. Fell free to use it. When distributing it to another person though, I request that you redirect this person to this website.

buy-to-rent-buy-to-live-xls

Comments on the post or the worksheet welcomed!

The difference between “Money as debt” and “Capital”.

Capital is something tangible and valuable that can be exchanged for something else. It cannot be created out of thin-air; it has to be built up first (through saving/delayed consumption/expended energy).

Money as debt is not Capital, it is a promise of Capital:

  • Of course a loan is money as debt, but actually most of the money sloshing around our current economic system is initially coming from loans (see my other post on Central Banking and Fractional Reserve), so most of the money used in our system is money as debt.
  • Money as debt is created ex-nihilo by banks when they issue a loan.
  • Even cash: coins (except coins made of precious metals) and bills are a promise. Indeed, cash is sitting on the liability side of the Balance Sheet of the central Bank. A long time ago (more like ~50 years ago), Central Banks held gold as assets on their balance sheet, and issued bills and coins as promise for gold (on the liability side). Users of those bills would use them, knowing that the bills/coins themselves were a promise for gold and could be redeemed as such at the bank.
  • Nowadays, cash is not even backed with a promise for gold, it is back with the “full faith and credit” of the government (meaning the government taxation ability to extract value from the population to then redeem those liabilities with things of similar value).

Money as debt is working based on trust: I trust, when I accept a payment with cash (bills and coins), or with a cash transfer from bank to bank, that I will be able to exchange at a later stage this money for something of equal value. Should the trust be broken, numbers on an accounts are just electrons (not extremely valuable) and coins and bills are just metals (of low value those days for most coins) and paper (again, not extremely valuable, certainly lower than the figure written on it).

What form can take capital? Anything valuable intrinsically:

It could be a car, a house, a factory, a machine, raw material, land…

Something intangible like a patent or copyrighted book/song cannot be considered Capital for single owner, as the value of this particular thing depends on the promise for Society to enforce the exclusive right for the user to use it. If Society fails on that promise, the patent can then be used by everybody, and the book/song can be copied/listened to freely. If the promise is broken, the value (for the owner) goes to almost zero.

Still, for Society as a whole, such an invention, or creation may be invaluable (think about the rabies vaccination or Beethoven 5th Symphony, those do not belong to anybody anymore, but are still extremely valuable to Society. They are Capital, but for Society, not an individual.

Gold is also Capital in the sense that it takes energy to dig out of the ground and refine (so it is limited in quantity) and it is valuable to most people on Earth since time immemorial, so it fits the definition of Capital. I may do another post on that later.

Easiest way to understand capital comes from a comic book written by Irwin A. Shiff (who died last month, R.I.P.). This is a great read so I encourage spending a bit of time on it. The first few pages deal with the essence of what is Capital. After that the author describes the effect of government on the economy. It is still an interesting read, but out of scope of this post.

Note: In the comics, the Author makes reference to loan not being issued due to not enough “deposits” available at the bank to do so because of consumer credit crowding out investment credit. This was true a long time ago when banks were making loans based on deposits, but since the start of the fractional reserve banking system, this is not true anymore; the Bank can make new loans just by crediting the borrower account with new electronic digits (see post on Central Banking and Fractional Reserve).

How the world works – Fractional reserve banking

In this first post, I will try to explain maybe the least understood and most important part of our financial system, the fractional reserve banking system, and its limitations. It will most likely end-up as a quite long post, as I want to be as clear as possible.

Let’s imagine a really simple system, comprised of 1 company (C1), 1 bank (B1) and the central bank (CB) of this system.

at the start, the company is starting its business, and has therefore 0 asset, 0 liability (let’s assume the full company assets will be funded by the bank).

The balance sheet (BS) of the various actors, at the start, is as follows:

Fractional reserve1

Then C1 requests, and obtains, a loan from B1 to develop its business. B1 creates the money “ex-nihilo”, by adding on its balance sheet, a loan to C1 on the asset side, and crediting the current account of C1 at the bank.

On the same day, C1, not ready yet to use the money, put the money back at the bank as a deposit. In our system, there is only one bank, so B1 it is.

Fractional reserve2

Here, let’s stop a moment to make several important remarks:

  • First, notice that the principal for the loan has been created by B1, but not the interest that will be necessary for C1 to repay the loan to B1 in the future. C1 will have to source the interest from outside. This has huge implication for the financial system; we will get back to that later.
  • We assume that C1 puts back the money to B1 as a deposit. In reality, of course C1 would spend the money to develop its business, but this money would then end up in C2 or C3 balance sheet as “cash” and at some point this cash is bound to be deposited back to a bank. Of course the money may not end up back to B1, but maybe in another bank, such a bank would also emits new loans the same way B1 is doing, and some of that new “money as credit” would similarly end up in B1 balance sheet. If we assume C1 represents all the company in a complex system and B1 all the banks, then the money lend by B1 to C1 will end up back on B1 balance sheet as a deposit at some point.
  • An important point is therefore that once money is created through loan creation (let’s call that “money as credit”), this “money as credit” never leaves the banking system unless:
    1. The “money as credit” is kept as physical cash outside the banking system (limited option as there is only a fraction of the whole amount of “money as credit” moving in the system compared to the physical cash i.e.: bills and coins).
    2. The loan is paid back by C1 to B1, in which case the situation goes back to (1) above, except for the interest that C1 should have paid to B1.
    3. C1 defaults on its obligations to B1, in which case on B1 balance sheet, the loan to C1 disappears and on the liability the Capital of B1 disappears: a loss to B1.
  • As we have seen, by creating new loans, the size of our simple economy’s money supply has expanded. Making new loans is indeed “inflationary”. A contrario, paying back a loan makes the economy goes back from stage (2) to (1). It reduces the amounts of “money as credit” floating around (money supply) and reduces the size of the economy. This is therefore deflationary.

B1 can create almost unlimited loans that way. The only limitation is what is called the “reserve ratio”:

Fractional reserve3

In case (3) above, B1 has made a lot of loans to C1. Its ratio of loans (1000 in bold red above) to reserve (100 in bold black above) is now of 1000/100 = 10. This reserve ratio is mandated by the CB as a rule. It can change over time. If, as in above example, the maximum loan to reserve ratio allowed by the CB is 10, B1 cannot make any additional loans before first having its loan to reserve ratio go down.

Suffice it to say that in our current economy, banks are not close to their maximum loan emissions at all, I will explain why later in the post. Nevertheless, most of the CB “extraordinary” measures taken place since 2009 have been to increase the reserves of the Banks, hoping that with more reserves, the banks would make more loans and grow the economy. This is why the CB actions so far have been mostly useless for the physical/real economy (the economy of people and company) and have not resulted in growth. It has nevertheless had huge impact on the financial economy (bank balance sheets, stock market size etc.).

Before explaining why those CB actions had no impact on the real economy, let me show, in accounting term, the Quantitative Easing (QE) impacts. For that I will had an additional actor, the government, G1. QE so far has mostly (not only) taken place by the CB purchasing government bonds, which is why I add this actor. This actor is not mandatory though, as QE would work exactly the same way with the CB purchasing company bonds or stocks (it is actually the case in Japan QE and to a lesser extend in US and Europe QE).

Fractional reserve4

I have restated the BS of the various actors a bit to balance the whole thing and show several things:

  • The government issued some bonds to finance its activities (the usage of the money is not important here, so the assets are mentioned as XXX).
  • Such bonds have been acquired half by B1, half by C1 (instead of keeping its treasury as cash, the company elects to have some government paper, really common occurrence).
  • In the above situation, B1 has reached its loan to reserve ratio of 10 (500 loan for 50 reserve, the rest of the reserve having been used to purchase the government bonds)

Now what is the impact of QE?

Fractional reserve5

The CB purchases the bonds from B1 by replacing such bonds with newly created reserves. Those reserves appears ex-nihilo, they are not coming from the initial Capital of B1 (as in example (1) above).

It has several far-reaching impacts:

  • First, as when B1 is issuing a new loan, it expands the size of the money supply, it is therefore inflationary.
  • Second, now B1 has new reserves, and its loan to reserve ratio is back to 5, it can issue for 500 more of new loans to B1. Should it do so, it would be really inflationary.
  • Third, by adding a new buyer for government bond in the market (the CB), demand for such bonds increases. Since supply did not (in our above example between (4) and (5), there is no more government bonds issued), it means government bonds value increased -> Government bond interest rates decreased.

Impact of the decrease in interest rates on government bonds:

  • The value of the bonds on the Balance Sheer of C1 have increased, it could sell them back to B1 for a profit. B1 would then be in a position to sell that to CB through more QE for even more effects.
  • The government can now issue extra debt, or roll existing one for cheaper, giving it more money to spend on something else than interest. It is one of the main effects of QE, keeping the government rates low, as if rates were where they should be (higher than now with QE), most of the developed countries government would not be able to service the huge amount of debt they have.
  • The problem here is that high interest rates are a good limit on government profligacy; look at the government debt level of “crappy” country like India or Russia, which have high interest rate: they cannot borrow cheaply so they do not borrow. Western governments have not used the extra savings from cheaper rates to try to reduce their debt; instead they have piled on more debt, since it was cheaper (lower cost of debt -> increased demand…).
  • All rates are impacted by a decrease of the government bonds rate (housing loan rates, credit cards rates …), since all else equal, a buyer would find government bonds less attractive after QE since the rate is down and would consider buying another type of asset, increasing its price and decreasing its yield. Therefore all rates would go done as well somehow.

Impact of all rates going down:

  • Everything bought on credit would initially be “cheaper”, increasing demand for such things -> prices would increase to compensate (price inflation, coming from the money supply inflation). See this post regarding real estate to get an idea of the mechanism. It works for any asset class (stock etc.).
  • A derivative of that increased demand would be Companies putting in place extra supplies (new factories, new commodities extractions etc.), that would be done on credit (good, the Bank has now additional reserve it can create loans against…). Such supply increases take time to be put in place, so there will be inflation first. Of course, such an artificial increase in demand / supply (which is only due to an artificial rate decrease, not due to extra population or any real reason for which the rates could have decreased) would at some point reach a limit, after which we would have oversupply -> deflation, but this is still several years away.
  • Of course, should rates increase again at some point, such extra supply, which was not needed with higher rates, would be superfluous, we would again have oversupply and deflation.

This QE process can be expanded, the only limits are:

  • Bonds inventory left to be bought: in our example, after step (5), B1 has no bond left. It can nevertheless buy the bonds of C1, but once that is sold to the CB as well, the CB owns the totality of G1 debt and there cannot be more monetization of Government bonds. CB can still buy other things like stocks, Mortgages Backed Securities (MBS), corporate bonds… Of course the government can issue extra debt as well. History has shown that one can always count on a government to issue new debt. As such, this is not a real limitation.
  • Such increase in money supply, if left unchecked, will end up at some point in hyper-inflation (post on that coming at some points), as there is so much money in the system that people lose faith in its value. This is the end-game if the process continues.
  • Should the process of extra QE to fuel extra demand and extra supply stop at some point and should the oversupply work its way through the system there will be deflation and an economic depression. Indeed QE was put in place to avoid a depression: we already had reached a point of oversupply, over-indebtedness in the system before QE. QE only lowered the rate (allowing more indebtedness) and increased demand (allowing more oversupply). Should it stop, the crisis will need to resorb both the previous indebtedness/oversupply as well as the extra additional one we created through QE.

Exit from current situation comes either from a huge depression and deflation, or hyper-inflation (loss of trust in the currency) and… A huge depression….

Now let’s have a look at why it did not work as “well” as mentioned above to get increased economic activity and inflation (do not get me wrong, there is inflation, but not a lot of economic activity).

In our case (4) above, we saw that the bank had already reached its loan to reserve ratio limit (and was therefore reserve constrained, it was not able to make new loans, even if there were demand for it). QE in such situation would results in extra loans made to the economy (C1) shortly after the new reserves were released on B1 BS.

Now assume that the bank is not reserve constrained as C1 had no need for up to 500 of loan, but for example only needed 300 at that point, and did not anticipate extra needs in current economic situation.

Fractional reserve6

Doing the same QE in that condition would have the below results:

Fractional reserve7

B1 would have more excess reserves, but since it was not reserved constrained before, there will not be extra loans made to C1 (aside from the lower rates and their various impacts described above).

Now assume that C1 is already in a tough financial situation, because of low demand (hey, we were in a depression at the time of start of QE). Even if it wanted new money to expand its activity, B1 would refuse to lend due to too much risk of not being repaid.

Now you can also assume C1 is relatively fine financially, but C1 clients themselves (part of C1 in my mini economy) have too much debt already and cannot buy more C1 product, even if they were cheaper on credit (again, we were in a depression at the time, so prudent people would actually try to reduce their debt in such case, as they fear for their jobs etc.). Again, C1 will not expand in that condition, and not request extra loans.

In such case, the only impact of QE is to give additional “excess reserve” to B1.

What can B1 do with such reserves?

It cannot buy stock directly (I think, comments welcomed), but it can buy more government bonds. After that, it can exchange those government bonds with another Bank through a repo transaction (repurchase agreement):

B1 sell the bond to B2 (who can use its reserve to pay for it) for cash with the agreement that it would buy it back at the same price, minus interest, at a given date in the future). B1, with this new cash (which is not “reserve” anymore), can buy stocks. In short, B1 cannot force the real economy to use more loans to grow the economy, but it can buy other financials assets (bonds, stocks, MBS, etc…). That creates extra demand for such assets, which is exactly what we have seen since the start of QE:

  • No real growth during the past 7 years for most developped economies (to get real growth, you need to discount the nominal growth (the figure reported by the governments) with realistic inflations numbers).
  • But huge increases in asset prices:
    • Real estate prices are extremely high in all Europe, most of the US and most big cities all over the world.
    • Stocks markets are at all time high or decades high.
    • Rates on all types of bonds (high grade, high yield etc.) are at all-time low (meaning prices are at all time high).

The conclusions of QE is that people with assets before the start of QE have seen those asset increase in value, but on the contrary people without asset have not gotten any benefit from QE (and on the contrary, they got inflation, lackluster economy, no salary increases…).

One final point on the fact in current economic paradigm of fractional banking the money as credit needed to issue new loan is created ex-nihilo, but not the interest to service such a loan.

The money to pay interest has therefore to come for elsewhere: as long as there is more new Money as credit created in the system (more loan getting emitted than loan being repaid + the interest for such loans), one can always get money from elsewhere.

Now should the loan growth slows down below new loan emission + interest for existing loans (or even below just new loan creation, since interest rates are so low those day we can “almost” ignore them), it will get harder and harder to source the money to pay back the existing loans.

It will first come from the “real Capital” of all the economic actors (in our model, only the bank had Capital, so it means other actors will default on their loan, resulting in loss to the bank, losses that would deplete Capital). Such mechanism will make such Capital more and more valuable as time pass, a system where the money value increase with time is the same as a system where asset value decrease -> deflation.

Once all Capital has been depleted, the system will implode, as it would become impossible to sell anything even for 1 cent of currency, as there will be absolutely no “real money” in the system, only debt.

Of course, before this happen, one can count on the government to issue lot of new debt to pay back old one plus interest, for the “independent” CB to buy all that debt and for everybody else to understand that in such system the government and CB will never be able to stop, resulting in in total loss of faith in the currency of the system: hyper-inflation. At which point, after years of hardship (read “When Money Dies” from Adam Fergusson for a vivid account of that during the Weimar republic days in Germany), existing debt in the system will be totally worthless and the system will restart with a new currency.

At the end of the day, what mathematically cannot be repaid won’t be…

When thinking about this last part, a system that cannot survive unless it grows bigger and bigger all the time and draws in new entrants (new loans) to pay back old ones with interest looks really much like a Ponzi scheme. A loooooong lived one (one can say it started when the convertibility of “money as debt” to gold disappeared), but a Ponzi scheme nonetheless…

Such a systems work correctly (if not fairly) as long as it is possible for it to grow bigger and bigger. It indeed misses the limitations of the previous economic systems (capability of emitting new currency not always matching the economic needs for such new currency). I am not sure the technological progresses that were made in the last 50~ years would have been possible without such a system.

Now, on a quite finite Earth (we are not yet colonizing Mars or expanding across the galaxy, so for all intend and purpose, today’s system is finite), with close to 7 billion inhabitants and counting (how many more can we add sustainably), the system may be reaching its limits. There is no perfect system, previous one was not, next one will not be, since human is not perfect anyway. The only thing one can do it get out of the way when the current system crashes.

Please leave your comments, things you did not understand, things that need extra explanation, I am pretty much interested in your feedback.