Blame (easy) Credit!

Or “Blame where credit is due,” or “credit blame is due…”  I’m not sure what’s the best “cute” way to state the obvious:  our economic problems and financial crisis are the result of too much easy credit.

As I noted awhile back in “four charts say it all,” the US begun building towards this crisis around 1982 as both government and private debt started to sky rocket.  When the story of this crisis is ultimately told, it will not be focused on Lehman Brothers, Bear Stearns, credit default swaps or collateralized debt obligations.   It won’t even be primarily about predatory lending, subprime credit fraud, GSE (government sponsored entity) excesses from Fannie Mae, or leveraging at a rate of 35 to 1.   These are all part of the story now, but were the consequence of an economy thrown off balance by irrationally cheap and easy credit.  One can imagine better decisions at Fannie Mae, more responsible derivative trade, or a real estate market without subprime fraud.  But one way or another, if credit is too cheap and too easy, the economy will venture off in bizarre directions.   Why was credit so cheap and easy for so long?

This certainly wasn’t expected back in the early eighties, when Paul Volcker, Federal Reserve Chair, oversaw a massive rise in interest rates to fight inflation.   In 1981 and 82 a thirty year fixed mortage carried interest rates greater than 16% a year.  Average credit card debt per household in 1983 was $1000, by 2008 it hit $9000, much of it from the subprime market (and much of that debt was securitized like sup prime mortgage debt).

Government debt, of course, soared in the 80s from 30% of GDP at the start of the decade to 60% of GDP by 1990.  And, even the government stabilized its budget by the end of the 90s (only to rise again in the aughts), private debt rose at a continuing pace as cheap easy credit kept flowing.   So why did this happen — why didn’t people take the debt bubble seriously?

One reason is the faith that so many in the US had in markets to handle anything that might come up.  “Markets get it right,” Alan Greenspan said, even though he would later be forced to recant that view. This led to a view that regulation was unnecessary, and that the financial industry could run its shenanigans — including things like packaging high risk debt or even securities backed by high risk debt as new financial instruments to be sold on the market as AAA rated (meaning super safe) derivatives.   A second reason is the view that as long as inflation was low, credit could be kept cheap.   The idea was that inflation would be the indicator that credit was too easy to get, so without inflation, no problem!

This meant that a lot of people were fooled by the bubble economies.   During the dot com craze, people liked to say it was the “new economy,” and the impact of the technology revolution altering the nature of economics.  In a world where communism had died, the wealth generated by globalized high-tech free market capitalism could grow at an unprecedented pace.   Even when that burst, the real estate bubble created the same self-deluding fantasies.

Now, the fed should have seen that bubbles are a form of inflation.   Even if the CPI (Consumer Price Index) isn’t rising, something is amiss when speculative bubbles so easily grow.   The lack of consumer inflation is also questionable — Chinese goods flowed into the country, replacing more expensive American made products (as the US de-industrialized), and often being of lower quality.   So we were consuming larger amounts of lower quality goods produced by cheaper labor, with the Chinese Yuan under valued.    Low quality should be taken into account.  If a good has to be replaced twice as often, doesn’t that really make it twice as expensive?

Also, when government spending increases as ours did, one expects the dollar to lose value, and credit to become more expensive as people start to question the financial stability of the country (the sovereign debt question, which we’ve seen hound Greece and Ireland).   But the willingness of China to keep buying our debt, allowing us to run a huge current account deficit helped keep global demand for dollars high — and the currency relatively strong.

Globalization means inflation can be stealth.   It can show itself in ways not traditionally measured by the government, and thus go under the radar of central banks.  In this case the twin bubbles (dot com, followed by housing) and the rising current account deficit should have signaled a need to cut back on cheap credit.   Instead, low inflation and an unrealistic and even delusional belief in the economic health of the country caused bubbles to be embraced as permanent, and paper wealth to be considered as good as savings.   After all, people reasoned, $200,000 of equity in my house is as good as $200,000 in the bank.  More, in fact, because home values rise and the bank pays really low interest rates.

And, of course, with easy credit people could borrow against that paper wealth, and with lax capital regulations (how much capital financial firms had to have to cover their potential obligations), especially on derivatives, firms could leverage to 30 to 35:1, meaning that they were investing/controlling 35 times the amount of money they actually had assets to cover.   You can’t do all that without extremely cheap, easy credit.

This was unsustainable.  A mix of high oil prices in 2008 and the inevitable end of the housing boom helped spur a massive retraction in both wealth and trust.     When banks and other actors saw that the debt had been allowed to grow to ridiculous levels, the reaction was swift and severe — a complete drying up of credit, to the point where by September 2008 people feared that credit could dry up completely, bringing forth a certain depression.

Easy credit was the problem, but no credit is even worse.  Credit is the life blood of capitalism, it makes innovation and adjustment possible, countries where credit is hard to get usually are countries with backgrounds or dysfunctional economies.   And though the TARP program helped restore enough trust in credit markets to keep the system going, it didn’t solve the problem.

Think of it this way.  Let’s say someone eats lots of fatty foods and doesn’t exercise.   He then has a massive heart attack after keeping this up for 30 years.  He is about to die, but the doctor manages an emergency by pass operation, and installs a pace maker.  That allows the patient to function.  Yet while that prevented death, the patient is still overweight and leading an unhealthy lifestyle, and if that doesn’t change, another perhaps deadly heart attack is likely.   A patient has to also change habits, eat better, and exercise.

That’s where we are now.   If we try to simply revert to the behaviors and ideals of the last couple decades, we’ll set up another crisis.  If we can break our addiction to cheap/easy credit, we can start constructing a sustainable economy.

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