Were you – like me – ever amazed at how so many people could afford bigger and bigger homes, New England beach houses and Florida condos, expensive cars? The answer, according to a terrific article by Ben Funnell in the Financial Times, is simple: cheap, available credit.
Debt, he says, is “capitalism’s dirty little secret.” Cheap mortgages, cheap car leases, and the use of home as veritable ATM’s created fictitious living standards for the middle class and the bulk of the population at a time of low productivity and paltry growth in incomes, and where the bulk of the gains in wealth were scooped up by the top fraction of households.
Put simply, the benefits of economic growth have gone into the pockets of plutocrats rather than the bulk of the population. So why has there been no revolution? Because there was a solution: debt. If you couldn’t earn it, you could borrow it. Cheap financing was made widely available. Financial innovations such as the asset-backed securities market aided this process, as did government-sponsored agencies such as Fannie Mae and Freddie Mac. Regulators welcomed it all while perhaps taking insufficient account of the moral hazard problem it posed: that ever-increasing leverage meant the authorities had to keep interest rates low, otherwise the debt burden would cripple consumption. This prompted more leverage, which exacerbated the problem.
Many of those houses have now been lost – “owners” turned into renters. The new Bimmers and Benzes traded in for used Toyotas. It will be a long and painful readjustment for much of America as we head toward a new normal.
July 2nd, 2009 at 9:10 pm
Not a secret so much as not mainstream thought, but you make a good point. Karl Denninger has been onto this for years. Here’s what he says about this recession being a credit-driven recession a la the Great Depression:
“The types of recessions are inventory driven recessions, the most common, and credit driven recessions.
The last material credit driven recession was in the 1930s. We called it the ‘The Great Depression.’
Inventory-driven recessions are primarily about excessive industrial capacity for demand. That is, manufacturers and suppliers of services get too bullish about prospects, build too much capacity and inventory, and wind up engaging in a destructive price war in an attempt to ‘win’. This drives down profits and ultimately forces the weaker firms out of business, ergo, recession – GDP and employment decline. Having cleansed itself of the excess, the economy recovers. The trigger for these recessions is often (but not always) an external shock such as the oil embargo in the 1970s or the collapse of the Internet fraud-and-circuses games in 2000.
The second sort of recession is a credit-driven recession. Excessive credit creation – that is, loans going too far toward ‘fog a mirror’ qualifications (and in some cases, such as the most recent event, actually reaching ‘fog a mirror’) drives one or more asset bubbles. These pop when effective interest rates in the economy reach an effective level of zero, usually because the amount of leverage available becomes for all intents and purposes infinite (Bear and Lehman at 30:1, Fannie/Freddie at 80:1, AIG at god-knows-what, and duped “home buyers” buying with zero down for a true infinite leverage ratio.) This excessive credit creation drives a speculative asset bidding war which in turn causes prices to go sky-high for one or more types of asset.”
http://market-ticker.org/archives/1175-To-Dennis-Kneale-Youre-An-Idiot.html
With asset bubbles, the banks making loans against bubblicious assets, or that own bubblicious assets like mortgage-backed securities, get wiped out when the credit contraction that follows deflates the value of those assets, making them insolvent. Insolvent, that is, without scandalouly high leverage ratios hidden by bailouts that pump up assets in an effort to reduce leverage.