The Great Debt Crisis Begins
There is growing talk on Wall Street about the possibility of a recession. Since the beginning of the year three Wall Street firms (Merrill Lynch, Morgan Stanley and Goldman Sachs) have all stated they believe we are either in a recession already or are very close to a recession. In other words, it's no longer a matter of if a recession happens but when it will happen and how long it will last. In response to these developments, various presidential candidates have proposed various solutions. However, none of these will work, largely because this is not a typical slowdown caused solely by slowing consumer spending or business investment. Instead, it is a slowdown caused by inflated asset prices and a nation gorging on debt. As a result, it will probably take a lot longer to come out from under this problem.
A recent Los Angeles Times Article stated the basic problem thusly:
What makes bubbles so dangerous is that their consequences, when they burst, are wider, often more damaging, and certainly more unpredictable than those of ordinary downturns."We are more prone to bubbles than we used to be," said John H. Makin, a former senior Treasury official with several Republican administrations and now a scholar with the conservative American Enterprise Institute in Washington.
"The old-fashioned recession, where the consumer ran out of gas or there was an economic policy mistake, doesn't seem to occur much anymore," said Alice M. Rivlin, a former vice chair of the Federal Reserve and Clinton administration budget director. "As we've seen from recent events, bubbles seem to be playing a bigger role."
The basic problem faced by the US economy right now is excessive debt caused by recklessly low interest rates from the Federal Reserve. Here is a chart from the St. Louis Federal Reserve of the effective Federal Funds rate since 2000.
Notice the US had record low interest rates for a period of nearly three years. This led to a debt binge of mammoth proportions. Here is a chart of total household debt outstanding from the St. Louis Fed:
Notice the amount outstanding increased from around $8 trillion to a little shy of $14 trillion within a period of seven years. That's approximately a 75% increase in total household debt outstanding.
All of this debt has to go somewhere; it doesn't just exist in a vacuum. To accommodate this increase in total debt, we've seen a huge increase in structured financial products. In and of themselves, these are not bad devices; they have been around for approximately 25-30 years. However, they were used very recklessly over the last 7 years, and especially over the last 3-4 years. The short version of what happened is simple: lending standards deteriorated to the point where literally anyone could get a loan. These loans were then sold to investment firms, who pooled them together and carved them into various bonds, which were in turn sold to large institutional investors like pension funds, insurance companies and hedge funds. The idea underlying structured financial products was that risk was spread out to the point where the bonds were more or less insulated from default problems. However, when defaults skyrocketed higher than anticipated, we discovered that the risk wasn't contained nearly to the degree we thought. Instead, everybody started getting hurt.
Right now the Federal Reserve is treating this situation as a "liquidity crisis", meaning they are literally throwing money at the problem. They are hoping that by flooding the markets with money the money will get spent in the form of loans and credit. However, the market has ample liquidity. The problem is we are in the middle of a debt crisis:
During a liquidity crisis, the issue is one of supplying money to those who, for whatever reason, have suddenly shortened their time preferences. Mr. Practical, writing on Minyanville's Buzz & Banter, characterized it this way:
Suppose there is a rumor that a large bank has made a bad loan. Because banks lend out more money than they have on deposit - this is called a fractional reserve banking system - if everyone goes to the bank and demands their money at the same time, a liquidity crisis can occur because the bank does not have enough cash on hand to satisfy the demand from its depositors. The Federal Reserve will then step in and provide liquidity, allowing the depositor demands to be satisfied. If the rumor of the bad loan proves to be false, then the issue is one of liquidity. Time preferences soon return to a more normalized state, depositors return, everyone feels better. But, if the rumor turns out to be true, it doesn't matter how much liquidity the Fed provides, the bank will go bankrupt.
Similarly, the issue today is not one of temporary liquidity, time preferences being shortened out of a temporary risk aversion. The issue is too much debt supported by too little value and income generation. As a result, time preferences are retreating, risk aversion is growing, and access to credit is diminishing.
Here's the basic problem. All of that debt in the household debt chart assumes a certain asset value. Here's a simple example. Suppose a bank makes a $100,000 loan for a home valued at $100,000. If the home appreciates in value, everything is fine. However, let's assume the home's value decreases to $90,000. Now the loan is inherently less valuable because the underlying asset has decreased in value. If this situation persists or worsens, the lender will have to devalue the loan to some degree to reflect the lower asset value. Now, take this situation and apply it to the entire US economy and you get an idea for what exactly is going on right now.
To make matters worse are two inter-related issues. First, the US economy is very much based on credit creation. As a result, the financial sector sits at the center of the US economy. Here is an overly-simplistic (and poorly drawn) demonstration.
Basically, the financial sector acts as an intermediary between consumers and business, pooling deposits and investments and funneling those to business in the form of credit. Also note the financial sector provides credit to consumers in the form of credit card, consumer and mortgage loans. In other words, when the financial sector takes a bit hit, it impacts the entire economy.
The second problem is the accounting nature of the financial system. It is essentially based on a "fractional reserve" system. All this means is financial firms have to have a particualr asset to loan ratio. For example (and hypothetically) this means financial firms must have say 10% of their total outstanding loans in assets. Now, suppose the value of the assets on their books starts to decrease. The financial firms ability to make loans is diminished. This is why all of the writedowns announced by literally every financial firm out there is so important. It means their ability to extend credit is diminished. As a result, the ability to borrow in the economy at large is diminished, which is devastating to an economy like the US' which is heavily dependent on credit creation to function.
In summation, the US economy is at the beginning of a huge problem. The economy depends on credit creation. However, the financial sector is hampered in that ability right now because the value of assets backing outstanding loans is decreasing. This lowers the value of outstanding loans, which in turn limits the financial sectors' ability to extend credit. So long as the US economy is experiencing deflation this process will continue.
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The proposed "stimulus" will probably not work at all, or, if it does, will only have a temporary effect. What we must do is...get rid of a significant chunk of this debt--by PAYING IT OFF. Nothing but time and hard work will accomplish this. Give up some stuff, and pay the bills, whether you are the individual, the corporation, or the government.
Instead of quick fixes, we need fundamental changes--in practices AND in attitudes. We are not "OWED" or "ENTITLED" to anything but what we work for and earn.
The citizens and other consumers in the United States will continue to fall farther and farther behind with each "cycle" for one simple reason:
We don't make anything anymore. We can't even run our military without importing materials and supplies from other countries, not all of whom are what used to be called "reliable allies". More to the point, the financial rewards of creating and improving tangible goods are not finding their way into the paychecks of the bottom 90% of Americans. So long as that continues, with no meaningful changes of direction in what is still largely (in theory) a production-driven economy that doesn't produce anything, we're screwed; destined to emulate the present-world power and prestige of, say, Holland, if not Mesopotamia.
Is that really what we want? We're running out of time to change things in any meaningful way -- and the more we listen to the status quo-beholden media establishment, the worse things will eventually become.
After all, plenty of media, corporate and political figures had effusive praise for the "new Germany" of 1933-1938, that had seemed to find its way out of a terrible economic crisis. And we know how well that turned out.
We are about at the point in the US where Germany was before Hitler took over.
I believe you can just about predict the outcome.
The "CAFE" standards which describe the required mileage of a fleet of cars produced and sold, seems a good analogy for the consumer capacity of Americans, or any economy for that matter. When we lean down the earnings of the consumers in America beyond the point where we can even borrow to buy, ... and certainly can not pay cash as some have tried in the past to do, ... then it seems we have hit a wall for the moment.
In the end, the greed of all the individual corporations to charge as much as possible for their product, while paying as little as possible for their labor, ... has collectively killed what was the "Golden Goose" of American Consumerism. If a "Free Market" is the best of economic systems, what part does the consumer play in it? Seems to me, that the Consumer is like a bear in hibernation, but about to waken once again with teeth bared and nails slashing toward those who have risked her and her young.
For the corporations who believe they can sit back, deny a role in her abuse, and pretend to be a bystander, ... listen up. You are about to hear Her in Her most agitated state. Foreclosures, reposessions, and loss of earnings are making Her very cranky indeed. While the banks might seek funding from overseas to stay afloat, ... they will come back to Americans to lend to us. I will, as far as possible, work from a cash position. Screw you who stole my neighbors' homes, and ruined my towns' businesses!
We are addicted to borrowing, my friend. We must hit bottom before we can see a better day.
Until then your calculations of our economy's demise are like the risk that Mars will be hit by an asteroid. Mars has escaped that risk, ... but I fear we will not!
Is the whole system of the macroeconomy defined by simple quantum growth and decay valuation laws? Thus far, the saturation phase has prospectively and retrospectively conformed to a perfect quantum fractal model. Will the decay phase likewise conform to a similarly predicted model? Let us hope not.
You have it at last. Thanks for the simpler graphs. Many investors are confused by complex graphs. We flee those who use them. We invest with those who use simple graphs & show a record of good performance.
The United States Senate
7 April 2004
Dear Mr. zzzzzzzz
As chairman of the US Senate Banking, Housing and Urban Affairs Committee I will continue to monitor interest rates and their effect on the economy. I am, however, confident in chairman Greenspan’s strong leadership and his aggressive efforts to grow and bolster the economy………
Richard Shelby
I love how the picture shows a one-way movement of money through banks going from the consumer to business. I mean, we always knew that was how banks worked, but the picture really makes it all clear.
Since wages have not kept up, we can't compensate for the lost revenue on global oil purchases and the rising costs associated with it. People start falling. Americans standard of living declines/profits drop and the US workers can't maintain the higher standard of living most high rollers have been accustomed to.
We haven't invested in our population, many production jobs were lost, we aren't able to whether the storm now we rely on foreign investment. Which is not good, because American perception abroad is at historic lows.
This disturbed me. The "sub-prime loan" crisis is receiving much hype and speculation, but it seemed to me a diversionary tactic from the true cause of our economic struggles. I have to wonder if the war being played up against Iran is not due more to this "economic war" than terrorism.
Receiving an oil tax from all over the world is ALOT of money. Billions? Gone from our economy. To blame it on the "poor credit risks" alone seems cruel to me. They were the most vulnerable. Many are going to falter, even with "good" credit as inflation hits.
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Warning: Average citizen-not a financial guru
I read the crisis started when Iran began accepting payment for it's oil in other currencies, breaking the US dollar monopoly through Saudi Arabia/OPEC. The biggest benefactor has been Europe
-Iran began accepting other currencies for oil
-The dollar's monopoly was broken and its value began declining-demand was less-no more exchange rates in big business pockets.
-The Euro benefited most from this and as an example of Iran's success in this, in October of 2003 you could buy 1 Euro for $1.19. By the end of 2006 it took $1.31 and on Oct. 11, 2007 one Euro cost $1.43. So many countries adopted the Euro, so it's replacing the dollar in the oil market as the needed currency for trade.
Iran received (unconfirmed) assistance from Venezuela, Russia & China. A sort of "economic cold war". We are now feeling the effects of that loss, companies who benefited from this are seeing their bottom lines hit record lows, they raise prices to cover the deficit, require earlier payment from consumers of their products/loans/mortgages, etc, thus squeezing the American consumer. Then the rates rise. Bam. Sub-primes go under.
"The old-fashioned recession, where the consumer ran out of gas or there was an economic policy mistake, doesn't seem to occur much anymore," said Alice M. Rivlin. Wrong! Free trade is an economic policy mistake, if ppl don't have decent livable wage jobs nothing the economic policy hacks do will change it and that is why it is all bubbles and no substance.
Gee I saw the immediate effects at the very beginning of RonnyRayguns' drizzle down on the middle class.
I thought it was a bust from the first time I heard him utter it.
I lost my job, I also saw first hand what happened in Fort Lauderdale the sudden rise of homeless and crime due at least in part to his throwing the mental patients out of hospitals.
I still am amazed that some folks still see ol Ronnie as a Gawd.
Naming aircraft carriers after him and GHWB were huge expenditures that had no reason, just more spending our taxes like a drunken sailor on their pet projects while making sure education and every other public domain service suffered. Deregulation of everything only gave the wealthy what they wanted, not what we needed.
I then worked in sectors that catered to the rich. I never got over how they acted, "Im RICH so you should Give me" mindset of many.
Most of our citizens have spent themselves into debt that will be a disaster and since our government is nearly bankrupt no help there either..
I am not talking about hand outs such as are given to no bid contractors, I mean now that the middle class is spiraling around the drain a hand up is needed and there will not be one.
I count my partner and myself lucky. He now has a good job, but I am disabled.
We managed to barely keep a roof over our heads when after 911 he got laid off twice in less than six months, he worked in the aerospace field for parts companies that catered to the airlines as well as aircraft belonging to the armed services. Outsourced.
We are in debt for a house and a car, and that only because there is no way to cough up enough to pay cash for either one.
We do not carry any credit card debt for more than a month.
We try to operate on the pay as you go system.
We are in a boatload of trouble folks. When the elites are going bankrupt, we on the bottom of the "trickle down economy" pay their bills. Hell, I can barely pay my own.
The recommendations of these “insightful” economists are to persuade the Fed to increase the monetary base, because one outcome is certain if the Fed follows the desperate advice of these “experts.”
The result will be that the exchange value of the U.S. dollar will plummet and inflationary pressures will skyrocket. Gold prices, already breaking records, will continue to surge.
To me, this debt crises has occured from the ending of many regulations on the financial services industry including as to banking, mortgages, credit cards and tighing up the bankruptcy laws for individuals as well as limiting the consolidation of the banking and finacial industries into fewer entities.
We need more competiton for consumers as to financial services to hold down their costs, and increase interest rates. Mergers of large institutions must be suspended.
The lenders must have to face greater risks if they overextend or offer credit to high risk persons and they cannot be allowed to demand usurious interest rates to offset that risk.
They must be limited in how much higher interest rates can be applied and how to eliminate minor errors by consumers leading to huge increases.
Huge fees for late payments, overdrawing your account or using an ATM not of your bank or using a card outside the USA must be capped.
They must have easy to read rules and policies in readable print and not in legalese.
Rules must be also put into place to limit perverse incentives to mortgage brokers and others in financial services to discourage improper granting of credit.
Marketing must be made more honest and not make highly tempting offers of extensive credit to college students and other high risk persons. They also need to cut back on how many times a year they can send marketing materials to current credit holders and to potential new customers.
Require higher down payments on cars and homes.
All these things may not be easy and may not completly deal with the comming debt crises, but it would sure help now and in the future.
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