Thursday, September 29, 2011


Our modern world is built on debt. Instead of saving up for big purchases, we borrow the money and pay them off over time. On the individual level it's how we buy our houses, cars, and fancy electronics. It is also how our cities and states build roads and bridges. Our businesses borrow money in order to expand. In general there is nothing wrong with debt.

Unless you start borrowing to meet operating expenses. That's where the world is right now and why the economy is not going to recover quickly, no matter what the politicians do.

Forty years ago people managed their debt better. General credit cards were rare. Most cards were tied to individual stores or chains. You had a gas card for the brand of gas that you bought and a card for the department store you went to. Sears and Penny's had their own cards. All of these were reviewed regularly to be sure that you didn't get too deep in debt (this was for the card-holder's protection). Banks had Christmas clubs where you put in a set deposit every payday for a year in order to have a set amount of cash for holiday spending (this is one reason that the Christmas buying season didn't start until Thanksgiving - people didn't have their Christmas shopping money before then).

Since then we have had an explosion of debt. Prior to the tax simplification in of 1986, interest could be deducted from your income tax. After that, only interest on your primary residence was deductible which caused a rise in mortgage-backed debt.

Short-term consumer debt (credit cards) always charged a rate higher than inflation but legal cap on interest was raised in the late-1970s to keep up with the high-inflation of the time. This was never lowered even though inflation has been negligible for more than a decade. That means that banks make huge profits on credit cards which gives them an incentive to offer ever-increasing amounts of credit.

In 1993, the economy was given a boost when long-term interest rates were lowered. That allowed people to refinance their homes at a lower rate and spend the difference. Banks could make a nice profit by refinancing loans then selling the loans. Starting in the late-1990s, programs to increase minority home ownership caused the standards for granting mortgages to be reduced or nearly eliminated. Previously you had to put up a 20% down-payment and show that the mortgage would be less than 1/3 of your monthly expenses. Those requirements were waived. Interest rates continued to drop fueling more refinancing. At the same time the lower standards caused a bubble in real estate values.

Banks figured out ways to combine mortgages into a new type of financial instrument. The idea was that real estate values might drop in one area but would keep increasing in general and the default rate on loans was fairly constant. If you combined mortgages from across the country into a single instrument and tossed in some mortgage insurance equal to the expected default rate then you had an investment that was nearly a sure thing. Given the low interest rates for business loans, fortunes could be made by taking out a loan to buy these instruments.

Complex mathematical models were created to evaluate the risk of these investments but they assumed a steady market. Besides, the rating agencies such as Standard & Poor made a fortune by rating these investments as safe.

So consumers borrowed which caused the big investment banks to borrow. There was so much money to be made that anyone who questioned the basis for this new economy was fired.

While consumer and corporate debt exploded, countries did a lot of borrowing of their own. As part of the progressive movement, most countries established an implied social contract which said that their government would help the poorest and provide free or discounted medical care and retirement. This was accompanied by an explosive growth in government. Compared with Europe, the US was a piker in this. Many European countries provide free medical care, university education, and child care along with generous vacation. The stability of this was always questionable because of Europe's low birth rate.

The problem is that, even with high taxes, there was not enough money to pay for all of this so Europe borrowed heavily. The US did a lot of borrowing of its own but hid a lot of it in the Social Security Trust Fund. Since this is money that the government owes to itself, it is not usually counted in the national debt but it has to be repaid, regardless.

When Bill Clinton became president he was shocked to find that the biggest single item in the budget was payments on the national debt. Working with a Republican Congress, Clinton managed to turn the deficit into a mild surplus (not counting the Social Security Trust Fund which continued to grow). Between the collapse of the Internet Bubble, the recession of 2001, and the terrorist attacks on 9/11/2001, and general spending by the Bush administration, the US budget went back into deficit. Payments on the national debt actually decreased as the Treasury took advantage of lower interest rates to refinance its own debt.

But you cannot keep running the world on debt forever. Rising demand in China caused an increase in the price of raw materials. In order to head off inflation, the Federal Reserve raised interest rates. This caused people with variable rate mortgages to default on their loans. This, in turn put enough newly foreclosed houses on the market to pop the real estate bubble. House prices started going down instead of up and a quarter of the country found that they owed more on their house than it was worth. The default rate went up again.

Suddenly the mortgage-backed financial instruments were not a sure thing any longer. Banks found that assets that had been worth billions were suddenly worthless. This led to a credit-crisis.

Between the sudden tightening of credit and the failure of the housing market, the economy went into a steep recession. This led to a drop in tax revenues which made the deficit much worse. The government's response was to try to stimulate the economy with new spending which made the recession worse.

Over in Europe, it turned out that many people had invested in Icelandic banks which went under leaving the Iceland government on the hook for more assets than the country was worth. Ireland had suffered its own real estate bubble. Spain had wasted billions on green energy initiatives that turned out to cost two jobs for every new job created. Portugal and Greece had been borrowing heavily just to finance lavish public benefits. With the world in recession, nations world-wide saw tax revenues drop and most of Europe found itself being squeezed.

Greece needs help just to pay operating expenses and still meet payments on its national debt. With a default a distinct possibility, no one wants to buy their bonds. Their only hope to remain solvent is for the rest of the Euro-zone to either give or loan them money.

Even though Europe is reaching limits on how much it can borrow, citizens are rioting in the streets. They want their promised services and refuse to believe that there is not enough money to pay for them. The same thing is happening in the US although not on the same scale, yet.

The long-term problem is that the debt-based economy was unsustainable. Period. Once you reach the position that Greece is in, you cannot keep borrowing because no one will give you loans.

The US will be in this position in a decade. By that time entitlements and interest on the national debt will take up the entire budget. There will not be any money left for anything. No roads. No education. Nothing.

Currently the left is calling for increased spending in order to try to restart the economy. "Yes," they say, "We will have to deal with long-term debt eventually but first we have to get past this short-term problem." This approach is just making things worse. a few days ago the White House pointed to a prominent, independent economist who said that the President's jobs program would reduce unemployment by as much as a million people. The proviso is that this boost would be for one-year only and after that it would be a drag on the economy.

The problem is that we cannot put things back like they were. People are more wary of debt and the banks that survived are much more wary. You can't reinflate a bubble economy. At the same time, the long-term problems have to be addressed soon and they will take more than taxing the rich.

It is true that austerity budgets will cause short-term pain. The only payoff will be the lack of an international collapse a decade or more in the future. Many politicians see this as an opportunity. They will accuse the responsible side of wanting to throw grandmother off a cliff. They insist that the social contract is more important than fiscal realities. If all else fails, their back-up plan is to pay their debts through high inflation. All of this will be disastrous but the disaster will take place in the future.

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