Credit Where Credit Is Due

Last week, in a speech before the London School of Economics, Fed Chairman Ben Bernanke offered a perverse economic theory in his quest to gather support for never-ending Wall Street bailouts;

This disparate treatment, unappealing as it is, appears unavoidable. Our economic system is critically dependent on the free flow of credit, and the consequences for the broader economy of financial instability are thus powerful and quickly felt.

In other words, credit is the lifeblood of our economy, and the continued operation of credit providers is an issue of national security.

In truth, not all economies run on credit. But over the last decade, the United States became a bubble economy that needed unlimited credit to keep from collapsing. In a legitimate economy, it is not credit that fuels spending and investment, but simply income and savings. It's too bad our Fed chairman does not understand the difference.

That American families now routinely rely on credit to make every-day purchases is a habit that needs to be broken and not encouraged. What we need in America is more restraint and less indulgence. For example, Americans in the current economy should not go into debt to buy new cars. Given the level of debt that weighs down the typical family, Americans should defer such purchases until they have paid down existing debt, or replenished their savings to the point where they can afford to pay cash.

Until that time, Americans should continue driving their old cars. In the meantime, the untapped savings could be made available to local businesses that would use it to finance badly needed capital investments.

But such a drastic reversal in financial culture represents the kind of change that no one in the outgoing or incoming Administrations appears willing to consider. By providing perpetual support to lenders who have bankrupted themselves through bad loans, the government merely guarantees that bad economic behavior will continue.

Credit is indeed vital to an economy, but it does not constitute an economy within itself. The important thing to remember is that credit is scarce, and is limited by the stock of savings. Savings loaned to one individual is not available to be loaned to another until it is repaid. If it is never repaid, the savings are lost. Loans to consumers not only crowd out more productive loans that might have been made to business, but they have a far greater likelihood of ending in default.

In addition, while business loans increase our capital stock and lead to greater productivity, loans made to consumers are merely spent, and do not create conditions that will make repayment easier. When businesses borrow to fund capital investments, the extra cash flows that result are used to repay the loans. When individuals borrow to spend, loans can only be repaid out of reduced future consumption.

One of the reasons we are in such dire straits is that consumers have already borrowed and spent too much. Many did so based on the false belief that ever-appreciating real estate would ultimately provide the means to repay their debts and finance their lifestyles. Now that reality has finally set in, why should the spending spree continue? The fact that a GDP comprised of 70 percent of consumption is currently contracting should not surprise anyone. In fact, such a contraction is long overdue and the government should not do anything to interfere.

In trying to perpetuate the illusion, the government wants to revive the spending spree that has led us to this disaster. But how can such actions possibly help? How will more debt improve the economy? Wouldn't our circumstances be vastly improved if we paid off some of our debts and replenished our savings? Wouldn't we be in better shape if instead of buying more stuff we concentrated on producing it?

The unpleasant reality is that years of bad monetary and fiscal policy have over encumbered our economy with debt and undermined our industrial capacity. The sooner we can begin to repair the damages, the sooner we can right the ship. If instead we merely administer more of the same, the ship will sink in a sea of inflation.

Comments

[xerxes317:]

I agree we are in deflationary period but as they keep printing more money the less valuable the currency will be worth. In turn things have a lower price but with money being worth less the rsult in real terms is inflation. Such as the german marks were after WWI. The currency problem is illustrated by the dramatic sell off by foreign governments and institutions in the T-Bill and bond markets.

Jan 18 09:26 AM

[khl:]

But now GMAC, Chrysler, American Express and a whole host of other companies are now bank holding companies. These guys are out there lending as their purpose is to sell cars, increase credit, etc. Eventually that new money is going to find its way into the world and when it does, watch out. The fact is, no fiat money ever lasts indefinitely. Eventually it collapses. Go back in history. The dollar will be no different. Once the politicians get their hands on the money supply its just a matter of time. And how much longer are the Chinese, Japanese and Arabs going to keep taking our green stamps? No hyper inflation is coming and it will be here sooner rather than later.

Jan 18 09:44 AM

[Crude Oil T...:]

Peter is dead on when he says we need to produce. It is that simple people. You need to produce something here in the U.S. that another American needs and sell it to them. It is that simple! We have become the new Europe. Europe relied on the little worker bees in the U.S. and imported workers to rebuild after World war II, mostly from Turkey. Now we have raised multiple generations of young people that are to good or important to work. China is our worker bees and we are importing our labor from the south. That is where all of our wealth is headed. Throw in middle east oil, what do you expect. Maybe we could start with becoming a natural gas exporter, can you just imagine!

Jan 18 10:07 AM

[patio:]

Not at all true. Our currency is holding its value, increasing actually, and T-Bills are still being purchased. The world has voted with all our problems, we are still a better bet than the Euro, etc.
Right or wrong, the smart money is betting on the US.


On Jan 18 09:26 AM xerxes317 wrote:

> I agree we are in deflationary period but as they keep printing more
> money the less valuable the currency will be worth. In turn things
> have a lower price but with money being worth less the rsult in real
> terms is inflation. Such as the german marks were after WWI. The
> currency problem is illustrated by the dramatic sell off by foreign
> governments and institutions in the T-Bill and bond markets.

Jan 18 10:28 AM

[Big K:]

Clearly when you produce goods to make money long-term, such as cars, TVs, drugs, etc. you can't steal so easily. You actually have to know what you are doing to survive and make sacrifices. It takes time and care to build such a business. Instead, America went to handling money as a way of making money. This has two benefits. It allows the theives to steal the money by selling crap, ie bundled mortgages, CDO, CDS and other fabricated derivative swindles. These schemes also can be set up quickly. Afterall, it's just paper. After Enron became largely a trading company, then it became a scam house. Once we let the masters of Wall Street become traders of mortgages, oil, commodities, stocks, now they are scam houses. It's time to get back to basics as the article says. Let's make some needed products and stop borrowing. This should hold for the government as well. There is no reason why we should allow the government to keep borrowing money in good times and bad. Once we put a stop to that, in addition to the above, America can heel.

Jan 18 10:30 AM

[surgcare:]

I believe we're entering a new paradigm which will need a new name such as " Deflationary hyperinflation" to describe this new phenomena . That is where things such as homes , autos , TV's ,general merchandise is in deflaion but things such as commodities , food , energy ,building materials become expensive or inflationary , that is things peope need will be in inflation and things we don't need will be in deflation .

Jan 18 10:58 AM

[Prudent Man...:]

Stagflation anyone?

An economy is only as good as what it produces not what it consumes. It would be Utopian if no one had to work and that all we had to do is consume.

Hate to mention that there isn't any Santa Claus regardless of what Socialist Paul Krugman, economic adviser to Enron, writes!

Jan 18 11:44 AM

[anarchist:]

Yes, I like that term, let's give it an acronym such "DH" as Americans don't like to make the effort to use correct terminology so this is an acronym they can use at cocktail parties to show that they are financially hip. I live in Mexico and so far I have seen nothing except inflation. There may be deflation in Mexico but I am not seeing it, food prices are up, school fees are up and energy prices are up, real estate depends on location. I live on the Southern Baja peninsula and prices here are not necessarily representative of those on the mainland.


On Jan 18 10:58 AM surgcare wrote:

> I believe we're entering a new paradigm which will need a new name
> such as " Deflationary hyperinflation" to describe this new phenomena
> . That is where things such as homes , autos , TV's ,general merchandise
> is in deflaion but things such as commodities , food , energy ,building
> materials become expensive or inflationary , that is things peope
> need will be in inflation and things we don't need will be in deflation
> .

Jan 18 01:23 PM

[Rob Viglione:]

Do lenders in Zimbabwe have a higher propensity to lend? Is that why Mugabi's government is printing trillion denominated bills? Hyper inflation comes from government printing, not bank lending or velocity of money increases. Just plain and simple printing.


On Jan 18 09:24 AM patio wrote:

> The great Irving Fisher agrees, George. You cannot get inflation
> when lenders won't lend ( or at least go back to sane criteria )
> and borrowers neither qualify nor WANT to borrow. All the inflationista's
> have the same argument, but, but, they are printing so much money.
> But thus far, no velocity increase- we should have seen something
> by now, eh?
> The other kind of "inflation", goods increase in price, would come
> from our dollar devaluing vs. other fiat currencies. Not happening
> either.
>
>
>
> On Jan 18 08:49 AM George Kesarios wrote:

Jan 18 04:35 PM

[Rob Viglione:]

Even more importantly than producing things American want, we need to produce things of value to consumers in other countries. This is the only way to repay our debts through decades of trade deficits. Foreigners hold our paper for a reason, which is to reclaim a portion of our national output at some time in the future.


On Jan 18 10:07 AM Crude Oil Trader wrote:

> Peter is dead on when he says we need to produce. It is that simple
> people. You need to produce something here in the U.S. that another
> American needs and sell it to them. It is that simple! We have become
> the new Europe. Europe relied on the little worker bees in the U.S.
> and imported workers to rebuild after World war II, mostly from Turkey.
> Now we have raised multiple generations of young people that are
> to good or important to work. China is our worker bees and we are
> importing our labor from the south. That is where all of our wealth
> is headed. Throw in middle east oil, what do you expect. Maybe we
> could start with becoming a natural gas exporter, can you just imagine!

Jan 18 04:40 PM

[Rob Viglione:]

The "smart money" usually bets against the crowd.


On Jan 18 10:28 AM patio wrote:

> Not at all true. Our currency is holding its value, increasing actually,
> and T-Bills are still being purchased. The world has voted with all
> our problems, we are still a better bet than the Euro, etc.
> Right or wrong, the smart money is betting on the US.
>
>
> On Jan 18 09:26 AM xerxes317 wrote:

Jan 18 04:43 PM

[Glen L.:]

I wonder how many of the commenters here have personally relied on credit to finance a lavish lifestyle. Can we have a show of hands, please?

I've had the experience of running up huge credit card debts after starting up my business, which suffered from a lack of clients for a couple years. Far from financing a lavish lifestyle, on a couple of occasions I used credit cards to buy groceries. It was a terrible time of late payments, overlimit fees, dunning phone calls, exhorbitant interest payments -- in short, a time of fear and loathing and constant worry.

If only our Congressthings and the cartel bankers had to experience what I went through when they borrow and spend like there's no tomorrow. Ah, but there is no such thing as cosmic justice.

Jan 18 06:09 PM

[John Lounsbury:]

Peter - - -

I have taken issue with some of the positions you have taken (in other articles), but here I am enthusiastically in agreement. You wrote three questions (I inserted the numbers):

"1. How will more debt improve the economy? 2. Wouldn't our circumstances be vastly improved if we paid off some of our debts and replenished our savings? 3. Wouldn't we be in better shape if instead of buying more stuff we concentrated on producing it?"

I won't repeat what I have written in other comment streams and see by others here and elsewhere. BVut I do want to answer the questions.

1. More debt can not improve the economy unless it is undertaken to create means of production. Debt to finance (leverage) more debt and debt to finance consumption will be destructive.

2. Yes.

3. Yes.

Weel written article and well argued position.

Jan 18 07:53 PM

[Smarty_Pants:]

"3. Wouldn't we be in better shape if instead of buying more stuff we concentrated on producing it?" - John L.

Equally as important is the fact that the "stuff" we produce has to be something that consumers need. If I were to borrow gobs of money to produce buggy whips I would probably go bankrupt before long. Borrowing for any old 'productive' business won't help if the "stuff" produced isn't high on the list of necessities for consumers (remember they're saving more and only buying 'stuff' they gotta have).

This is part of the problem with trying to build an economy with credit. If the FED, via banks and low interest rates, are lending money for any 'productive' business at all, then a lot of that lending is going to be for naught and it will wind up wasting limited resources in the attempt. The result will be more deleveraging as those failed productive businesses are liquidated in the future.

Artificially low interest rates spur borrowing for enterprises which might not be tried if higher rates were the norm. This is the source of economic mis-allocation which winds up costing the economy in the long run.

'Production' for production's sake isn't much better than borrowing for consumption. The production must be goods and services that are most desired as 'necessary' by the consumer for the borrowing generate a lasting enterprise and make economic sense.

Jan 18 08:32 PM

[happysoul77777:]

PS has no credibility. His arguments are mostly irrational.

Just imagine the world where consumers cannot buy houses,cars, TVs, etc. using credit.

Does anybody like to live in Russia? They use little credit!

Jan 18 09:12 PM

[Hmm?!:]

That was the world. I do not have to imagine it.


On Jan 18 09:12 PM happysoul77777 wrote:

> PS has no credibility. His arguments are mostly irrational.
>
> Just imagine the world where consumers cannot buy houses,cars, TVs,
> etc. using credit.
>
> Does anybody like to live in Russia? They use little credit!

Jan 19 01:38 AM

[Econ 101:]

Paulson and Bernanke and Pelosi have sold us out to the chinese. They will forclose right after the hyper inflation and riots of 2010.

While I dont think PS is all that accurate, I figure it is because he is holding back because the truth wont sell very well to most of his readers. Keep tryin'

Jan 19 02:40 AM

[Did U Think...:]

Why does it always have to be one or the other with people. People are saying either deflation or hyperinflation. The truth is that they will both happen in succession.

Inflation is an increase in the supply of money and credit relative to goods for sale. Deflation is a decrease in the supply of money and credit relative to goods for sale. Banks are getting killed right now. In addition, consumers are losing jobs and are hunkering down. Less credit offered + less debt accepted in a debt based economy is going to be deflationary for sure. Asset and commodity prices of all types reflect this. It's a great time to buy a used yacht in Florida!

But some day, perhaps 12-36 more months out, banks will have gotten nationalized, consolidated, etc. and will try to make money again. That means they will need to loan. These loans will occur on a higher money base than before. This will lead to significant inflation if not hyperinflation. If at the same time the gov't continues spending like crazy and actually printing money then money printing could actually become a larger part of the money supply growth relative to credit than before and that will clearly be strongly inflationary. With credit people assume the money supply is just more flexible. It expands when people borrow and contracts when they pay off debt (or default). But when the gov't prints money it is forever.

Jan 19 03:12 AM

[ustaad:]

We have to think about credit as a continuum, not as a 0 or 1 game. There are critical parts of our economy that are dependent on availability of credit (short term borrowings by GE, IBM or other blue chip companies; states/municipalities financing infrastructure spending). On the other end of the spectrum, there is irresponsible use of credit by a section of consumers. I'm not even sure I would call all forms of consumer credit as bad or irresponsible.

We need credit to be free flowing but at the same time have to ensure it never becomes cheap as in recent times. If the cost of credit is appropriately high, it should automatically take care of a good chunk of the credit excesses that the article warns us about.

Jan 19 09:21 AM

[Conan the B...:]

"Credit is indeed vital to an economy but it does not constitute an economy within itself".

Of course, it does. Our economy is Service oriented and Credit is the lifeblood of a Service oriented economy.

Tight Credit standards, whether to consumers or Businesses, cut the supply of blood to the entire body.

Cut the supply of blood too much and the Body will Die.

The current influx of money is a transfusion to replace the blood loss resulting from the wounds given the Economy by the Financial Institutions.

Another Transfusion is on the way. Hopefully the patient will recover sooner than later. But there is a very big difference between recovering and restoring the old euphoria which was created by too much blood flowing through the system.

LOL on your timing of same.

Jan 19 07:01 PM