Root Cause of the Recession: Bad Consumer Credit

A simple explanation of the cause of the current economic problem: For 25 years, we have had enormous increases in consumer credit, much of which was neither necessary nor could the consumer pay back. When these consumer loans started going massively unpaid, the crisis erupted and it has led us to deflation of prices, which has led to recession and probably will end in depression.

A more professional explanation of the cause for the economic problem: Economists, particularly at the Fed, focus on the “private credit aggregates”, which includes all household and non-financial company debt used to finance consumption and investment (mortgages, auto loans, home equity loans, credit cards, etc). Then economists compare this to the nominal GDP (gross domestic product).

For 30 years, from 1954 to 1984, there was an extremely close relationship between private credit aggregates and GDP. (Go to the underlying article by Richard Clarida to see the chart demonstrating this.) In 1984, $3.5 trillion of nominal GDP was supported by $3.5 trillion of private credit outstanding.

By 2007, $14 trillion of nominal GDP was supported by $25 trillion of private credit outstanding. By 2007, we had nearly double the amount of private credit as a % of our GDP. We believe much of this excess to be unproductive debt which simply could not be paid back. This is the problem.

This unproductive credit is the reason for the crash of 2007 which continues today and will continue for at least some time more. The break with the traditional relationship of private credit with GDP is the indicator that we were getting too much bad consumer credit.

Today we know that bad credit as liar loans for home mortgages, adjustable rate mortgage loans where after a couple of years the rates went to levels that simply were not payable by the borrowers. As the increase in house value exploded upward, consumers took out home equity loans to spend on vacations. Virtually everyone assumed the increase in real estate was a permanent increase in wealth and therefore one could spend more and borrow more because the consumer was rich enough to afford it. Consumers took the attitude the credit card debt could be thought of as sort of permanent financing which did not really need to be paid off.

Then smart guys on Wall Street invented ways to make it easy to grant credit (mortgage backed securities guaranteed by companies who did not have the ability to honor their guarantee (AIG and bond rating agencies) and erroneously rated the debt as triple A credit.

This creative Wall Street financing made it possible for inherently bad loans to get financed. This is the imprudent and unproductive consumer debt that has led to the current crisis.

The next question is, logically, if we had the economic indicator, why are we talking it about it only now? Why didn’t someone sound the alarm? The simple reason is that the economists took their eye off the ball. The economists simply did not take seriously the private credit indicator.

But there were several specific reasons for not following the indicator. First, private credit and monetary aggregates have lot in common as indicators. But monetary aggregates were going through a transformation. monetary aggregates, which include checking, time and savings deposits in banks, used to be a pretty good measure of the amount of money in the economy.

But this was before we got securitizations which are bank type loans but outside the bank system. In the early 1980s, the only securitized loans were some mortgage backed securities. The shadow banking market which we have today did not exist. As a result, monetary aggregates and private credit were nearly the same in the 1980’s but they very vastly different by 2007.

Furthermore, economists were in practice basically only tracking inflation and the increase in the GDP. Since other indicators seemed to be better predictors of inflation and GDP, economists seemed to have stopped looking at private credit. This was a serious mistake.

Summarizing, 25 years ago private credit started growing much faster than GDP. This led to an immense amount of bad credit that had to explode at some point. The housing market started exploding in 2005 and the financial markets in 2007. We are now in the process of normalizing our credit with all the adverse attendant consequences. When the consumer credit market stops working, it ultimately takes with it manufacturing, finance and other dependent sectors.

Two economic realities fall out of the decline of consumer credit. They have serious ongoing consequences for the economy.

1. Deflation is here and has much further to go. While many thought deflation was not possible, it is not only possible but it is currently a primary factor in understanding much of what is happening in the economy. For a free, outstanding description of “deflation”, get Bob Prechter’s description of deflation here. Relevant points: Deflation is always initiated by credit excesses, which we clearly have now. Webster defines deflation as a contraction in the volume of money and credit relative to available goods. That is to say, price declines are a consequence of less money and credit for the same amount of goods. This has important consequences in coming months for the value of all asset classes, including housing, commercial real estate, gold, oil other commodities as well as stocks and bonds. They will all being going down as result of a reduction in available private credit. While inflation, even hyperinflation (because of the government stimulus program) may be a problem down the road, for the coming months, maybe even a year or two, holding long any of the asset classes mentioned above is likely to cause a reduction in your net worth. This writer believes we are currently in a bear market rally and we will soon see the ongoing deflation effect lead to much further declines in the price of all asset classes. This view has technical support in that there are clear signs the private credit will continue the make important reductions in the quantity of credit in spite of the government economic stimulus plan.
2. The government economic stimulus will largely fail. While the government is putting various trillions of dollars into economic stimulus, the reduction of private credit is in the tens of trillions and this makes economic stimulus look puny in terms of the market generated loss of private credit. There is not enough government money to recover the loss of private credit. This writer, perhaps erroneously, believes he has a unique insight which he calls the “Wood Limitation to Economic Stimulus”. This rule says that government economic stimulus will work at the beginning of the economic cycle and in the middle where additional credit will be found for productive investment uses. But at the peak of the business cycle, most useful applications of credit have been found and additional money goes to unproductive uses, condemning them to failure. A New York Times article perfectly illustrates the problem. The article says if we use the new mortgage lending guidelines, we are not going to have much lending. The implicit suggestion is that we ease up on the lending guidelines, but the problem is that we will just generate more bad credit with lax credit standards. The “Wood Limitation” explains why former Fed Chairman Alan Greenspan talked about conundrums (referring long term bond rates not following short rate increases) and Paul Krugman in his recent book “The Return of Depression Economics” says wistfully that economic stimulus “sometimes works and sometimes does not work”. At this point in time, much of the stimulus money of the government will inevitably go to non productive purposes because we are at the end of an historic business cycle.

This writer believes the undue expansion of consumer credit, and the resulting unproductive credit that cannot be paid, is the simple explanation for the economic problems we have today. We were happy to see the prices go up, particularly our housing, because we felt rich.

But we are shocked when the bad credit explodes and the economy starts to right it itself to the new reality, including job loss and the decline of our asset values which makes us much poorer. More prudent government management of the economy could have avoided both excesses, i.e. the artificial high from excessive credit and the terrible collapse from the resulting bad credit.

We need widespread agreement that greatly increased bad consumer debt is a root cause of our current problems, and that bad credit leads to the deflationary effect on prices. If we can agree on that, we would probably hold better public discussions on the best actions for government to take to deal with the problem.

This article relies heavily on information taken from an outstanding article written by Richard Clarida of Pimco. I recommend you read his more professional telling of the facts.

Comments

[Dave Wrixon:]

Yes, but it may be too simplistic just to blame the consumer. Government and Business has been equally reckless in borrowings.

Jul 26 04:13 AM

[Dave Wrixon:]

"This has important consequences in coming months for the value of all asset classes, including housing, commercial real estate, gold, oil other commodities as well as stocks and bonds. This has important consequences in coming months for the value of all asset classes, including housing, commercial real estate, gold, oil other commodities as well as stocks and bonds."

This statement simply ignores the existence of other economies, the demand they have have on global resources and the impact on foreign exchanges, and in turn the impact that will have on the US internally.

Jul 26 04:21 AM

[Dave Wrixon:]

Having made those criticism the broad thrust of the article is pretty accurate, I am just not convinced that the deflationary argument will hold true, indeed I am increasing led to believe that Deflation is a Bogeyman that is simply being used to justify the otherwise unjustifiable.

Jul 26 04:24 AM

[James Wood:]

A critical piece of logic in this article is that deflation is really mathematical. Reduce the total money suply for a fixed of amount of assets, and prices will go down. While it is true there is a lot of money outside the US, most of these markets are having the same problems as the US. This is particularly true of Europe. Spain,England, Ireland have the same and even worse problems in real estate. Much of Europe has lent heavily to Eastern Europe, partiuclary Austria and Germany, where there is soon to come much loss on these loans. Only in Asia, partiuclarly China, and perhaps Brazil, do we see signs of realtively early recovery and lesser losses going forward. On balance, the rest of the world will reinforce, not short term reduce, the deflationalry effect on the US.


On Jul 26 04:21 AM Dave Wrixon wrote:

> "This has important consequences in coming months for the value of
> all asset classes, including housing, commercial real estate, gold,
> oil other commodities as well as stocks and bonds. This has important
> consequences in coming months for the value of all asset classes,
> including housing, commercial real estate, gold, oil other commodities
> as well as stocks and bonds."
>
> This statement simply ignores the existence of other economies, the
> demand they have have on global resources and the impact on foreign
> exchanges, and in turn the impact that will have on the US internally.

Jul 26 08:49 AM

[Gregman2:]

What caused the necessity of such massive borrowing in the first place? "This writer believes the undue expansion of consumer credit, and the resulting unproductive credit that cannot be paid, is the simple explanation for the economic problems we have today." I think if you go back and look at the origins of off shoring (especially with the advent of the big box stores), you'll see that a decline in real wages may be linked to this increase in borrowing.

Jul 26 12:08 PM

[lynnybee:]

O.M.G. ..... these are the kind of articles that set me boiling mad. Why are there no articles written regarding the REAL reason that the average person is in debt! ..... the average person doesn't make enough in WAGES to even live a simple independent lifestyle! If you are a young person nowadays how do you afford rent + auto expenses + utilities + food + cell + gas + unexpected expenses related to health & auto ? ......... the real reason that people are in debt is because they do not make enough in wages and use credit out of desperation to just meet daily needs.

Twenty-five years ago no one was in debt ! Twenty-five years ago I was earning $15/hour working for the airlines. Twenty-five years ago I paid $8 for an office visit to my doctor. (Hospitals & utility companies were called "community services" with no profit motive.) Twenty-five years ago .......... RONALD REAGAN & ALAN GREENSPAN. Once this market is at it's ultimate bottom, it will be 25 years ago & certain people sure did make a lot of money......... just not the average person.

The average person was forced into credit out of desperation because of low wages. The big banks knew it, took advantage of it & deliberately targeted the American Public. We were targeted, plain & simple.

What goes around comes around.

Jul 26 12:44 PM

[Valley Boy:]

You are exactly right. I'll add that the young people I know are saddled with student loan payments since the powers-that-be at the educational institutions kept raising the tuitions over the years.
I have to wonder if the younger generation is going to support the stock market and Social Security.


On Jul 26 12:44 PM lynnybee wrote:

> O.M.G. ..... these are the kind of articles that set me boiling mad.
> Why are there no articles written regarding the REAL reason that
> the average person is in debt! ..... the average person doesn't make
> enough in WAGES to even live a simple independent lifestyle! If you
> are a young person nowadays how do you afford rent + auto expenses
> + utilities + food + cell + gas + unexpected expenses related to
> health & auto ? ......... the real reason that people are in
> debt is because they do not make enough in wages and use credit out
> of desperation to just meet daily needs.
>
> Twenty-five years ago no one was in debt ! Twenty-five years ago
> I was earning $15/hour working for the airlines. Twenty-five years
> ago I paid $8 for an office visit to my doctor. (Hospitals &
> utility companies were called "community services" with no profit
> motive.) Twenty-five years ago .......... RONALD REAGAN & ALAN
> GREENSPAN. Once this market is at it's ultimate bottom, it will be
> 25 years ago & certain people sure did make a lot of money.........
> just not the average person.
>
> The average person was forced into credit out of desperation because
> of low wages. The big banks knew it, took advantage of it & deliberately
> targeted the American Public. We were targeted, plain & simple.
>
>
> What goes around comes around.

Jul 26 01:32 PM

[jerrydd:]

Of course Gov debt, war, lax regulation, energy policy and wall street had nothing to do with it!!

Give me a break, other than the last 4 yrs of Clinton, real income has dropped for 30 yrs!!

The wealth has went from regular people to the rich. How come the rich pay 22% of income vs 29% for the middle class?

Real inflation is several times official 'corrected' inflation.

So let's put the problems blame where it lies, in the national debt, tax, energy, war and lax regulation of the republicans who have either been in charge or kept reform, a balanced budget from being or staying in place!!

Jul 26 07:54 PM

[perceptions...:]

We are just past the Peak of the biggest Credit binge in history and it will take quite some time to find a new equilibrium!

So, Credit was/is one of the causes of this downturn, but it is also a symptom as well.

At the core of these current issues, are the twin Peaks of past growth, Oil & Population growth.

We have scaled these Twin Peaks, to the very top, because we could; and now we are decending the other sides.

Given that Oil has Peaked & the Population is about to Peak, after a once in history aging of Baby Boomers, the question is what unknown innovation &/or new Energy supply, comes next, because another population explosion is not going to coming to the rescue!

Jul 26 09:49 PM