Sunday, October 5, 2008

Til Debt Do Us Part

One of the most often repeated responses to the current financial crisis goes something to the effect of why can't people just stop borrowing like there's no tomorrow and live within their means. This is a response that I am inclined to agree with. Often, however, this principle of sound household management is then applied to business, which is a mistake. The fact of the matter is that not all debt is created equal.

Most would agree that no debt should be incurred unless there is a reasonable expectation that it can be repaid. This is a standard that can be applied to both individuals and businesses. Implicit in the judgement as to whether or not a debt can be repaid are assumptions about future prices and income. In both the short and long run, these types of predictions are difficult to make with much certainty. Given this, it is prudent to always tend toward the conservative side when making forecasts about future prices and income.

Clearly, this was not happening in the mortgage markets. This fact is at the heart of the problem and we are all suffering for it. The thousands of small, individual decision made about lending over the last several years have brought us to this point. Some previous economic theorists have espoused the notion that private vices breed public virtue. That is to say, individuals serving their own self-interest in pursuing profit, will increase the material well being of all by increasing total economic output. I am not sure the current crisis totally discredits this notion, but it certainly gives one pause. In it we have a demonstrated cases where individuals, making decisions in their own interest, have actually subtracted not added to the total economic activity. In fact, individuals have traded personal, short term gains for the well being of the whole. Certainly somewhere there was a mortgage lender, investment banker, CEO, etc. who thought I can do this because it is just one little loan, but if everyone did this it wouldn't work. Well, apparently everyone was doing it.

The consequences of the course pursued in mortgage lending are broadly distributed and visible to most, even if the causes of what is happening are less so. An understandable response to irresponsible lending is to clamp down on lending. The problem lies in the possibility of this restriction of lending going too far. Resulting in a situation where no bad loans are made and no good ones either. This situation will only worsen our economic circumstances, not improve them.

Credit Where Credit is Due
In any society there are going to be people who, for whatever reason, have a substantial amount of financial resources. There will also be those people or groups of people that have ideas & know how. These could be ideas about a new product or service or a better way of doing something. These ideas could be as simple as recognizing an un-served market (nothing groundbreaking there, just realizing there are some people willing to buy something that no one is selling them). In almost every case though, it takes money to put these ideas into action.

A market based system relies on the ability of the people with the ideas to borrow from the people that have money. Without this mechanism, only those that have financial resources to start with would ever be able to put their ideas into action. It's not hard to see how this situation will lead to a less than favorable outcome. Even without central planning, an economy run in this manner may end up looking like that of the Soviet Union - never enough of what people want and need. Additionally, an economy run like this is in direct opposition to a core American value. Namely, a value that recognizes that good ideas can come from anywhere, not simply from those with money.

The danger with a credit contraction then, is that the people with the good ideas, those that will be profitable and add to economic growth, won't get the money they need to put their ideas to work. This is a situation that affects the start of new businesses and the growth of existing ones. It is by and large, a long-term phenomenon though. Every business venture that doesn't start today, won't affect today's economy, but these missing economic players will affect the economy of tomorrow. There is another side to the credit crunch, one with more immediate impact.

Some of the reporting on the economic crisis has included the information that it was the state of the short term credit markets that convinced the Treasury and the Federal Reserve that they had to act. This short term credit market is where businesses can access money to meet immediate cash needs. This is a market that has functioned very well in the past, was very liquid, and was seen as very safe since defaults on these short term loans were relatively rare.

But why should businesses need short term loans, don't they have enough money to pay their bills? The short answer here has to do with the lag between the time businesses make something and the time it takes to get paid for it. A simple example would be a firm that manufactures some item. The firm receives an order for its goods, buys the raw materials, completes the manufacturing process, then collects payment for the goods. This is not an instantaneous process. In most cases, the raw material supplier and the workers that perform the manufacturing demand payment before the firm is paid. Even Wal-Mart has to buy the merchandise they put on the shelves (and pay the people to put it there) before you go to the store and buy it.

But why can't the firm just put away cash during those periods where payment from their customers exceeds debits from suppliers and workers? They can, and some do. Every business has to make decisions about its cash holdings. Some firms also realize that cash is another product that they have to sell. That is to say, if they have more than they need, they can lend it to businesses in need of cash and make a profit. This is where those short term credit markets come in. Businesses turn to these markets to let their excess cash turn a profit and to borrow cash for those short-term periods where costs have been incurred, but payment from customers just hasn't been received yet. If over the long run, the payments received from customers are not enough to pay back the short term borrowing and secure a profit for the firm's owners, the firm will cease to be in business. But the fact that the firm has to do short-term borrowing during the course of business, is no reason to think that the firm shouldn't exist at all.

No doubt there are many businesses of all sizes out there that do not need to turn to these short-term credit markets ever. But for those that do, these markets provide a valuable resource and contribute substantially to overall economic production.

If these credit markets, both short and long term cease to extend credit to people and businesses with good ideas the economy will suffer, which means that ultimately, people will suffer.

A Debt in the Family
This defense of debt in the business community should not be used to defend household debt. Within the restrictions noted above (reasonable expectation of repayment, conservative estimates about the future) households should be able to incur some debt. What we have seen over the last few years though, doesn't come close to meeting these restrictions.

Entering into adjustable rate mortgages whose payments exceed monthly income, wiping out all (and in some cases more than existed) home equity, and an addiction to credit card usage. These are just some of the despicable and dangerous behaviors that US households have engaged in over the last few years. Let's face it, putting your home up as collateral on a loan to buy a plasma television, botox, or a trip to Disney World is so stupid it approaches criminality. And this is exactly what many of our fellow Americans have done. These actions are not sustainable and it would appear the bill has come due. While I hope that thrift will once again be a trait both demonstrated and imitated by households throughout the county, I am not convinced we are on the verge of this becoming a reality.

Before any change in the way US consumers use credit can take place, individual people and households have to recognize and accept their role in this crisis. I don't believe this recognition will ever take place as long as leaders refuse to confront people with their individual responsibility and instead offer alternative explanations for the crisis. Unsurprisingly, this refusal to tell it straight affects people throughout the political spectrum. Sadly, if individuals cannot come to grips with their own role in this, meaningful and valuable reform to address the problems in the financial sector and the economy as a whole cannot and will not take place.

This discussion has focused on households and businesses. The government obviously has a role to play in coming to terms with its own attitude toward debt. But in the midst of this crisis, it would seem that the correction of this problem requires the immediate attention to be paid to households and businesses, that is, individual Americans. Only when we put our own houses in order, will we be able to put our national house in order.


Anonymous said...

I have enjoyed reading all your blogs and slow to say so. I have learned from them as well. I am impressed with your writing, your insights, and your common sense approach. And it makes me wonder if you've considered writing a book. I also know about and appreciate your sense of humor. Maybe you could combine humor and crisis and make us laugh to feel better if we're crunched by the economics of today.



GGS said...

I love your literary allusions, and also, though I've forgotten to say so until now, the name of your blog.

This entry is very interesting, as to the steps and sequences that have to happen in order for the economy to be sound.


Joe said...

I should've bought all the cool toys and deck my house with plasma TVs. Then I could've have my Countrywide adjustable mortgage terms adjusted when I stopped paying the bill. Seems like I'm getting screwed. :(