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May 20, 2008

Alcoholic fumes

Friedrich von Blowhard writes:

Dear Blowhards,

Someone, I can’t remember who, described The Economist as being an excellent economic indicator. Not because it accurately analyzes the real world, but because it accurately reflects the perceptions of the world shared by our economic elites and governmental decision-makers. So back a month ago, I read with some attention the April 3 edition’s leader titled "Fixing Finance."

For me, the money quote was this:

Finance is a brain for matching labour to capital, for allowing savers and borrowers to defer consumption or bring it forward, for enabling people to share, and trade, risks. The smarter the system is, the better it will do that. A poorly functioning system will back wasteful schemes and shun worthy ones, trap people in the present, heap risk on them and slow economic growth. This puts finance in a dilemma. A sophisticated and innovative financial system is susceptible to destructive booms; but a simple, tightly regulated one will condemn an economy to grow slowly...The notion that the world can just regulate its way out of crises is thus an illusion. Rather, crisis is the price of innovation, so governments face a choice. They can embrace new financial ideas by keeping markets open. Regulation will be light, but there will be busts. The state will sometimes have to clear up and regulation must be about cure as well as prevention. Or governments can aim for safety and opt for dumbed-down financial systems that hobble their economies and deprive their people of the benefits of faster growth. And even then a crisis may strike.

I actually burst out laughing reading this in my family room, causing my dog and my children to look at me oddly. (Don't worry, this happens to me a lot.)

According to the Economist, you can have an innovative financial sector and fast economic growth with a few bumps along the way, or you can have a tightly regulated financial sector and slow economic growth. Oh, and even with your tightly regulated system, you’ll have still have a few bumps along the way, because I guess it’s impossible for regulation to work. Or something.

The oddest part of this diatribe is how it papers over the actual outcomes of our era of innovative finance. After all, in the paragraph above the Economist explicitly lays out the description of a poorly functioning system. It is one that will:

#1) back wasteful schemes – like, say, that subprime mortgages can be carelessly written on the assumption that housing prices will always rise, that consumer spending can be juiced forever with money borrowed via home equity lines of credit, and that leveraged buyouts of deeply troubled companies like Chrysler make sense because the investment banks fronting the debt would make vast sums on the deals and they could quickly sell the high-risk loans to greater fools, um, to other investors

#2) shun worthy ones – like our failure to invest in our manufacturing base, or in our overcrowded airports, crumbling roads and bridges, or in technology that will increase our energy security, or…well, you get the picture.

#3) trap people in the present – like when people are encouraged to buy houses they can’t really afford, only to find that they’re unable to sell or refinance the loan because the price of the house has fallen, and they now owe more than the sucker is worth? You mean trapped like that?

#4) heap risk on them -- check out the rapid rise in consumer and business bankruptcies

#5) slow economic growth -- ha, ha, here we are in the aftermath of our second popped-bubble in less than a decade, trying to figure out if we can find even a sliver of economic growth amid a forest of troubles in housing, employment, manufacturing and retail sales.

So the evidence indicates that our current financial system is a poorly functioning one, right? No, apparently not to the Economist because…well…hmmm…I'm guessing they like hanging out with London bankers who make big bonuses or something.

Ah, those crazy Brits, I thought. How amusingly eccentric.

However, the people who claim that what the Economist says is what the elite among us think apparently know what they’re talking about. A few days later on April 10 our Great Economic Leader, Fed Chairman Ben Bernancke, came out with this speech on "Addressing Weaknesses in the Global Financial Markets: The Report of the President's Working Group on Financial Markets."

And, by golly, Ben is singing from the same hymnal as The Economist! A portion of his remarks:

Healthy, well-functioning financial markets are essential to sustainable growth. In particular, much experience shows that economies cannot perform at their full potential when financial conditions are such as to restrict the supply of credit to sound borrowers. We are addressing these financial strains and their potential economic consequences with a number of tools, including the provision of extra liquidity to the system and reductions in our target for the federal funds rate.

Granted, our economic Supremo goes into a bit more detail than the Economist on how our "sophisticated and innovative financial system" became "susceptible to destructive booms":

Although many factors played a role, to a considerable extent the current problems arose in the implementation of the so-called originate-to-distribute approach to credit extension.

For those coming in late, the "originate-to-distribute" or securitization model is the central financial innovation of contemporary finance. In this approach, the lenders who made home, car, student and corporate loans didn’t hold on to them as investments but sold them to investment bankers to repackage them into securities. The securities were then sold to relatively unsophisticated investors -- like, say, the guys managing your pension fund. The well-paid if not terribly street-smart managers of those investment funds didn’t worry about what they were buying, because poking into the details was hard work and after all those securities were given the highest possible rating by credit rating agencies. Granted, the rating agencies were paid to deliver those ratings by the investment bankers, that is, the people who were selling the goods. This is exactly equivalent to buying a used car from a dealer on the recommendation of a mechanic on the dealer’s payroll, a circumstance which might have given pause to anyone over the age of five but one that didn’t trouble the regulatory guardians of our financial markets. This wonderful securitization system conveniently relieved the loan originators, the investment bankers and, apparently, the credit rating agencies of having to worry about boring details like the actual ability of borrowers to repay the loans in question, as they all got paid richly with fees and tried to keep as little as possible skin in the game. (For the loan originators like Countrywide and the rating agencies like S&P that meant, of course, no skin at all.) The revenues from this process accounted for most of the outsize profits of the financial sector and the rating agencies of recent years. As was utterly predictable, this 'innovation' eventually led to the creation of vast quantities of securities that were packages of toxic waste. (Because the investment banks hadn’t been able to pass off 100% of their exposure, this ultimately led to the massive writedowns you’ve read about over the past 9 months.) But according to Mr. Bernanke, this is a mere glitch in an otherwise nearly utopian system:

This approach has had considerable benefits, including increased access of small and medium-sized borrowers to the broader capital markets, but pitfalls in its implementation are now evident..The originate-to-distribute model thus broke down at a number of key points, including at the stages of underwriting, credit rating, and investor due diligence. Financial institutions were caught, in some cases, by inadequate risk management and liquidity planning. These problems notwithstanding, the originate-to-distribute model has proven effective in the past and with adequate repairs could be so again in the future. [emphasis added]

In other words, Mr. Bernanke wants to get us back as close as we can to the status quo ante of the good old days, say 2006. Granted, he admits in passing that the system is so loaded with conflicts of interest that it broke down at every single point along the chain, but apparently we can fix it all with just a few, albeit oddly unspecified, tweaks.

But this is a mere trifle. The real bone I have to pick with both Mr. Bernanke and the mavens at The Economist is their shared -- and apparently unquestioned -- assumption about the merits of debt. To wit the Economist and, apparently, Mr. Bernanke, seem to believe that more debt is better for our economy than less debt, and the quicker we get back to cranking up the volume on the debt machine the better life will be for all of us.

Is this true?

Let’s look at the evidence. The U.S. has, fortunately for our inquiry, conducted an interesting real-world experiment over the past 50-odd years: we went from using some debt to using a whole lot of debt. A summary of this change is available at the American Institute for Economic Research website.

This website tracks the changes in debt load among a variety of sectors in the U.S. economy: financial intermediaries, households, nonfinancial businesses, the Federal government and state and local governments. Since 1952, every portion of the economy -- except Federal and state governments, has increased their debt load.

(Note that the term "debt load" doesn’t measure the absolute amount of debt, but rather debt as a percentage of GDP. This is a pretty good approximation for the ratio between the amount of debt and the cash flows out of which the principal and interest payments must be made. In other words, this is pretty much the same as describing the size of your car loan or mortgage as a fraction or multiple of your annual income.)

According to the good folks at AIER, non-financial businesses as a group have roughly doubled their debt load over this period; households have roughly quadrupled their debt relative to their paychecks; and the financial sector has increased its debt load by more than an order of magnitude.

From 1952 to roughly 1980 the growth of indebtedness kept roughly even with the growth of the economy; that is to say, the U.S. as a whole maintained a constant debt load during these years. We were living within our means, so to speak. However, starting in 1980 we apparently decided that we’d been far too conservative about debt, and we apparently found ever increasing levels of debt rather sexy. And in the years since 1997, we’ve become true debt junkies.

To get a quantitative idea of the where the increase in indebtedness over the past fifty-odd years occurred, I calculated how much the two sectors that have proven most enthusiastic about debt – households and the finance industry – have jointly increased their debt loads in each of the last six decades. During the 1950s, 1960s and 1970s the debt load for these two sectors rose relative to GDP, albeit at a fairly modest rate. During the 1980s and 1990s there was a significant speedup in the rate with which these sectors added debt. And in this decade, households and the finance industry have added debt at a blistering rate.


But if the Economist and Mr. Bernanke are correct, then this accelerated piling up debt in the past three decades must be a very good thing, economically speaking. Particularly, given the explosive growth in debt over the past 7 years, the American economy should have reached a kind of pinnacle of economic wonderfulness.

To test if availability and use of debt has been good for the economy, let’s look at the annual growth rate of each decade over the past sixty-odd years. As you may recall, a few weeks ago I posted a graph of real (that is, inflation-adjusted) growth in GDP per capita for America over the past few decades.


The reason I chose to focus on real per-capita GDP is that it is widely considered the best single number to suggest the overall wealth of an economy. To evaluate economic growth, I looked at the compound annual growth rate of per-capita GDP for each decade of the past 60-odd years. This annual growth rate in per-capita GDP is the best approximation of how healthy the economy 'feels' -- that is, how rapidly average societal wealth and income is rising, year over year.

Now let’s plot the data of these last two graphs on a single chart. The pink line shows economic growth (with numbers on the left-hand axis), and the blue line shows the growth in indebtedness for households and the finance industry (with numbers on the right hand axis.) What relationship do we see?


I don’t know about you, but these graphs look awfully like inverses of each other. In other words, debt in these two sectors seemed to grow most rapidly when economic growth was slowing, and it rose only modestly when economic growth was fast. I’d have to conclude that the data doesn’t bear out the Economist’s and Mr. Bernanke’s notion that an ever greater load of debt is the fertilizer or driver of economic growth. It's more as if debt is what people resort to when their economic prospects aren't so hot, a sort of Dutch courage for those facing diminishing economic prospects.

Indeed, contra to The Economist, it looks to me as if the increasing profitability of the financial sector over the past three decades, which has been a direct consequence of our tendency to dose ourselves with ever greater hits of debt, has perhaps not really been such a sign of economic strength and sophistication at all.

Graph from Hellasious from Sudden Debt blog

Rather, the strength of our financial sector is a result of how we've chosen to disguise weakness in our underlying economic fundamentals.

Maybe repairing the great engine of securitization and pumping out more debt, which seems to be both The Economist’s and Mr. Bernanke’s great aim, is actually a really bad idea. Perhaps if we are forced to contemplate our economic prospects without the alcoholic fumes of ever-increasing indebtedness we’d get serious about making some better economic decisions. Whereas, it appears, the boys down at the Economist and Mr. Bernanke want us all to have another drink or six. You know, you might almost think they earn their living as bartenders.



posted by Friedrich at May 20, 2008


The tone of this blog post strikes me as paternalistic. It makes me cringe.

If people out there want to go into debt and someone is willing to give them a loan, so be it. And there are people out there who do want to go into debt because they strongly value living in a nice home, or they want to take a chance at starting a business, etc.....

Are you really arguing we should impose barriers on financial markets to limit individual debt so we can invest in our struggling manufacturing base and bloated aviation industry????

Yeah, I'm sure most people would be more than willing to move out of there houses into apartments so JFK can get an expansion and GM given a blank check.

The bottom line: I don't think Americans will give up their ability to finance their lives for the purpose of more centralized planning.

Posted by: thehova on May 21, 2008 2:25 AM

This is a very well-written post; shame it won't get as much play as the booty-shaking post (but hey, economics isn't sexy!).

The analysis of our economic situation, I believe, confirms some of the things some of our Depression-era grandparents taught us about never getting into debt. It's a shame leading economists didn't learn these lessons, and ironic because Ben Bernanke is supposedly a Depression Era historian.

Posted by: Days of Broken Arrows on May 21, 2008 2:49 AM

Right on Fred! Sometimes you make me wonder...

Posted by: SFG on May 21, 2008 11:12 PM

DOBA, one thing that I will say about Friedrichs eeconomic/financial posts is that they are very long.

And, a long post on why some film director is great is very different than a long, analytical piece dealing with real numbers, real things and possible policy implications.

Don't get me wrong. Friedrich does a great job, but ...

breaking these types of posts into smaller pieces might be helpful. Also, he could add teasers and cliff-hangers.

It will be just like watching House or Lost.

Posted by: Ian Lewis on May 22, 2008 8:56 AM

I enjoyed the depth this post got into. What I find depressing is why this isn't taught in school.

I'm convinced Frank Zappa was right when he said in school they teach you just enough to learn how to get a job to produce useless crap people can buy, and they don't really want you to think.

Not everything is bite-sized in life. Anyway, the graphic that criss-crosses economic growth with debt is frightening, considering debt is crushing everyone now.

Thank God I listened to my grandfather and not my status-conscious Yuppie parents as to how to live my life financially. Those Depression Era-types had it goin' on!

Posted by: Days of Broken Arrows on May 22, 2008 3:21 PM

I liked this post despite & because of its length. Part of our problem, I submit, is that citizens are unwilling to try to understand any problem that takes longer than ninety seconds to analyze.

Maybe if folks actually read their mortgage applications, or those 30 page agreements that came with their credit card approval letters, we could have had slow, steady growth without government regulation.

Posted by: Nate on May 23, 2008 12:36 PM

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