The crisis deepens and politicians still don’t get it

24th November 2008

Its extraordinary. The Credit Crunch ‘debtonated’ on 9th August, 2007. Today, fully fifteen months later politicians and policy-makers in both the US, the UK and Euroland are still facing crises at banks – and don’t appear to grasp the real nature of the crisis, addressing symptoms instead of causes.

So far, their recapitalisation of banks and injections of liquidity have failed to halt the slump, and once again this week is dominated by the news that a bank too-big-to-fail – Citigroup – has effectively been nationalised by the US government.

Lets try and help politicians and policy-makers, by detailing the causes of the crisis in laywoman’s terms. After all, it is not very complicated.

First and foremost this is a crisis of indebtedness. Probably the most severe debt crisis we have known. That much should be obvious. The Anglo-American economies are rapidly being suffocated by a thick blanket of debt, the result of the bursting of what must surely be the biggest credit bubble in history.

The bursting of the credit bubble led to the bursting of other asset bubbles – most notably the property bubble and more recently the commodity bubble.

Some economists treat the property bubble as the cause of the implosion; I disagree. The credit bubble fueled the property bubble, and all other asset bubbles, and it is the bursting of the credit bubble that has led to the bursting of the property bubble – not the other way around.

Indebted individuals and households do not know which way to turn. Their creditors (the banks) are unwilling to write off the debt, and give them a fresh start. High rates of interest on mortgages in both the US and UK mean they cannot easily re-finance their debts. In the US, as Graham Turner notes, the one-year adjustable rate mortgage has actually risen from 6.41% in 2006 to 6.8% today in 2008, despite steep cuts in the Federal Funds rate. Wells Fargo charges 9.87% for so-called jumbo loans of over $417,000!

New buyers find it tough to gain a mortgage, to raise funds for the high deposits now required to purchase a property, and to pay the high rates of interest on mortgages. Demand for loans therefore has plummeted.

The result is highly predictable. High rates mean more and more homeowners are defaulting, hurting their creditors – the banks. Banks foreclose on homeowners, and evict families – hurting families. A glut of properties floods the market – hurting the construction industry. First-time buyers withdraw from the market because of high rates, and because they expect prices to fall further. As a result, house prices spiral downwards, with no sign of stabilising – hurting the economy as a whole.

A similar crisis engulfs the corporate sector. Companies borrowed heavily during the heady days of easy money. Now the rates on long-term loans/bonds are high, and they are unable to re-finance, or borrow afresh. The result again is highly predictable. Corporations cannot roll over debt, or raise funds and are laying off workers and/or going bankrupt. This has led to sharp and quite dramatic rises in unemployment in both the US and the UK.

A combination of rising unemployment and falling property prices are scaring those consumers that still have jobs. They are easing up on consumption, and starting to save.

Governments have helped re-capitalise banks and nationalised a few – but little of this has addressed the cause: the insolvency of individual, household and corporate debtors. The weakness of the finance sector can be explained by the weakness of their debtors – homeowners and employers. Helping the banks, while ignoring homeowners and employers has, not surprisingly, meant no halt to falling house prices and rising job layoffs.

The more house prices fall and unemployment rises, the more harm done to the finance sector. Bailing out banks fails to put a floor under house prices, or to keep companies solvent – and therefore fails to help banks. Indeed quite the opposite is happening.

The bail-outs of banks have been costly – pushing up government borrowing. The more that government borrowing rises, the more that yields on long-term government bonds (e.g. US Treasuries) rise. . This rise in the cost of government debt pushes up the cost on long-term corporate debt and mortgages…making re-financing and borrowing for companies very expensive – at the height of the severest debt crisis in our history!

So government borrowing is having a deleterious effect on long-term interest rates, and therefore on the costs faced by employers and homeowners. This is common sense as long-term borrowing costs are important to new home-buyers, businesses and investors.

This is why a group of us – including Graham Turner of GFC Economics – argue that government spending alone will not address the crisis faced by homeowners and companies. Indeed too much government borrowing might make things far worse – because of the impact on long term borrowing costs.

The solution? Simple. Lower long-term borrowing costs.

This can be achieved by central banks buying up long-term government bonds and thereby lowering the yield on these bonds. This in turn will lead to a fall in the interest rates on long-term corporate bonds/loans.

It’s a far cheaper solution than increased government borrowing to fund tax cuts, or re-capitalise banks – and if carried out in time – might avoid the debt deflationary trap that Keynes warned of, and that Japan fell into in the late 1990s.

As I said. Its not complicated.