Credit Must Stop

By: David Saied

If you read the newspapers, or watch the opinion of politicos, mainstream financial and so called economic “experts”, you would believe that the current crisis will only get better when “credit eases” and begins “flowing back again”. Most politicians and high ranking government officials, from Congress to the White House, from the Fed to the Treasury, repeat this mainstream siren song; they claim that the problem with financial markets and the economy is that credit has tightened and that this will prolong or deepen the recession if government does not intervene to ensure that credit “unfreezes”. However, contrary to what mainstream economists and politicians say, the current problem is not lack of credit but exactly the opposite; the current problem is that all sectors of the U.S. economy have become highly overleveraged. Therefore, the quickest way out of the current economic malaise is to allow banks to act according to their better business sense and stop credit to firms and households that have too much debt.

Federal Reserve Chairman, Ben Bernanke, in a speech on December 1, 2008 at the Greater Austin Chamber of Commerce said:

To offset to the extent possible the effects of the crisis on credit conditions and the broader economy, the FOMC has aggressively eased monetary policy.…that offset has been incomplete, as widening credit spreads and more restrictive lending standards have contributed to tight overall financial conditions. In particular, many traditional funding sources for financial institutions and markets have dried up, and banks and other lenders have found their ability to securitize mortgages, auto loans, credit card receivables, student loans, and other forms of credit greatly curtailed. Consequently…the Federal Reserve’s strategy has been to support the functioning of credit markets and to reduce financial strains by providing liquidity to the private sector–that is, by lending cash or its equivalent secured with relatively illiquid assets.

Let’s analyze this statement. First, it seems that Bernanke is saying that the dangerous and artificial negative real interest rate policy has been implemented by the Fed to offset the effects on credit conditions, meaning credit tightening. This is what some economists would call the “Oh-my-God” theory of regulation, that is that a regulator, when he sees that the outside world is not behaving the way he thinks it should, usually according to some preconceived model, must regulate it to force agents to behave closer to their model. In other words, the Fed wants to “help” banks to lower rates and lend, even contrary to good business sense and proper risk management that make bankers want to curtail credit and increase rates.

You do not need to be a banker or a financial expert to realize that in a crisis risks are higher, thus, you either reduce credit by being more selective or increase interest rates to compensate for the higher risk premiums, or both. Private lenders in any economy logically want to reduce their exposure to a financial crisis and recession risks by reducing credit. On the other hand, they might be willing to lend more, but at a premium to compensate for these higher risks. At this stage of the crisis lenders want to rationally raise interest rates. Everyone knows that more businesses will go under and more people will be laid off in the near future due to the worsening recession; which in turn will make the level of loan defaults rise. Therefore, how come does the government want lower rates and more credit?

If you look at the figures, credit has not contracted; it has just stopped growing at unsustainable rates (see chart and recent Robert Higgs article).

Bernanke continues by saying “that offset has been incomplete, as widening credit spreads and more restrictive lending standards have contributed to tight overall financial conditions.” That is, the Fed is lowering rates and the banks are increasing their rates (thus, spreads increase). It seems that this statement suggests that this is something that is not right. Government officials are saying that credit must flow again even though household debt is an all time high at over 120% as a percentage of National Income (it never went above 65% before 1980).

But wait, banks are also applying “more restrictive lending standards” and this, in spite of all the data and risk management, seems to not make sense to the Fed or to the Government. Weren’t loose credit standards what started the mortgage mess in the first place?

He then says “many traditional funding sources for financial institutions and markets have dried up, and banks and other lenders have found their ability to securitize mortgages, auto loans, credit card receivables, student loans, and other forms of credit greatly curtailed”.

Investors, after being badly burned by buying securitized mortgages and loans, have logically stopped buying these riskier instruments. However, these words seem to suggest that in Bernanke’s model it is not quite right; thus, investors might have to be “stimulated” into buying these instruments, even if the fundamentals and returns are not there.

Bernanke adds this statement: “the Federal Reserve’s strategy has been to support the functioning of credit markets and to reduce financial strains by providing liquidity to the private sector”.Is raising rates and improving credit standards a sign of financial strain? Is reducing credit to overleveraged households, in the middle of a recession, a sign of financial strain? Is reducing credit to overleveraged firms a sign of financial strain? I would beg to differ. Markets were working extremely well in spite of the massive and unprecedented Federal and Treasury intervention. Banks were trying to raise rates and stop credit to avoid further losses and in response to a much riskier environment. On the other hand, most intelligent investors are not going to buy securitized loans unless these pay a risk premium.

Neo-Keynesians believe that the economy and credit should always expand. If credit is not growing then there must be a problem and the economy is in “danger”, according to them, therefore the Federal Government has to intervene massively. Former President Bush at the beginning of the crisis in September said:

banks holding these assets [toxic assets] have restricted credit. As a result, our entire economy is in danger. So I've proposed that the federal government reduce the risk posed by these troubled assets, and supply urgently-needed money so banks and other financial institutions can avoid collapse and resume lending.

As predicted by the Austrian Business Cycle, a long period of artificially low interest rates (see graph below--the real Fed Funds Rate has been negative 5 years of the past 8!!) will induce high debt and lower savings. Alan Greenspan, who was at the helm at the Fed during most of this period said in August 2005:

History has not dealt kindly with the aftermath of protracted periods of low risk premiums”This negative interest rate policy has created a huge dislocation between savings and credit (see graphs). Credit has ballooned and savings has collapsed (see graphs).

Source: BEA, NIPA, Platinum Consulting1

This excess credit has resulted in unsustainably high levels of debt. Household debt, which in 1957 stood at near 45%, stands at an all time high at over 120% of National Income (see graph).

The same is true for Business debt (near 90% of National Income) and financial sector debt (near 140% of National Income). These are the real threats looming over the American economy. And this problem can only be solved by curtailing credit (or raising rates) not expanding it. Contrary to what our public officials and mainstream economists are saying, credit must stop, so debt comes down to more sustainable levels and savings has to flow back up again for a sustainable recovery to begin. And this cannot happen until the government stops intervening in financial markets and lets interest rates rise up again to normal market levels.

David Saied was head of Public Policy for the Republic of Panama and considered to be one of the economic architects of Panama’s current miracle economy; he is also the former SEC Chairman for Panama, and is currently finishing graduate studies in economics in Boston, Massachusetts.