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Five Things: What Comes Next?


Still trying to turn finite resources into infinite prosperity.

"Unseasonable mirth always turns to sorrow."
- Cervantes, "Don Quixote"

As the ongoing debt crisis continues, we have transitioned from Stage One, the initial Wall Street impact of debt-deleveraging, to Stage Two, the Main Street impact, and are now well into Stage Three, the coordinated Fiscal and Monetary response to the debt crisis. The question, then, is what comes next?

Before we get to the What Next? question, let's revisit the basics of what is happening and what it means. To listen to pundits and politicians, we are experiencing a "credit crunch," with the primary driver being, according to conventional wisdom, a risk aversion on the part of lenders.

For example, the Financial Times recently reported on a study from the credit-scoring firm, FICO, that banks reduced access to revolving loans such as credit cards and home equity lines of credit for about one in five US borrowers in the six months up to April of this year. Moreover, the FICO study said, banks not only cut credit lines for a larger share of US consumers than they had in the previous six months, they also became more aggressive in their cuts.

This sounds very much like a classic "credit crunch." But our crisis extends deeper and well beyond these small symptoms, and that's what is important to understand. First, let's discus what a "credit crunch" is, and then we'll look at how our situation differs and what that means as we transition to the most critical and perhaps misunderstood stage of the crisis.

1. What is a "Credit Crunch"?

The simple answer is that a "credit crunch" is a general decline in the the supply of, and demand for, credit. The second part of that equation - demand for credit - is crucial, but we'll get to that momentarily. First, let's look at the basic mechanics of a "credit crunch."

Under certain circumstances, the market (or on occasion the Federal Reserve) can induce a decline in the supply of credit (or at least a decline in the growth rate of the supply of credit) by raising interest rates. This makes money more expensive for borrowers, and as a result slows the growth and demand for available credit. This is what a central bank attempts to do when the growth of inflation exceeds their "comfort level."

But a credit crunch occurs when banks become more risk averse - less willing to lend - even though interest rates may remain the same, and in extreme cases, even though interest rates may go lower.

This risk aversion on the part of lenders makes it more difficult for even the most credit-worthy borrowers to obtain money at reasonable terms. In effect, interest rates - the cost of money - can become infinitely high for many borrowers. As a result, it becomes difficult to fund projects and investments, which can slow economic growth, which in turn can make lenders even more unwilling to lend; a vicious cycle of economic pain.

2. Why does credit growth matter in the first place?

Because in our fiat-based monetary system, economic growth is dependent upon credit expansion.

What does that mean? And why is it a problem?

First, a "fiat-based monetary system" is simply the name economists give to an economic system where money is created through fractional reserve banking techniques. Fractional reserve banking is the practice of issuing more money than a bank holds in cash reserves. So, in a fiat-based monetary system, if risk appetites are supportive - that is, if borrowers are willing to take on debt - then credit expansion can feed into normal risk-seeking behavior, and if excessive can foster unsustainable booms; dot.coms, housing, certain commodities.

As long as credit expansion and demand for credit continues at an accelerating pace, the appearance of prosperity continues as asset prices increase. But there are two sides to this credit coin; access to credit is one side, but demand is the other. And the demand for credit is the side the central bank has the least amount of control over. A central bank can make credit available, but there must be a demand for it or it's like throwing a party where no one shows up.

In our economy, as we have seen, the "accelerating pace" aspect is critical, for it is the key to maintaining the boom. All we need to do is look at the monetary aggregates and we can easily see that the acceleration aspect is what has gone missing, and worse, that the demand side is what is largely responsible for that, even as bank lending growth itself has slowed.

3. What do we mean by "credit expansion," anyway?

First, credit is not in and of itself necessarily a bad thing. Capitalism thrives on the productive use of credit. But what has transpired over the past decade is that credit has increasingly been used as a substitute for weak economic growth.

Essentially, new money was created by the banking system and offered at artificially low interest rates and, later, to borrowers with increasingly low credit quality. By offering willing borrowers money at artificially low rates, this encouraged increased time preferences among economic actors, which is to say that investment horizons were lengthened and risk tolerances were widened.

This is how debt was pyramided to such an extent that one small setback, in subprime borrowing for example, resulted in such a widespread problem, problems which quickly spread to other supposedly safe credit risks. And as this continues, we are seeing that prime loans now account for more than half of the seriously delinquent mortgage loans according to the most recent Mortgage Bankers Association. (Hat tip to Calculated Risk for pointing this out.)
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