Credit Crunch 2

Sadly, I believe that this recession probably has not reached its nadir. I know much evidence suggests it has, but fundamental problems remain that are being masked by the concerted action of governments in the most developed economies i.e. America, UK + Europe, and Japan. Even if recovery is now certain, crunch 2 is already set in motion.
Broadly, the problem was a collapse in confidence in the viability of high debt to income and income to savings ratios in the most developed economies. This was expressed as reduced confidence in the ability of debtors to service their loans. That problem was precipitated by a collapse in confidence in house prices as they reached unsustainable multiples of income in America and later the UK, and then other parts of Europe. That house price situation was mainly enabled by over generous lending criteria and stable low interest rates over a protracted period. At an anthropic level, irrational optimism and competitiveness are the underlying drivers of these problems. At a policy level, governments failed to take into account those human traits to exercise sensible control. At a factual level, it is obvious that no country or individual can continue to increase its debt to income ratio indefinitely, nor should have a high income to savings ratio. However, that is what governments continue to do and allow. Probably most politicians lack sufficient expertise to see and avoid the probelms. Those few that do just hope is to have their moment of glory and money, but be gone when the account has to be settled. This indicates another deep problem, that a system of government by politics is flawed at the most basic level. Government should be run by experts, not by power obsessed self-serving administrators.
Take a look at the video on this useful blog post to see a wise economist explain the debt problem in more detail, as not just a confidence problem, but also an absolute problem. Australian economist Steve Keen explains the problem, and that more trouble is to come.
The Times tell us of Ann Pettifor who also forecast the credit crunch, and also thinks the debt mountain has more trouble in store for us.
So why is the credit crunch yet to revisit us? We need to look at the main tactics being deployed to fix the crisis in confidence; they are low interest rates, public sector spending exceeding revenue, increasing the money supply, deferral of foreclosure on debtors, and direct incentives to spend. The most significant of these is ‘public sector spending exceeding revenue’. This is effectively shifting the balance of the problem from the private sector more to the public sector in the belief that confidence in a larger debtor will be higher. That is a reasonable assumption, but debts must be serviced even by government, and that is funded by taxation, which must then increase in the future. The notion is that as private sector spending slows, public sector spending is increased to help maintain business until private spending recovers. Governments have failed by overusing that tactic, so it needs cautious use. The tactic of ‘reducing interest rates’ is not safe. As we look back at the original problem, sustained low interest rates fuelled the unfounded early confidence that helped lead to high debt to income and income to savings ratios. In addition, low interest rates create compelling disincentives for savings, and low savings levels are part of the root causes of the problem. Further, the increasing retired population partly lives off the interest from its savings, so they will take a less active part in a spending lead recovery and at the margins will be looking for help. The tactic of ‘increasing the money supply’ enables more public sector capital expenditure in the short term, but also increases inflation in the midterm, which erodes the value of savings as welll as debt, further exaggerating the problems of savers stuck on low interest rates. If the problems are not rectified quickly, the tactic of ‘deferral of foreclosure on debtors’ only delays inevitable for many, and buries the remainder in long term debt. Providing ‘direct incentives to spend’ is another disincentive to save and head toward debt, so a lot of this kind of stimulus can also be a bad thing.
In conclusion, I think the wise among us know that moderation in everything is best. We have experienced a period of excess growth and are seeking to diffuse the inevitable correction and return to another period of unsustainable growth with some very strong policies over a short period. It is possible that one strong imbalance can correct another, but the stronger and faster the measures the more tortuous it is to achieve good balance again. I have low confidence that the failed institutions that enabled the problem forged in our human failings have the vision to correct it. I have even less confidence that a system of power obsessed self-serving administrators will ever be effective as government. I expect that even if this situation is rectified in the near term, unless sober experts are appointed to form governments that crunch 2 will one day visit us. On the bigger picture of how we conduct ourselves, perhaps we should question the race back to a hedonistic consumption based life style.

Understanding the Credit Crunch

This post documents my understanding of the credit crunch and its associated ructions thus far, along with some wider understanding of related important economic factors. In it I address: what are the problems, what caused the problems, what are the consequences of the problems, what is being done to fix the problems and what are the consequences of this fix.

What are the problems

The problems are manifold and the pressing problems for individuals such as elusive credit, falling house prices and job insecurity are really consequences of problems in a larger picture, so I will focus on that. That larger picture has two important players, the large financial institutions and state / central banks controlled by government(s), together they modulate economies. The main macro scale problem for the money lenders seems to be a lack of confidence in their ability to avoid collapse under the weight of bad debt. Specifically, it is the fear that much more than expected of what has been lent will not be fully recovered and lead to large enough losses to make the lender unable to continue in business. The main macro scale problem for state / central banks seems to be the possible collapse of money lenders, especially those that also provide savings services. The collapse of large financial institutions will have a negative effect upon the confidence of the whole financial system that could cause a cascade of secondary problems through an economy.
Certainly there is a poor position on mortgage debt and one does have to wonder how it was not obvious to the lenders that they were getting into it, but that does not mandate rampant defaulting on repayments. It was obvious to me for years that a property bubble was forming and would need correcting. I always assumed it was even more obvious to lenders and that they had calculated the best level of risk to accept in order to maximise profits, balancing those that would continue to pay with defaulters. It is rather a surprise and suspicious that they claim not to have seen it coming. Regardless, the lack of lender confidence slows down business as usual and perversely increases the probability that lenders will fail. It is the cessation of business as usual at the money lenders that is creating the dramatic economic effects. Unless we can identify the causes and find fixes for the problems the fear of failure will translate into actual failure and the problems will be amplified.
The credit crunch problems are exasperated by shortages of food and fuel causing steep price increases. These are a simple consequence of supply not keeping up with demand. Although their timing is unfortunate they are only related in so much as they restrict consumer spending patterns, which has a deleterious effect on business, slowing overall growth and confidence.

What caused the problems

Housing has increasingly been used for profiteering. It always has been used this way by architects, builders, mortgage providers, landlords, estate agents, solicitors and surveyors, among others. However, recently two classes of interested party have burgeoned. One class is the speculators. Speculators have no product and offer no service, they are simply there to profit and are the biggest cause of the problems. Speculators pump up what they have already identified as hyperinflation in prices. Some speculators may call themselves ‘property developers’, but they do little or nothing but profit from a bubble situation. Just to be clear, people who take out buy-to-let mortgages are also speculators, they differ from traditional landlords in that they must borrow to acquire property to let. This is obviously a risky practice and inflationary for property prices. The other notable problem class is those with meagre means being offered excessively easy terms to buy.
Property was bought with increasingly easy to obtain loans for increasingly tangential reasons; for example: buy-to-let property, holiday homes, weekend homes, university accommodation and just plain resale i.e. naked speculation. This combined with the demands of rapid immigration and a property supply that did not increase quickly enough, to cause unsustainable house price rises above wage rises. Housing, like pensions is too important to be used in that way, government should impose controls to prevent its misuse.
Some of this profiteering is long term, with people using it as a pension because of the poor quality pensions. The UK government does not provide a sound pension scheme, except naturally for themselves and other public sector workers. A good pension scheme should: be 100% underwritten by the state, have a guaranteed minimum growth rate, be contribution based, have a guaranteed minimum pension at the end regardless of contributions but based on time resident, be index linked, not be means tested, be ring fenced and protected by law. It seems the government believes that only the public sector are worthy of a good pension. They are, as ever, helping themselves.
So the causes seem to be increasing use of residential property as a means of speculation and pension savings combined with poor lending criteria. The problems only seem to have become visible when the inevitable increasing bad debt arranged with less financially solvent borrowers as mortgages on inflated property prices precipitated a collapse in confidence. That increase in defaulting was triggered by an increase in interest rates which were held low for a prolonged period to avert the worsening of the previous economic slowdown. During that period many poor loans were made that could never be sustained on a return to more normal interest rates.

What are the consequences of the problems

Debt is used as money i.e. the potential to recover money at a profit from loans is being treated as money. This works well enough if you know that the loan will be repaid with interest. Unfortunately, not all loans are repaid, some fail and money is lost, but as this is statistically at an expected level its effect of reducing the value of the rest of the debt can be taken into consideration. When that rate of failure jumps, confidence plummets in the value of the loans and they are less valuable alternatives to money. The loss in confidence in their own loans and those of other lenders who were similarly unwise, tends to restrict them from lending to all classes of borrower, including each other, to reduce risk. This has the effect of reducing the number loans made, how adventurous lenders are, how high the repayment rates are and how much collateral is required. Those changes in turn make it difficult for business to borrow for expansion and ride out problems and so employment and the greater economy suffers. Also, reduced borrowing by consumers slows spending, with the effect of reduced opportunity for businesses to profit from sales.
We may wish to consider the sustainability of economies built upon the premise of continuous growth in consumption. Large disparities in the relative sophistication of economic development must be sustained and the more sophisticated economies need to retain the perception that their economic model is best. If they fail in either part, people will stop pursuing the growth model. Debt has potential for significant further expansion providing lenders can consolidate to drive economies of scale and operate on tighter margins and apply pressure to keep interest rates low enough that borrowing is the only obvious route for many purchases.

What is being done to fix the problems

Firstly it is rather worrying and suspicious to me that the state / central banks seem to have been as blind to these problems as the money lenders claim they also were. Can they really be surprised that many years of house price growth above wage growth fuelled by low cost loans would lead to problems when interest rates rose. It seems so stupid that I would be quite credulous if a plot of grand proportions to profit under the guise of the credit crunch was revealed to me.
Anyway the government tactic to solve this problem is to get the state / central bank to lend money to the lenders. That should enable the lenders to keep trading, as their confidence of surviving problems is increased and the whole system stabilises. There are still a lot of loans that will take time to become worth what was lent, as property prices can take years to normalise, or they can be normalised quickly but catastrophically for some. Unfortunately, the government doesn’t have any money to lend, in fact it is itself a big borrower. So as neither has any immediate money the government has offered bonds (which currently are sufficiently sound to be considered as good as money) in exchange for quality debts of the lenders, proving certain guarantees are made. This is following the drawn out normalising process, rather than the rapid normalisation process. The former has the advantage of apparent stability in the short term, but the disadvantage of producing a tardy correction for the medium term and so slows the economy as a whole. The latter is better in the medium term as it affords all parties more time to recover, even the worst hit, but is worse in the short term for those in the worst positions and for general confidence if the effects are not well isolated. Both approaches will be equal in the long term as normalisation must occur.
One feels bound to ask here: who has the money. It seems that everyone is borrowing money, somebody must have some. An interesting question and to answer it one needs to remember that money is just a vector for production i.e. work done multiplied by efficiency; twice as efficient gives twice the production for the same amount of work. So the question should be: is there enough production to pay for the debt. One buys things with ones own productivity, but that includes recycling the productivity of others; specifically in creating the basic inputs to ones own work. If there were a finite amount of productivity in the world then clearly there could be no growth and so any debt should remain static. However, increasing populations and efficiencies, particularly in currently low technology economies, provide the continued growth in productivity. That is likely to continue and so debt levels can also increase, but they should not increase faster than the rate of increase in productivity.
Whether productivity is increasing or not, what level of debt can be sustained? Can it be as much or even more than the level of production? I think the answer to these questions is in confidence in the stability and predictability of the economy, markets and debt arrangements. As long as we have confidence that a debt will be repaid as arranged we can increase debt. If sufficient confidence exists then there is no reason why debt could not be arranged that could span whole lifetimes or even generations. The obvious inference from this is that we can have more debt than earnings, so long as we can sustain confidence in the stability and predictability of the economy, markets and debt arrangements. I would suggest that we are already in such a position and that explains the state / central bank conservative tactic of protecting the status quo as the least risky but otherwise least sensible option. Clearly a strategy for preventing the situation is preferable. That would imply a clutch of strong measures and checks to provide the required stability.

What are the consequences of this fix

Normally the government sells bonds to raise money. Bonds are a promise that the government will repay the money in the future; in the interim they will pay interest on the loan. The government (tax payer) must pay interest to the bond holders and in this case gets in exchange for those bonds another less reliable form of debt from the lender, rather than money and that makes the lenders more confident. Unfortunately, the country now owns the poor quality debt instead of money and is paying interest on it. In fact as we know the value of the mortgage debt the country has now acquired is over rated, not only is the country paying interest for these loans, it will have to wait years for them to be worth their face value. The net effect of all this is that the profits of the lenders in the bubble years have been protected by the government at the expense of the tax payer. Greater government debt must be paid for by taxation or cuts in services. Although this is a terrible deal for the people as a whole the government is essentially arguing that it is better than a collapse of financial institutions with potentially catastrophic ramifications. However, it may be that a better deal for the tax payer is a tactically managed collapse where the worst institutions are isolated and made to carry the whole burden.
A proper strategy to avoid us getting into this kind of situation would of course be preferable and that needs a slew of measure to check for abuses and imbalances. Unless such a system is put in place we face the probable repetition of this situation in the future.

Prognosis for the Economy

What is the prognosis for the economy?
There are three fairly obvious possibilities:
Firstly, some people think that most of the problems for the financial services have happened and so are we are near to a turnaround. This sentiment is evidenced by the current vacillating of the share markets.
Secondly, other people think that the financial services have precipitated a wider economic recession and now that will take over to drag down the economy into a deeper hole. As the economy is enabled by financial services that could certainly be true and consumer spending is changing, showing increasingly parsimonious spending patterns.
Thirdly, others believe that recent activities by central banks have staved off a potentially deepening crisis. Certainly, making more credit available to banks reduces the risks of further banking problems, which would pique the lack of confidence. However, has enough been done and are there other techniques that could be employed.

Which View is Correct?
The fact that the financial services sector was jointly at the heart of creating the problems and the fact that they are vacillating now over its depth means that they don’t have a clear vision of if we are at an economic low point, even though they are the ‘experts’. Central bankers seem to be at least as much in the dark as the financial services gurus, because they didn’t see the problems coming either. They have made increasingly strong efforts to avert a cascading of the problems into the wider economy and this indicates they too don’t know how far this will go. A preponderance of others have commented that they expect things to get worse before they get better. It would seem that the ‘clever money’ would be on a deepening of the current macro economic problems, exasperated by falling property prices along with rising food and fuel prices.
The full effects of problems on this scale do take time to ripple through an economy, so it is likely that even if we have reached the nadir of the original problems for the bankers, they may yet be revisited by their wider effects. So although none seems to have a full understanding of this problem plexus, we can expect the shockwave to ripple through the economy for some time. An important question is: will the after shock feed back to the financials strongly enough to initiate a new vanguard of problems.
My own view is that this crisis will deepen. Lending is constricted by tightening positions in financial services leading to tighter loan conditions. Many people have become comfortable with living at the edge of financial solvency and have started to find their newly restricted position forces them to cutback hard. This pruning of expenditure will denude businesses at marginal operational viability, which in turn will feed costs to the economy through unemployment. Fortunately, the businesses that are least viable and able to ride out a slowdown will tend to be small and although there will be a constant flow of them, they will have less of a confidence damaging effect than mass employers making redundancies. Also, people love to buy stuff and have a short memory for problems. As soon as their positions stabilise they will be back with what credit they can get and there will be creditors with money to lend. Further, service dominated economies are quicker to respond to demand, so for example the US and UK economies should bounce quicker than manufacturing based economies. Therefore, although I expect things to worsen, I also expect that they will flip back quickly to growth. Financial stability and solvency are less of a concern for many today and that combined with faster and more free flowing information than ever will resolve to a faster turnaround in the economy. We will soon return to the consumer dream, not because I want it, or think it is a good idea, but because most people want it. Given the desire for something and the opportunity for others to make money from that desire, there will be a race to make sure they get it, as soon as possible.

What should central bankers do?
Firstly, they must restore confidence. Confidence is the most important factor for a healthy financial services sector and central banks have moved to improve it. So much of the economic success of a country now depends upon its financial services sector that it must be unencumbered. Therefore, improving the stability of financial institutions with government backed loans is a possible scheme. However, this tardy tactic is essentially printing money and hence inflationary. Central banks know that the excessive valuations placed on residential property must be normalised. Price growth has exceeded wage growth and that leads to a bubble that draws in a disproportionate percentage of overall income to service that debt. This is not good balance and balance, after confidence, is most important. The central bankers should be encouraging the rapid normalisation of this over valuation to quickly restore parity. Drawing out normalisation will only delay the return to a balanced growing economy and I am concerned that a government statement about preventing people from losing their homes could do just that. They have not detailed how they plan to do this and it could be empty rhetoric, but if not and they start to intervene at this point they could stifle recovery for some time. An interventional strategy would have been much better to prevent the bubble. Intervention now should be to encourage a property market decline.
Secondly, they must address the root causes of the original crisis. They are manifold, but two stand out as significant: Excessive speculation using residential property, especially by people who do not understand investment markets. A poor pension system which encourages people to look for other ‘stable’ savings vehicles, in this case property investment was used.

What can we do as individuals?
As a general strategy, buck the trend. Be a saver when all about are spending big. The best time to spend big is when everyone else is not, you get the best deals then. Particularly, you should be looking at the big things: buying a house or moving to a better one, buying shares and a nice car at a bargain price. So, property will soon be a much better deal, shares already are, but will probably become better still and slightly used luxury cars will soon be everywhere at great prices. Simple really, just difficult to do.

Mad as a balloon!

We are all encouraged to sell our work before we have even done it, for those nice shiny things. Lenders understand human nature and the future of money management ~ see Debt to save the world. If you are a prospective first time UK house buyer I sympathise, you are trapped. It has become a competition of who dare take on the largest debt. There are plenty of 125% mortgages available and several 130% offers! Those of us who are not trapped need to resist the temptation, or at least understand it.
This crazy situation can only be reversed if financial services regulators prevent large salary multiples, high loan to valuation, very long repayment periods and fractional (shared equity) mortgages being used to calculate the acceptable size of a loan. Unfortunately such regulation would be a very unpopular move with lenders and in the short to medium term with borrowers. Perhaps it is best implemented at the bottom of a house price cycle when there will be more acceptance of it, especially if it were be phased in gradually.
I will not be surprised when lenders start offering us mortgages before we have even left school. That way lenders can extract even more from the most successful in society; people will always go the extra mile for their children. This will, like private schools, tend to perpetuate advantage and an elite successful class, making the idea of social mobility even more farcical.

Debt to save the world!

Are you wondering how the problems in the US sub-prime market can be so pervasive? I am. Surely that market can’t be that big and not all of those borrowers are going to default. I suspect the problem is more to do with a lack of confidence afflicting the markets. They have had such a good run for so long people are suspicious and looking for that next crash. This probably says as much about human nature as it does about debt. However, in general the amount of debt is increasing while savings decrease (lowest household savings ratio since 1960), so should we be concerned? If we extrapolate carefully from this situation we can uncover some interesting trends that will impact on us all.
The US sub-prime problem is a personal debt problem rooted in the combination of: widespread lending to people at the limits of their ability to cover repayments, at low interest rates, with high loan to value conditions, in a confidence lead rising property price market with big property development programs. Later, increased interest rates were the trigger that pushed those closest to the edge over it and once enough had succumbed the price bubble burst. With increasing repossessions, declining property values and high loan to value conditions lenders suffered big loses. They then tried to increase their margins to recover their positions by increasing interest rates on their most risky situations and pushed more borrowers into the red exacerbating the situation.
Significant personal debt was once a facility only available to a small fraction of people, but recently it has become available to almost all people. This broadening of the debtor base to include less wealthy and financially sophisticated customers tends to encourage debt commoditisation. Commoditisation reduces profit margins, consequently money is chasing larger customer volumes and larger fractions of the market. This change militates against the small lender, increasing pressure to consolidate into fewer global money managers (GMM) providing credit and debt services. When they become large enough their financial power will eventually succeed even that of central banks to influence interest rates and so governments will gradually relinquish some economic control to them.
In addition to growing personal debt, governments are not shy about creating a public debt on our behalf. This has been the case for a long time, such as when financing the second world war effort, for which we could not reasonably have been expected to save as we did not plan it. Outside of unplanned costs like war, how can it be that a whole country can’t live within its means? Like any individual, government should save for expenditure rather than use the more expensive option of borrowing. Unfortunately, saving is a long-term strategy that is not encouraged by our current system of government. It is much easier to ride a wave of popularity fuelled by spend from debt than to tell everyone we have to save. The end effect of this is again to imbue the GMM with greater control as they increasingly own the money lent to the individual and the state.
The rise of the GMM will have some interesting consequences. Firstly, interest rates are facing long-term downward pressure as the GMM seek to encourage every person and country to become a customer, essentially owning some of their generated wealth. So the GMM will seek to make debt easier to afford with lower rates and savings are going to be less remunerative due to tighter margins between their credit and debt services. This will be a problem for savers (who fund the GMM) if inflation is not restrained. One corollary to this situation is increasing pressure on governments to keep down inflation. This will lead to tightening on expenditure, for example leading to more frequent disputes with public sector workers over pay. Another corollary to this is that those seeking higher rewards will increasingly become financial instrument market speculators, so we should see an explosion in speculation management services specialising in certain sectors of the markets and on specific classes of investor. For similar reasons as in the creditor consolidation, international financial market consolidation is inevitable and already ongoing. Protectionists economies lack vision and will find their markets increasingly sidelined until they capitulate, but then their influence will be much smaller. Secondly, economic power will increasingly rest with the GMM, with governments forced to recognise their influence. This should eventually resolve in GMM taking a moderating role in international disputes, becoming the ultimate non-partisan authorities that no government ever can be.
So, in the short term those debtors existing at the margins will have a tough time in several countries, but the problem is too small to cause lasting or widespread damage. In the medium term this is a lesson about hubris being tolerated. In the long run the GMM will ultimately convert our own desire to get things without saving first into a stabilising international force. The emergence of the GMM and their concomitant economic power is a defining characteristic of our age.