Bankers may be the villains of the credit crisis, but what about the borrowers? The credit bubble was the latter day means of financing the switch from thrift to leverage by US individuals. US citizens abandoned the idea of building the American dream on hard work and savings and instead used the cement of debt.
It all started when Paul Volker took over as Fed Chairman in August 1979 and set the example of pursuing an inflation-busting monetary policy. This gave us the twin decades of disinflation. Disinflation was a great good, allowing the world economy to grow faster, more productively and more continuously, without much in the way of cyclical ups and downs. Of course, many other factors contributed, but in the end, it was sound monetary policy that provided the stable backdrop of constantly falling inflation.
As inflation falls, the value of future income streams will increase. Tomorrow’s money gets to be worth more today than when more inflation eroded its value. This pushes up asset prices whose value is an accumulation of tomorrow’s profits and income (adjus- ted for inflation and the time cost of money). At the same time, disinflation makes it cheaper to borrow in both real and nominal terms.
The result was that people gave up saving. Why save from income if rising asset prices did your saving for you while you slept? Why not consume more than you earn if you can borrow cheaply using your constantly rising wealth as the asset to borrow against?
When Volker walked into the Fed 30 years ago, the US national savings rate had been relatively static for decades at around 20 per cent of GDP and total US debt to GDP was about 160 per cent. Household debt was 47 per cent of national income. When the credit bubble burst in August 2007, the national savings ratio had fallen to 14 per cent of GDP and debt had risen to 350 per cent with household debt at just under 100 per cent of GDP. Even today, household debt in the US, although now contracting, still exceeds the level at the beginning of this crisis.
The disinflationary forces that drove the switch from thrift to leverage are over. This means the next decade will be one of replacing leverage with thrift. That will hurt retail spending.
The latest increase in the savings rate may be a positive trend in itself. But so far it has only been possible because of the Obama stimulus package. That has accounted for all the 5 per cent growth in household income so far this year. All that has happened is the consumer has saved and not spent the fiscal handouts financed by the Obama debt splurge. From now on, the impact of the stimulus measures will slowly wane and that means any rise in household savings will hit consumption directly.
This will set off feedback loops between the real economy and financial one, in the opposite direction to that we have been experiencing. It will cause consumer incomes and employment to deteriorate, along with the real economy, giving rise to increased defaults on consumer credit, commercial real estate and other loans, as well as, of course, housing mortgages. The default ratio on prime mortgages is already well above the US treasury’s stress test limit set for the banks. And the default rates on consumer debt, including credits, are rising very fast. The credit crisis hit to banks’ balance sheets is far from over.
US financial institutions have already ‘fessed up to nearly $900bn in losses from the credit crunch, mainly from mortgages and associated debt. They can expect to lose another $600bn from the recession in the corporate and consumer sectors through 2010.
All this means reductions in credit to reduce bank leverage. This is why, despite the best efforts of the administration to set alight again the bonfire of credit vanities, there will be a return to thrift, driven as much by weak credit demand as impaired supply of it. The means of achieving increased savings in a period of declining or stagnating income is why hopes for a V-shaped recovery in the economy will not be fulfilled.
The writer is president of Independent Strategy, a global investment consultancy
