Time for some hard truth, folks. We have been living in superheated markets, we tried to dodge a painful correction, and now we have a panic. After the 9/11 attacks, Rudy Giuliani said “come to New York and buy stuff.” Ed Leamer proposed the same tonic two weeks ago. Perhaps they both should have qualified the statements with “pay cash.” During my lifetime, we Americans have lived by the mantra “growth is good,” and we have led the rest of the world down this path with us.
According to the precept that “more is better,” we have encouraged as much growth as possible, and expected our political and fiscal leaders to support these demands. We have always seen a slow economy as a bad thing. Basically, we’re greedy. This demand for ever greater consumption for everyone (we’re a democracy) got us addicted to the “juiced” return that a heavy dose of leverage provides. We cheer when consumer spending is “strong,” and corporate profits are “record-breaking,” conveniently overlooking the fact that virtually all of our growth since 2001 has been the product of increased leverage.
The U.S. has become what economist Hyman Minsky calls a "Ponzi unit." This means that we are unable to repay principal or even to pay the interest due on outstanding debts by our own income. We depend on borrowing or on selling assets even to meet our interest bills. This is true of our government, our personal finances, and, it appears, our major financial institutions. U.S. consumers, long saving a mere 2% of their personal incomes, have engaged in net borrowing since Q3, 2005.
Meanwhile, our financial system has employed armies of slick MBA’s to invent new instruments to introduce liquidity into the market. The problem is that all of this liquidity is illusory because it is based on borrowing. The whole system works because house prices have been appreciating at an artificially high rate since the tech bubble burst in 2001. Prices have risen because there were lots of buyers, but they were all leveraged buyers – many of them had no business buying a home in the first place. In a market where there is no credit available in the U.S., there are no buyers in the U.S. This is why the government is frantically trying to resuscitate the credit markets – without borrowing, we are out of luck, because we have no savings. Corporations are going under because they cannot obtain overnight financing and do not have sufficient capital reserves. Consumers are cutting spending because they cannot spend their rapid-growing home equity because it’s gone, and that’s where the spending power that drove this last cycle came from. This crisis has been a long time coming, but the borrowing orgy that has spiraled out of control from its beginnings in the first credit cards of the late 1940s has come to an end.
We are scrambling for a bailout plan now because we don’t want to face the music. We are in a situation where arbitrage has been mistaken for value creation, liquidity has masqueraded as adequate capitalization, and diversification and insurance have been substituted in place of conservative underwriting. On the borrower’s side, homebuying has been seen as an investing activity, refinancing has been used as a cash machine, and credit has been mistaken for wealth. We will not see a return to strong and stable financial and housing markets until we accept and embrace the uncomfortable truth that we cannot live on credit alone. Years of failing to discipline ourselves into greater saving and less leverage have backfired. The result is the violent de-leveraging currently wrecking the global capital markets. My main hope is that a similar fate does not befall our ever-borrowing government as it continues to pour good money after bad. The question to MBA’s is “how are we going to rebuild the system in a more sustainable way?”
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