Saturday, March 27, 2010

Credit Bubble

Are high levels of credit good for the economy? Ask many people that and most of them will say yes.

The Basics

When credit (unearned capital) is added to the economy, new products and services appear and/or the prices of products and services go up because there are more dollars chasing each product or service. When credit is serviced, capital is diverted from the economy. If the diversion of capital exceeds new capital inflows, then prices go down and/or products and services disappear.

The Problem

During the last 26 years, governments and financial institutions poured gluttonous amounts of unearned capital into world economies. Year after year, world economies have seen higher levels of credit. Now they are addicted and require higher levels of credit year after year just to sustain economic levels.

What does this mean?

World economies have mortgaged too much of their future economic activity. That’s what credit does. It creates current economic activity at the expense of future economic activity.

Why did this occur?

There are numerous reasons but the prominent ones may be US trade deficits and financial deregulation. Since 1975, the US has recorded trade deficits every year. To understand the net effects of long term sustained trade deficits, imagine ‘If you always spent more than you made’. You would eventually run out of money.

In-order to mitigate outflows of capital and the loss of jobs in manufacturing, the US economy evolved to become more serviced based and credit dependant, especially during the last 30 years.

During the 80’s, the Reagan Administration’s initiative to stimulate the economy by deregulating S&L’s caused an explosive growth of credit services. The lack of supervision led to highly speculative investments and eventually the S&L industry had to be bailed out. Despite this, deregulation continued and was expanded. In the 90’s, The Glass-Steagall Act which protected bank depositors from the additional risks associated with security transactions was dismantled. Commercial banks could now own brokerage firms and provide investments services and aggressively sell highly leveraged financial products. Consequently, the explosive growth of these brokerage firms was fueled by liquidity and credit sourced through their corporate parents.

During the last decade, ultra low interest rates combined with indiscriminate lending funded by Mortgage Backed Securities further inflated the credit bubble. Even with the past 3 years deluge of home foreclosures and personal bankruptcies, the credit bubble barely deflated because of the recent bailouts and stimulus programs which pumped massive amounts of credit and liquidity into the economy.

Where is the credit bubble?

The credit bubble has spread to most developed nations and emerging markets throughout the world via under regulated markets. Private and Institutional investors bought US and foreign financial investments and services that hedge commodities, leverage assets and overvalued securities. Additionally, foreign monetary policies were influenced by the US Federal Reserve’s policies. All the perceived wealth and credit generated from these investments, services and policies spilled over into and inflated stock markets all over the world, thus inflating prices for products and services and real estate all over the world.


(click on image to enlarge)

The above chart indicates that in Canada and the US, with the exception of the last 2 years in the US, the ratio of household debt to disposable household income has been generally increasing year to year for the last 26 years. I suspect that data from the respective charts for many if not most G20 nations would also generally show increasing ratios of household debt to disposable household income during the last 26 years.

From this data one can easily conclude that credit is responsible for a significant percentage of the economic gains (GDP) attained by many if not most g20 nations during the last 26 years. This trend cannot continue indefinitely and the last 2 years economic crisis was probably the 1st of many. In addition, each economic crisis will eliminate some products and services that leverage products and services. Economies will become less serviced based and credit dependant.

The current prices for most financial assets including stocks, securities and real estate as well as many products and services are unsustainable. It’s hard to ascertain how far prices have overshot their sustainable levels because the charts only go back to 1960. But reviewing the US chart data from 1960 to1984 shows a up and down cycle with modest gains each cycle. By charting minimum and maximum trend lines from the US 1960 to1984 cycles and sustaining these cycles average rate of increase would indicate that the US ratio today should only be between 65% and 75%, not 117.2%. Furthermore, even a sustained 65% to 75% ratio of household debt to disposable household income could still be too high. If left to their own devices, economies would evolve and eventually find their sustainable levels.

Peter Tsirlis


Post a Comment

Our World Needs Your Help

Share the articles with your friends, family, co-workers, colleagues, associates and acquaintances.

Use the Share buttons (Mail, Blogger, Twitter, Facebook, Google Buzz, Google +1) at the bottom of the articles.

If the comment boxes are not showing, click on "_ Comments and _ Reactions" link below the article.

Write and submit articles. If we like them, we'll publish them.

Contact us about donating time or money.