Debt Junkies

This is yet another blog post about the Debt Elephant (and the Depression Elephant) Since my first post on this topic, the stock market has continued slipping, sliding, slumping, plummeting and melting down. The dreadful clamor of shrieking investors has finally ceased, and has been superseded by a grim frightened hush, punctuated by occasional sobs, sharp intakes of breath and involuntary whimpers of despair from small bedraggled knots of investors huddled miserably around screens, watching fearfully as groups of green and red digits in little boxes decrease steadily and inexorably.

Of course there will be a dead cat bounce, but the question now on so many lips is: "When will it actually reach the bottom?" News just in from Europe seems to indicate that the market may have bottomed out. We will find out tomorrow if Wall Street has also hit bedrock.

It seems that the stock market behavior can be divided into long extended periods of irrational exuberance and short but deep slumps. Since the current period of exuberance was the longest and most exuberant in living memory, it stands to reason that the slump when it came was going to be one of the deepest and steepest. That's how it is when so much energy goes into defying gravity. Gravity always prevails (unless of course you attain "escape" velocity) and depending on the effort spent in defying it, your inevitable fall is all that much harder.

Around the world central banks and governments have tried, in vain, to stem the flow. Vast amounts of money have been pumped into the banking system in an attempt to provide liquidity. Their efforts have mostly made matters worse because:

• The response from the central banks has been one of unbridled fear. And fear is contagious. Especially for Markets which are essentially irrational and emotional. Just as a panic stricken horseman cannot calm his frenzied mount, the fearful central authorities cannot calm the hysterical stock market. Their consternation makes the markets even more skittish.
  
  
• What they are doing is counterproductive. By attempting to provide more credit central banks and governments are fanning the flames and making the situation worse.

I started blogging about this topic after I read Tim Colebatch's article "Are We Scared Enough?" in The (Melbourne) Age. Since then the blogosphere, the newspapers and all electronic media have been filled with opinions about The Credit Crunch. This has been misleading. And it serves the purposes of those who made a major contribution to the problem. The current crisis is not so much one of credit as it is of debt. There is just too much debt!

Now I will admit that debt can be good. An entrepreneur can use borrowed funds to start and nurture a thriving business which contributes to society and creates employment. Debt can enable us sometimes to purchase necessary items without having to wait for our savings to accumulate.

Whiskey is good too. One glass of a good single malt whiskey can leave one relaxed and at ease with the world. A bottle of whiskey however can leave you comatose. And two bottles could kill you.

Debt, like whiskey is good in moderation and toxic in excess.

As I said, I am a systems analyst not an accountant or an economist. However I spent a lot of time writing programs for the Finance industry. And one of the things I learned was that financial systems are supposed to be governed by rules. Just as Newtons Law states that "For every action there is an equal and opposite reaction", so the accountants swear by their cannon. "For every credit there is an equal and opposite debit". Or at least there is for folks like you and me, dear reader, when we deal in amounts of hundreds and thousands.

But it seems when the deal involves trillions it is possible to make entries on one side of the ledger only. When governments and/or central banks rush to the aid of the credit market and administer a trillion dollar liquidity injection, surely this must be good? They have created a trillion dollars of credit and that's what we need. Right? Well, if they are creating a trillion dollars of credit, they creating it in the hope that banks will lend it and so create another trillion dollars worth of debt!

It is of course, hoped that the stimulus of lower interest rates and liquidity injections will grease the wheels of the credit economy. In other words, consumers will take on more debt and the economy will keep growing and property will continue to rise at the same absurd rate it has been for the past twelve years.

After the shock announcement by the Reserve Bank of Australia of a one per cent cut in the interest rate, there was widespread joy around the country. On the front page of The Age, a beaming family of "battlers" announced that now they could take on an additional 50k of debt.

Now it may be just the fault of all those people who try to live beyond their means, who borrow too much and create all that toxic debt. Just as drug problems arise because of all those naughty drug addicts. But what about the dealers, the pushers? It takes two to tango.

Ask anyone over the age of sixty what it used to be like to get a loan, and they will probably tell you that the process first involved making an appointment for an interview at the local bank. Then on the day of the interview, the applicant, dressed in a clean shirt with a tie and freshly polished shoes would be ushered into small room with a large desk, occupied by sleek, well-fed looking pin-striped suit. The interview would consist of a series of probing questions about assets, liabilities income and expenses. Since the bank already knew the applicant's bank account details fibbing generally was not an option.

After the applicant had effectively proven that he didn't really need the loan and kissed the manager's boots, he might be lucky enough to have the loan approved.

Now back in those "good old days", credit cards were a recent invention (in Australia), and if you exceeded your limit, the card would be suspended until it was back under the limit.

All of this probably sounds strange to young people today, whose credit limit is automatically raised whenever they approach it. They must wonder, "How could banks be so cruel to borrowers?" Well, in fact the banks were just being prudent. The were assessing each applicant to see if they were a potential credit risk. And if there was the slightest hint of risk, credit would be denied. All of this was considered to be due diligence by bankers.

However it all began to change late last century. The rot probably started to set in in the nineties, but the real damage happened in this decade. Credit (and Debt) came to be treated as commodities. They could be bought and sold just like any other commodity. Or so the theory went.

The people manning a counter in a modern finance shop are just salespeople. They are just selling credit (debt). They don't do diligence or risk assesment, they just try to make their quota. After all, they are just moving product, like any shop assistant. Or so the theory went.

The modern finance shop does not need to assess borrowers because all the loans are securitized, collateralized, and farmed out. Or so the theory went.

It turned out the theory was flawed. The fancy techniques of securitization were so complex that nobody understood how they worked. Central to the mechanics of this practice was the novel approach of eliminating risk by spreading it around so extensively that it ceased to be a risk, because if the mechanism failed it could bring the whole system down (And we couldn't afford to bring the whole system down - could we?). What this turned out to be was not a means of eliminating risk as much as it was a means of pretending that risk didn't exist. And then it was discovered (too late) that the risk really did exist even though so much effort had been put into pretending that it didn't.

The modern day debt junkie has lots of temptation. He/she is bombarded with advertisements for expensive boats, luxury holidays and new houses. And the debt junkies are reassured that they too can have a share of the good life and they can have it right now and pay later.

And so we find ourselves in our current situation. Our economy is very sick. Like a poor old drunk with a failing liver it has been taken to hospital with acute alcohol poisoning. The good doctors have decided that what is needed is good stiff brandy to revive the patient!

The only way out of the dilemma is for the debt junkies on both sides of the Pacific to do "Cold Turkey". And along the way, we will have to reduce asset values. In Australia, rather than flushing money down the bottomless pit of high finance, we would be better off spending it on providing low cost public housing, to provide some real competitive pressure in the property market, and so make housing more affordable.

References, Further Reading:

• Are We Scared Enough?, Tim Colebatch, September 23 2008. When I read this article, I thought "No, we aren't". And I started blogging about it. I think we are getting there though. Soon we may be scared enough.
  
  
• Taking A Long Hard Look At Greenspan, Peter S. Goodman, October 9 2008. It certainly is time to take a long hard look at him and re-evaluate his role in the current crisis of Peak Debt.
  
  
• Stocks are on track for their worst year since 1937. Look for the comment by "TexasSceptic", who sounds as if he knows what he is talking about. But can you understand his discussion of credit default swaps? It seems more complex than a proposition from Lichtenstein. I always thought credit was just a matter borrowing money and paying it back (or not - as is the present case).
  
  
• The debt clock runs out of digits. Yes it's true! A digital "debt clock" near Times square, which shows the national debt, has overflowed! They had only allowed for 13 figure numbers. Guess they assumed, "In a sane world we'd only need thirteen digits - I mean if it ever exceeded thirteen digits we'd be right up the proverbial creek!. President Bush when he heard this said, "That means we'll never owe more than that, right?"
  
  
• Alarm bells for Australia as China tries to delay iron ore shipments. Yes, the resources boom might be faltering. Which would be seriously bad news for Australia. It's a good thing us Aussies are such good swimmers, because we chopped up the lifeboats long ago in order to burn them in the boilers. And then we gave all the life jackets to our bosses, because their need was greater.
  
  
• Merchants and Bankers Listing. Dan Byrnes, Armidale historian, raconteur, webmaster and poet without a blog, comes up with the provocative metaphor, that "The USA has exported its poverty". Whatever it is they exported it seems to be particularly virulent.
  
  
• Warren Buffet On Derivatives . This PDF which is a brief extract from the Berkshire Hathaway annual report for 2002 contains what is by now one of the most famous and prescient comments ever made by Warren Buffet, namely that derivatives are Financial Weapons of Mass Destruction.