Saturday, February 14, 2009

A simpler way to think of a credit bubble

Think of the U.S. economy as a household balance sheet.  You have assets, liabilities, and what is left is your net worth.  Your assets are houses, equities, etc.. and the debts against them.  In 1982, your assets had started appreciating in value, and your debts against those assets were modest.

However, since then, as your assets kept appreciating in value, you kept borrowing and borrowing against those assets.  First you bought more assets - real estate, stocks.   This was ok, as the value of these assets kept growing faster than your debt, and you were making enough in income to cover the cost of servicing that debt.   So the assets grew, the liabilities grew, but your net worth grew.

This has continued for almost 25 years, more purchases, more borrowing, with one exception.   Now we were just consuming on debt - buying TVs, computers, vacations, cars - spending more on stuff than what we make.   But we thought it was ok, because even though we had more debt, our assets grew faster in value.

We just hit a couple of points now.  First, the assets that supported all this debt dropped - so now we have more liabilities than assets:  negative net worth.   Second, we have income that barely covers the minimum payments.   As we all know, if you stick to minimum payments, your debt takes forever to pay off.  So now your income drops, and you can't even make that.

Well first and foremost, what does one do?  If your debts substantially exceed the value of your assets, and you income is falling and you already have trouble making your payments, then your options are limited.   Restructuring your existing debts may work by extending the term and payments.  However, if the quality of the collateral will not support it - a prudent lender would not be inclined to do so unless compensated - which  means higher payments.  See the problem?

The solution being done by Congress is to double down on debt and spend, hoping all the consumption will pump asset prices up beyond the additional debt to bring income up to support and and to a positive net worth. Ask yourself this - if you went to a banker with this idea to fix your debt problem, you'd be laughed at.

The solution is bankruptcy in the case of the individual.  Admitting that you cannot meet your debts, and having a quick and order liquidation of assets, using the proceeds to pay off creditors to the extent possible, writing off what is outstanding, and letting the individual start with a clean slate.   It is relatively quick, and painful, but it is better than letting a man be crushed for years under debt.

America has one of the most  dynamic economies in the world because it generally recognizes that it is better to wind up troubled enterprises quickly than let them fester and drag down everybody else.   You would think our elected officials would know that.

Sadly, it comes more apparent with each day, that the longer a  politican is in office, the more detached for the fundamentals of business and economics they become.

1 comment:

Realist Theorist said...

"America has one of the most dynamic economies in the world because it generally recognizes that it is better to wind up troubled enterprises quickly than let them fester and drag down everybody else."

Well said.

A few years ago, I read an article (I forget where) which compared job-growth in the U.S. against the EU. The U.S. was ahead in the NET numbers. The really startling part were the GROSS numbers. The U.S. Gross Job Losses and Gross Job Gains were an order of magnitude above the EU. The secret of the US was that is was allowing many more people to lose jobs and find new ones, instead of keeping them in less productive jobs.

I should try finding the numbers somewhere on the web, to confirm this afresh.