Insights & Advice

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Credit: the real cause behind The Great Recession

It has been almost five years since the start of the financial crisis. In its second year, the so-called recovery has been disappointing, unlike any other economic cycle since World War II. At the heart of this failure lies our country’s inability to recognize why this time it is truly different. That difference can be summed up in one word—credit.

We must reach back to the Great Depression to find the last time there was a large-scale banking crisis in which leverage and excess credit were the main cause of a recession. Too much credit (sometimes called leverage) is the “Achilles heel” of any economic system. Unfortunately, neither government nor the private sector has much experience in dealing with the aftermath of an economic credit binge. Instead, we have all tended to try and jump start the economy using the same tools we have been using since WWII. It won’t work.

Up until the aftermath of WWII, real private lending had grown about the same pace as economic activity. But in the early 1970s, credit began to grow at about twice the rate of economic activity and it continued expanding from there. Economists think that the credit binge was ignited by the collapse of the Breton Woods international monetary system. That agreement, established in 1944, was forged in an effort to reconstruct the world’s economy after the war.

Forty-four allied nations agreed to peg their currencies to the U.S. dollar. In turn, the dollar was pegged to the price of gold. The U.S. took the world off this dollar/gold standard on August 15, 1971. Currencies from that point on were allowed to fluctuate based on the economic fortunes of each nation and that’s where credit came in.

Governments and their economists figured out that the more credit (leverage) you used, the higher the growth rate of your economy and the longer that growth could be sustained. If you wanted a strong currency, the ability to borrow, and be able to make a name for yourself on the global block, the expansion of credit was a good way to do that. The challenge was balancing that credit growth with the underlying capital base of your financial sector. Up until then, that had not been a problem, but times change.

During 2004-2007, we expanded credit further and faster than anyone really understood. Like children with a new but dangerous toy, our financial wizards had no idea what excessive credit could do to an economy. Anyone that had first-hand experience (during the 1930s) had long since retired. Readers are now intimately aware of the sub-prime mortgage debacle, our credit collapse and its resulting impact on our financial system.

As a result of the crisis, a large fraction of the global banking systems’ capital base was erased almost overnight. In Europe it continues to unfold today. When something like that happens, it takes a long time to rebuild that capital base. In the meantime, lending is put on the back burner as banks struggle simply to survive. Without lending, the life blood of economic growth, the economy will and has experienced a deeper recession and slower recovery. That is the natural result of a credit crisis and there’s not much a government can do about it.

In the past, it took at least five years before lending (and investment) once again approached pre-recession levels. Credit, after all, has much to do with the trust and faith by the lender that the borrower will be able to repay the loan. A credit crisis like the one we experienced in 2008-2009, destroys that faith. No matter how low the Federal Reserve forces interest rates, lenders won’t lend until that faith is restored and they feel their capital base is once again secure. That takes time. The on-going turmoil in Europe’s banks simply delays that from happening.

In the meantime, ignore all the promises of both candidates. “Getting America back to work again” and similar slogans would require an understanding of the nature of the slowdown and an entire new set of tools to address it. Neither party’s candidate appears ready to recognize that this Great Recession is truly different from any in their lifetime. I doubt they or the armies of experts advising them will ever recognize the truth, except in hindsight.

The good news is that time does go by. It’s been three years since we have officially entered a “recovery”. In another two years or so we should be getting back to normal. I hope.

 

 

Posted in A Few Dollars More, Macroeconomics