Friday, May 29, 2009

Culture of debt might make recession worse than many think

It has been remarked on many occasions that this is the worst economic downturn in quite some time. By now, everyone has either seen the ill effects of the collapse, or worse, experienced them firsthand. What has been less recognized is one of the most important causes of the crisis, and an impediment to sustained growth in the future: a culture of irresponsible debt.

Wall Street’s reckless practices have justifiably received a great deal of attention. Investment banks and other financial firms were over-leveraged at the same time that they systematically underestimated risk. Perhaps the most well-known example is Lehman Brothers. Like other firms, Lehman leveraged its portfolios several times over. That meant huge returns if the portfolio did well. But when the credit crisis hit and returns were down, huge sums of wealth were wiped out. Better diversification and more judicious use of leverage might well have kept Lehman alive. Worst still, the problem is industry wide.

Excessive debt is a problem on Main Street too. The US census bureau found that the average American credit card holder carried $5,000 in debt. This was on top of mortgages, student loan repayments and the like. Some of the debt families held was inevitable; credit helped them buy necessities such as groceries and medicine when wages failed to keep up with the cost of living.

But too many took on a bigger sub-prime mortgage than they could afford so they could move into a larger house than they needed. Still others maxed out their credit cards to buy the latest plasma television sets, or the newest video games. Unscrupulous lenders and credit card companies actively abetted them by granting easy credit to people without good histories.

And that excessive amount of debt is one reason why normal government action to lower interest rates will be insufficient to improve the economy for the foreseeable future. Despite the fact that the Federal Reserve has cut interest rates to 0%--the Bank of England is not far behind at .5%--people simply are not borrowing. With so much in debt already, not even such a low interest rate will incentivize them to add more.

This can quickly become a vicious cycle. People will not borrow to spend because they have too much debt already. That means consumer spending will go down. More people will ultimately lose jobs, which means even less spending. Only when Americans have paid off enough debt to feel comfortable taking on mortgages and spending money will the economy revive.

Given how much debt they do hold, that might not happen for a long time; at the very least, it means the downturn will be longer than the typical recession. This means too, that much of the growth over the past decade was ultimately illusory. To make sure economic growth in the future is built on a solid foundation, it cannot be based so heavily off debt-financed spending.

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