April 14, 2009
“The heart of the crisis is that banks stopped lending” President Obama, from his speech on 4/14/2009
In his speech on 4/14/09, President Obama spoke about the current crisis. We were reminded that the problems with the economy started when banks stopped lending. He went on to say that people were laid off when businesses couldn’t get loans. The solution, therefore, is to “free up credit” and “get banks loaning again”.
Is this true? Let’s walk through our crisis in a simple, common sense manner.
The symptoms of our current problems started with the cracking of subprime mortgages. In essence, people with lower credit scores were unable to make their house payments. When defaults started, the underlying bonds (most of these subprime, as well as other types of loans, were packaged together and sold off as “CDOs”) began to sell off because investors doubted their investment merit. As more people began to sell these bonds, their prices went lower. Many banks held these types of loans on their books as part of their asset portfolio. As the value of their “assets” dropped, banks were forced to raise money to meet their mandated capital ratios. As banks tried to raise capital, their stocks dropped. Fear took over, and everyone began selling everything. There are more complexities to this story, but all we need to understand is the basics. The problem started when people couldn’t make their minimum payments.
What people don’t seem to understand is the basic rule of fixed costs. Every month, most people have to pay their rent, car payment, insurance, utilities, and buy food. At some level, we have a minimum payment that we have to make to maintain our current standard of living. This monthly payment tends to be similar every month, and could be considered our fixed cost of living. If this cost goes up faster than our income, then we have less money left over to spend on goods and services. In this last cycle, fixed costs soared. Remember, as house prices soared, mortgage payments went up. Further, Americans took out trillions of dollars in home equity withdrawals, leaving them with higher debt loads and higher monthly payments. The real cause of the crisis, and the root problem, is that debt payments became too large a portion of incomes. When people spend a large portion of their money on debt payments, they spend less on goods and services. When businesses, which provide goods and services, slow down, they make less money. In turn, they lower wages, fire people, and may even close down. As incomes go down, and people get laid off, they have trouble making their payments, and the cycle starts all over again. Hence, and this is critical, the real crises is that people took on payments (fixed costs) that were too high to maintain over the long term.
To make matters worse, many people spent more than their incomes in the years leading up to the bubble bursting. Further, most people failed to save money for the proverbial rainy day. Well, the rain finally came. We ended the boom years without much in savings, and for many, with high levels of personal debt. If we missed a paycheck, we couldn’t make our payments. We did miss paychecks, and the system has collapsed. So, what do we do now?
“A wise man changes his mind, a fool never” – Spanish Proverb
Let’s get back to our topic. Our leaders say that we need to get banks loaning again to get the economy going. If the problem that we have is debt, then how can adding more debt solve our problems? Keep in mind, the money that bailed out the banks is debt. Our future tax dollars are being used to give banks money so that they can lend us more money. I fail to see how we can pay off more debt if we are struggling with the debt we already have. And if our debt payments go up (and our taxes for that matter), what is left over to spend on goods and services?
On 4/14/09, our President declared that we “can’t build an economy on a pile of sand”. Well, debt is sand. We need an economy where business thrives, where people make money, and where fixed costs are low enough that people can spend and save. The “ownership society” that has been espoused over the last decade has been a farce. The owners have been the financiers that really owned the assets. Ironically enough, we Americans are bailing out the owners of the assets with our taxes, as we struggle to pay the interest burden that has been put on us. We have become merely renters, paying high interest rates for basic necessities.
Leo Tolstoy said it best: “Money is a new form of slavery, and distinguishable from the old simply by the fact that it is impersonal – that there is no human relation between master and slave.”
As Americans, we need to become owners. We need savings. We need productive, prosperous businesses. What we don’t need are debt burdens that slow down business, and mortgage our future!