I love fantastically absurd headlines. In this case, I really do mean it. The risk for a deep and long recession has increased, not decreased. I plan to explain why in just a moment, but I wanted to make a few declarations. I’ve been reading all I can on the actual history of the Great Depression, as well as the economics. When I read about the economics, I try to make sure I have a balanced coverage of economic viewpoints (in particular, I try to read the Keynesian and the Chicago or Austrian perspectives). There are very few things that anyone can agree on. One thing that everyone agrees on is that the Smoot-Hawley Tariff Act was a complete failure. Many economists and historians argue that it was tremendously harmful. When Obama is elected president, I promise to write an essay about it (sadly, it will be quite pertinent).
The Scenario
Suppose there is a person named Sam. Sam spends beyond his means, slowly running up his credit card. The economy isn’t so good, and Sam is likely to lose his job. The risk of a default is high. As a credit card company, you have two options:
- Raise Sam’s credit limit in the hopes that when the economy turns around, he will be able to pay off the balance.
- Keep Sam’s credit limit the same, knowing that a default is likely.
This problem has been studied by credit card companies for a long time. The economically smart option is 2. This is because option 1 doesn’t actually reduce the risk of default enough to justify the increased losses if a default occurs. In fact, because Sam is maintaining a higher balance, his credit score has likely fallen. The credit card company is likely to effectively decrease his credit limit (this includes increasing his rate).
I Have an Uncle
Uncle Sam has lived beyond his means for some time. Fortunately, Uncle Sam controls his own credit limit (but not his rate). He’s borrowed more than $10 Trillion. He’s planning on borrowing a lot more. But that’s not who I’m criticizing here. Uncle Sam is not the Sam in the scenario above (though he may be someday soon). Uncle Sam is now the credit card company.
America is in Debt
The US businesses and consumers (you, me, everyone else), owe a current aggregate of about $40 Trillion. That’s 40% of the debt of the entire world (yes, the US Government is 10% of world debt). Easy money policy in the government helped spur a credit bubble. Both businesses and consumers took part. To some degree, this is good: investments should be made in times of cheap money. To some degree, this is bad: debt must be paid back at some point. But thanks to government monetary policy, credit was available at rates decoupled from risk. That was bad. Many businesses and individuals are going to default. The government has responded by attempting to expand credit in a number of ways (mostly driven by the Fed, but also the recent bailout package). Today, the Fed agreed to step into the commercial paper market. This is raising Sam’s credit limit without substantially reducing his risk of default.
The Unintended Consequences
Let’s say that there are two businesses, Al’s and Bob’s. Al’s and Bob’s are in the same line of business (they are direct competitors). Al’s cash flow is slightly worse than Bob’s, but Bob’s isn’t doing so well, either. There’s a small recession going on, and consumers have begun to spend less. If nothing is done, Al’s will go out of business, and Bob’s will buy some of the productive capacity. Bob’s becomes the default choice for customers. Consolidation has occurred. If the government does something, both Al’s and Bob’s will survive a little while longer, but the cash flow problem won’t go away. Both will build up debt. The consolidation will eventually happen, but both businesses will have their balance sheets harmed in the process. Eventually, both will default. This was not the hope. The hope is that the consumer will be able to recover and both businesses will survive. The downside risk is still noticeably greater (both go out of business) than with no intervention. But even if things improve, both businesses will be straddled with new debt.
Reality
There is a massive credit unwind taking place right now. This is highly deflationary. It is so large in magnitude that the government interventions have had no effect on it. Note that it is this size difference that allows for deflation even while the government is trying to inflate… in a few years, the inflation will win, but the deflation will run its course long before then. Deflation makes the likelihood of default increase for any particular debtor. Extending credit to those who will not be able to pay it back makes the amount of debt defaulted on larger. It also will make recovery that much harder, as so much money was spent on trying to prevent the collapse. It would be far better to spend the money climbing out of the hole instead of trying to avoid finding the bottom. This is especially true because the efforts are really just digging a bigger hole. If the government wanted to avoid hitting the bottom of this hole, it would have to intervene on a scale that would be relevant to the global credit crisis (which is estimated on the order of $100 Trillion). I don’t believe that is possible. As such, extending credit only serves to increase the money defaulted on (resulting in a deeper recession), at the expense of using that money to rebuild (resulting in a longer recession).
