I strongly recommend reading this: ‘How unlimited interest rates destroyed the economy“, Thomas Geoghegan, Harper’s Magazine, April 2009.
It is subscription only. Here is a brief excerpt. The article is worth the price of picking up a copy at your local store.
Amidst all the writings about the financial crisis — both nonsense and expert insights — this describes an important and overlooked aspect of the problem. Perhaps the most important aspect. While the conservative media frets about the increase in government liabilities from $65 trillion to $70 trillion, tens of millions of American households groan under loads of debt from which they can never escape. Other than through bankruptcy. Here lies the potential for serious social unrest. Radicalism, perhaps even violence.
Opening
The number of collection and foreclosure cases in this one county {of Chicago} — 174,000 — is equal to the total number of people in three entire Chicago wards: every man, woman, and child. I stress “child” in particular, since the banks give out credit cards like candy. Yes, 174,000 cases — and that was before the economy tanked. These are not old-fashioned collection cases either. Typically, the banks are enforcing arbitration awards handed down by “private arbitrators” who more or less work full time for the banks. So the banks can sue anyone anywhere in any court in America without having to provide a witness or prove a case.
The pain of all this may get much worse. If deflation comes (even in a mild form), it means each dollar of debt will be harder to repay. That’s why populists in the 1890s took up their pitchforks: deflation made it increasingly difficult to pay off the principal on their loans. But at least in the time of William Jennings Bryan, they were only paying back at 5 percent. While we deflate, credit card holders will be paying off at rates of 20% to 35% , and 1890s-type deflation would make the rate feel more like 35% to 50%.
What’s the worst of all the legal changes that fill up collection courts? There are so many, but I’d pick the legalization of usury. It’s the form of deregulation that not only drove us into debt but also sped up the loss of the manufacturing jobs that created our middle class — that, in short, brought about our current Time of Troubles.
Conclusion
Finally, we should think about ways to “inject equity” directly into the accounts of working people rather than into banks. The best way to do this is to announce a plan to raise the gross replacement rate of Social Security from 44 percent to something closer to 65 percent, which is still short of the rate in many European social democracies. We can afford this as much as or more than they can.
We could aim to reach that goal gradually, over the next twenty years, but even announcing the goal encourages future-oriented thinking. It would encourage people to believe that they could invest in real things again, instead of pinning their hopes on the false and predatory promise of a big, Vegas style payout. The promise of a real public pension that people can live on would lead fewer of us to chase bubbles in good times, even as it gave all of us the confidence to keep spending when times were bad.
Schumpeter feared that this kind of countercyclical thinking by people on the left would lead to a stagnating form of socialism, or even the end of capitalism, But socialism, in the state run form he anticipated, is not inevitable, or even desirable. Social democracy, European style, which Schumpeter did not expect, is desirable. Sure, I’d like the European governments to run up a bit of public debt to pump up demand over there—I don’t think that’s so immoral. What’s immoral is to pump up demand, as we have, by handing out easy money at high interest and driving people into debt.
Even in Babylon they spared people that kind of captivity. We now have to ensure our own country does the same.
Afterword
Please share your comments by posting below. Per the FM site’s Comment Policy, please make them brief (250 words max), civil, and relevant to this post. Or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).
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For more information from the FM site
To read other articles about these things, see the FM reference page on the right side menu bar. Of esp interest are:
Posts about America’s debt:
- Death of the post-WWII geopolitical regime – death by debt, 8 January 2008 – Origins of the 1982 – 2006 economic expansion; why the down cycle will be so severe.
- A picture of the post-WWII debt supercycle, 26 September 2008
- Debt – the core problem of this financial crisis, which also explains how we got in this mess, 22 October 2008
I thought there already was a ceiling on lending rates? Like many people, I received a ton of credit card offers a couple of years ago. Regardless of the introductory rate, normal rate and/or lifetime rate, the default rate was 29.9x%. That can’t be a coincidence, I am sure that is mandated by law (maybe it’s a California thing).
#40: Define ‘easy’ credit. Who starts a business with unsecured revolving credit? Nonsense. People use it to buy crap from China they don’t really need.
I reiterate: Cutting the ceiling on credit cards in half is a mistake. If anything the ceiling should be fed funds rate or LIBOR + X%. Instead they should say you can’t have an unsecured limit of more than Y months of your income.
FM: “Inflation will not “work” because it requires marks, a people unprepared for inflation — not likely since the Great Inflation was the formative economic experience for the Boomers.”
interesting, i havent run into that line of reasoning before. But what if one was prepared, but the powers that be intended to inflate anyway? (supposing the powers that be turn out to be net debtors, which I’m not sure of) … What stands in the way of having a trillion-dollar rescue package every month or two? After 10 or 15 of those, it simply *has* to overwhelm the deflationary effect of the $14T loss in household wealth.
I’m just curious why you rule it out.
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Fabius Maximus replies: As people prepare for the “obvious” inflation, the government’s benefit from that inflation decreases. Consider the situation in 2 years (to pick an arbitrary number), when the recovery comes (exaggerated for emphasis). Everybody (including elderly widows in Smallville) will own just only hard assets, inflation protected securities, or short-term debt. The average maturity of the Federal debt will be 2 weeks. Under these circumstances the government must avoid inflation at any cost, as the resulting increase in its interest cost would be lethal.
“Under these circumstances the government must avoid inflation at any cost, as the resulting increase in its interest cost would be lethal.”
I wonder if this will happen. The fear of inflation has really been bugging me for a while. Thanks for your reply!
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Fabius Maximus replies: In my experience confident forecasts are usually made by those expecting that the future must follow the recent past. An easy test is to ask the one making the forecast to describe at least one alternative future scenario (something plausible). If they cannot do so, then toss the forecast and move on.
We see this today. The formative economic event for the Boomers was the great inflation, as the Great Depression was for the previous 2 generations. Their parents spent their lives fearing depression and deflation, as the Boomer’s see inflation always hiding under the bed. The future holds many more possibilities than these.
“Everybody (including elderly widows in Smallville) will own just only hard assets, inflation protected securities, or short-term debt. The average maturity of the Federal debt will be 2 weeks. Under these circumstances the government must avoid inflation at any cost, as the resulting increase in its interest cost would be lethal.”
Utterly rediculous and completely dependant on the concept of rational behavior.
This scenario is more likely: Let’s say as a recovery starts some experts warn of an inflation “bubble” growing. Many others predict a rosy future of few worries, afterall the “worst is over”. Some who have previously experienced such a thing and know what it looks like react rationally and shelter assets accordingly. Others haven’t seen it or think it can’t happen again or believe that the Gov’t actors whose actions started it can now reign it in because thats what they are supposed to do and say they will do. They go along like their future will be 2006 all over again.
Same irrational behavioral cycle that caused our current crisis acting on a different set of financial circumstances.
There is no rational economic behavior, only learned behavior and behavior adapted from learned lessons. Those who have not previously observed the extant circumstance (personally or through study) are almost always behind the curve in responding to it.
If what FM posits was true in the real world no old ladies in Smallville would have lost their retirement savings in the current supersized recession by listening to 30 something “financial advisors” They would have instead had all their money out of equities and in Treasuries 2 years ago.
Mark my words: it is precisely the hubris that “we” are prepared that makes inflation a certainty. Our recent history of preparation for hurricanes, terrorist attacks, insurgencies, financial bubbles, etc. just about guarantees it. Besides other than race riots its about the only internal disruption of the 20th century we haven’t repeated in the last decade.
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Fabius Maximus replies: You are making this much more complex than necessary. Economists and professionals are almost unanimous in their expectations of inflation, probably due the inflation being the formative influence for recent generations (fighting the last war). This will be the primary driver of institutional behavior, including that of foreign central banks — our largest creditors. In response they will, among other things, shorten the maturity of the treasury holdings. There are already rumors that our largest creditor — the People’s Bank of China — is doing so. That is sufficient to create the conditions I describe.
The flip side of the this coin in an underestimation of the probability that we will choose door #2, the alternative method of eliminating excess debt: default (which can take many forms, different colors of lipstick on the pig). Unlike inflation, awareness of which is burned into the boomers minds, deflation is considered to be impossible.