thoughts on subprimes

by Hugh

I posted something on Twitter about this, but that’s a stupid place to write about something as complex as the subprime mortgage problem, so I’ll do a little run-down here. In particular, I am struck by the (lefty) media spin, which is, roughly:

The government will bail out the big banks, and leave ordinary homeowners with their pants around their ankles, suffering foreclosures etc.

Or:

Good news! The Fed has reduced interest rates, to encourage more irresponsible lending and borrowing which is what got us in this mess in the first place.

While I have no doubt that the government will protect their rich banker buddies, and leave the ordinary people out to dry, this sounds like: “if only the government would help out ‘regular homeowners’ everything would be all right…please find a way for us to keep buying expensive houses that we can’t afford.”

Basically the media is saying: “Everyone should have a house, why can’t the government fix this stupid subprime thing so that everyone can have a house again?”

And the problem with that is that the mess starts in the first place from the government fixing things so that everyone can have a house, by crafting policies that encourage banks to make bad loans to bad credit risks; which further encourages people to buy houses that are too expensive, which drives the market up, so everyone’s happy until the bottom falls out of the whole thing. It’s nice for everyone to have a house, but the irony is that this whole mess is kind of like a right-wing version of socialism, where through low-interest rate policies, bankers all got rich as sin, people got to enjoy houses they couldn’t afford … and in the long run, as with any kind of expensive social spending, the whole economy might get trashed in the process.

[Here is a great web comic that explains the surface details of subprime mess].

The past 2 decades really haven’t seen anything significant in the way of recessions (1987 was the last serious one, and the dotcom bust of 2000 hardly had any long-term impacts on the economy in general). Generally the economy has kept growing, life has appeared more prosperous for many, and inflation hasn’t been much of a bother. How was that achieved?

Policy makers usually have two economic factors they try to balance: growth (good: meaning more jobs, more profits etc), and inflation (bad: meaning less buying power). Generally interst rates, growth and inflation have a strange feedback loop: Low interest rates => high growth => high inflation => raised interest rates to curb inflation => slow growth. You need to balance the two to keep the people and businesses happy, and in the past 2 decades we’ve seen unprecedented growth, coupled with insignificant inflation.

That’s strange, because big growth is usually coupled with inflation.

So how did we manage to have lots of growth (that is, continue getting much richer) with almost no inflation? There are two answers:

1. growth was driven by tons of cheap (ie low interest rate) credit (due to a low interest rate policy of the Federal Reserve, plus the government borrowing tons of money from China). When interest rates are low, you borrow lots of money to fund businesses and to buy houses.
2. inflation was kept down by tons of cheap goods imported from elsewhere (again, primarily China).

This has meant that we’ve become accustomed to more wealth and more purchasing power than ever. Wealth seems to be increasing all the time (for the big swath of upper middle classers, at least). And as for economic activity/jobs, much of that was fueled by a red hot housing market: build build build and sell sell sell means lots of people working and getting richer.

But it’s based on a fantasy: debt that allows us to buy cheap goods from elsewhere. The debt levels (personal and governmental) are unprecedented. And the reason the debt is unprecedented is that it’s a bad idea. Fueling economic expansion with major debt whether the socialist kind (government borrowing & spending) or the right-wing kind (citizen borrowing & spending) breaks down eventually.

And then what happens?

So while the subprime mess means people will lose their homes, and that sucks, the really scary question is about how you keep the US economy going at all in the long term. Especially if we plan to keep the sort of wealth we are accustomed to. It’s not at all clear. And if we can’t keep it going, what sort of turmoil is in store?

UPDATE: If you want to get depressed, read this (though do note, it’s more or less an ad for his book).