Sunday, November 23, 2008

The 2008 Credit Crisis: Causes and Consequences

What is this Credit Crisis about; What's actually happening to the real economy, and how does it affect investors? The roots of the credit crisis have been in the making for several decades.

What's been happening over the last four decades: Credit has been growing as % of GDP

In a fiat-money fractional reserve-banking economy, the supply of money in the banking system broadly correlates with the amount of credit (loans) that have been extended to companies and consumers.  As you can see from the following data, the money supply in the economy relative to GDP has been growing:

1970: M3 USD 0.6 t; Nominal GDP: USD 1.1 t; M3 to GDP: 54.5%
1975: M3 USD 1.0 t; Nominal GDP: USD 1.7 t; M3 to GDP: 58.8%
1980: M3 USD 1.8 t; Nominal GDP: USD 2.9 t; M3 to GDP: 62.1%
1985: M3 USD 3.0 t; Nominal GDP: USD 4.3 t; M3 to GDP: 69.8%
1990: M3 USD 4.0 t; Nominal GDP: USD 5.8 t; M3 to GDP: 69.0%
1995: M3 USD 4.3 t; Nominal GDP: USD 7.5 t; M3 to GDP: 57.3%
2000: M3 USD 6.7 t; Nominal GDP: USD 9.9 t; M3 to GDP: 67.7%
2005: M3 USD 10.1 t; Nominal GDP: USD 12.7 t; M3 to GDP: 79.5%

An increasing amount of credit has been extended by the banking system to economic participants. In a closed system, the credit can represent three things at a systemic level: (1) increased consumption using the credit, which in turn causes increased capital investment to support the increased consumption; (2) increased funding of capital investments by credit to support increasing consumption; or (3) increased prices of real assets and financial assets as the credit is used to purchase assets. 

Leading to Unsustainable trends: (1) building white elephants;  and (2) increasing financial savings while depleting economic savings

The first two in themselves would not be a problem, since increased economic productive capacity provides the basis for economic growth. However, the fact that the proportion of credit to GDP is increasing means that either (a) the structure of the economy is changing to become more capital intensive, where higher levels of capital are required to produce a unit amount of goods, or (b) that the increase in consumption and productive capacity is increasing at an accelerated rate. Unfortunately I believe that hasn't been the case, which means that society has been  building more capital goods than required - or in other words, we've been building white elephants. (I use the term "capital goods" loosely - it can also refer to housing, which produces "living space" which is captured in GDP as rental income)

The third is a problem if it is sustained for too long, because it drains the economy of real savings. As the price of homes and financial assets go up, individuals believe they have built up savings for retirement and emergencies. However, on a systemic basis, no economic savings are being built up to sustain capital goods creation. What appears to individuals as savings is actually financial savings, which is different from economic savings. In the economy, savings that fund capital goods creation (real productive capacity) can only come about from foregone consumption. Capital goods are created when people work on building machinery and houses instead of making consumption goods. This means that the aggregate amount of consumption goods created (and consumed) is less than the amount of things they have created (income). If the income from work is not forgone to fund the creation of capital goods, then there is no economic savings. If the growth in asset prices goes on for too long, it will cause the nation to appear wealthy as the financial savings and financial wealth appears to be high. But in reality, the economy's underlying productive capacity is deteriorating because no income has been forgone to fund it. At some point, asset prices will collapse for psychological reasons, or because the underlying economic productive capacity cannot produce enough income to sustain the high prices (e.g. when rents cost more than what jobs pay).

The consequence of which is this Credit Crisis
- What's happening in this crisis

The current credit crisis seems to be a confluence of these forces: (a) the build up of white elephants funded by income forgone in other countries (imported capital), (b) the sudden fall in value of financial assets after their prices rose to unsustainable levels, and (c) the diminished productive capacity of the economy.

The result is that people who have borrowed (financially) to invest in white elephants are going to lose their money and default on their debt. This means that there will be significant destruction of money in the banking system, which would lead to banks reducing lending as they work through the losses. This reduced lending is going to crimp economic activity and capital investments for a while, and lead to a recessionary bias. (In the past, before deposit insurance, this might have led to runs on the banking system, which would be enormously destabilizing and could change the psychology of the population to the point where people reduce their living standards by lowering their consumption of goods and services, leading to a deflation and depression as the population demands a lower economic output than what the productive capacity of the economy is structured to produce.)

At a societal level, it also means that the economy does not have the productive capacity to pay back (in terms of goods and services) the people who have spent time building the white elephants. They may not realize this, because they could have already received payment from the people who borrowed money to create the the white elephants. But the reality is that there are more of these dollars, which are claim checks on future economic output, than there are goods and services that the economy can produce in future. (If they had been building needed productive machinery on the other hand, the claim checks could be used to claim the future products produced by those machines). In effect, all economic participants are being shortchanged as their dollars are devalued (through inflation).

This is leading to:
(1) inflation, causing everyone to suffer;

In a society without representative government, this devaluation of claim checks wouldn't be so severe, because the money supply would contract as bad debts are taken onto the banks' balance sheets. This reduction in money supply (manifested as destruction of shareholder's equity and deposits) would reduce the number of claim checks in the economy, to match the actual productive capacity of the economy.

But it would of course, be manifestly unfair to certain segments of the population. The trades people (labor) who invested their time in building the white elephants would be made whole, while persons who have saved their income would be wiped out thanks to the misjudgment of the people who borrowed to create the white elephants.

Politically, this has been hidden through the government's deposit insurance schemes and capital injections. These have the effect of protecting the savings of the savers, and preventing the monetary base from contracting. But the effect of this is inflation, as there are now more claim checks than the economy is able to produce goods and services for in future. Savers are still harmed through inflation - but the inflation creeps up slowly, and is politically more acceptable.

Societal over-investment in white elephants is fraught with moral hazard. Whichever way you look at it, the bad judgment (or reckless attempts at making a profit from creating too many capital assets) of one group causes everyone to suffer. The negative externalities of misinvesting capital into white elephants is simply not priced in when investors borrow money to build capital assets. This is why credit/debt extension needs to be regulated. 

And also leading to:
(2) a Recession; (how is the recession going to play out?)

The economy is going to be recessionary in nature as the reduction in credit squeezes economic activity. The credit squeeze is also going to be difficult for companies that rely heavily on debt financing - they are going to face tough times as their cost of capital goes up, and some businesses that are economically viable in the long-term may go bankrupt. The extent of the recession depends on the amount of mis-allocation of capital (i.e. credit/savings) that has happened. There is also going to be an impact from job losses and company closures in industries that were geared to building white elephants, and servicing the people building white elephants.

A cursory glance suggests that M3 as a % of GDP has at most peaked at 69% of GDP prior to past recessions. Considering that today's (2008) M3 as a % of GDP is probably around 80%-90% (this is a guesstimate, because the Fed stopped publishing M3 data after 2005), it suggests we are going to face a economic recession worse than any since the Great Depression. Conceptually, this is going to happen as society as a whole realigns itself to "forget the debt owed for work done in building white elephants (this debt will never be repaid), readjusts, and gets back to its normal course of living" (unfortunately as we have described earlier, the fallout and impact to different segments of society is unequal). Society as a whole will adjust to lower economic activity than what the previous high level of capital investments suggested the economy was capable of. Practically, this is going to happen through two mechanisms:

(1) The banking system is going to reduce outstanding credit as debts go bad, and this will crimp economic activity. In the short term, this may even lead to deflation.

(2) Because of the Fed's injections into the banking system, and because of the existence of deposit insurance, inflation is going to kick in as the money supply stays constant while the economy's productive capacity contracts, or grows slower than what the prevailing money supply was "intended" for.

This will be a deep recession,
but it's probably not another Great Depression

This is going to be deep recession, probably worse than anything we've seen so far. But I think the odds of a depression (with regular people starving and living off soup kitchens) are low, because:

(a) Deposit insurance now exists, preventing money supply destruction, and preventing systemic bank runs which would send people into a psychological state that would get them to reduce their standard of living and consumption of goods and services, below what the productive capacity of the economy can produce, hence leading to severe economic contraction.

(b) the injections of liquidity by the Fed and Treasury, which help to prevent money supply destruction by keeping banks solvent and allowing them to keep their credit facilities open to economic actors.

(c) as long as free-trade continues to be viewed positively in the political agenda, the United States has products which it can export to countries holding lots of dollars in reserve, of which there are many (countries which the U.S. has trade deficits with). When these countries increase their purchases of U.S. exports, paid for with the U.S. dollars their central banks are holding in reserve, it will stimulate economic production and follow-on economic activity. In a sense, these are an untapped group of consumers which can kick-start economic activity should the domestic mood be so dour that people reduce their economic needs way below economic productive capacity.

(d) the U.S. population is still growing. People getting married will need new houses, consumption goods etc. While some segment of society, especially those got into excessive debt over the last decade, are going to reduce their standard of living, the introduction of new young people into the economic system should bode well for overall production and consumption. (Simply adding young people into a non-functioning/fragile economic base would be useless - look at many countries stuck in 3rd world conditions because the political-economy isn't set up for its young people to participate and create a better life. In the case of the U.S., a growing population helps because the political-economic framework exists to allow everyone to create a better life for themselves.)

We are in uncharted territory;
Living in a Grand Economic Experiment

Nonetheless, it's important to realize that we are in uncharted territory with the 2008 credit crisis, because society now has two tools that weren't present in previous credit-crisis led economic contractions: fiat money, and central banks.

There is a case to be made that many of the depressions since the 1800s were caused by a contracting money supply following a credit boom. Prior to the 1900s there was no central bank in the United States who could manage the money supply in a coordinated fashion. And broadly speaking prior to the 1960s, most countries were operating on the gold standard, which constrained the degree of freedom that central banks had.

We are living in the midst of a grand experiment which will tell us if credit-crisis led depressions can indeed be prevented through inflationary monetary policy, without adversely preventing the economic from making the structural changes needed to compensate for the excessive investments in white elephants. But make no mistake, this recession is probably going to be deep.

Sidebar Observation: Credit crises are a normal part of the human-economic cycle (Long-term investors should expect them)

How should long term investors think about the cycle of oscillating between bouts of "Euphoria Phase", with high valuations of capital goods like houses and companies/equities because of overinvestment / overextension of credit, and the subsequent "Subdued Phase" where the real price of capital goods drop as excess investment/debt is unwound?

My hunch is that the cycles run a duration of one human lifetime or so. The first ended in 1929-33, and the current one is ending in 2000-2008. If you look further back in history, credit led booms were also probably the reason for Panic of 1837, and the Panic of 1873 which led to the Long Depression. In other words, credit-bubble led cycles are likely to be an inherent feature of fiat money economies, and co-exist with the regular business cycles caused by inventory fluctuations. Investors and savers should expect these cycles. 

Investors living today in their 20s and 30s need to work within the framework of a subdued phase. This will probably last for some time, and the implication is that investors today should not rely on the broad conventional investment wisdom built up over the last 2-3 decades during the euphoria phase (such as the rule of thumb that stocks as an asset class will always outperform other asset classes, and the feeling that general stock prices always go up over time)

Post script (14 Mar 2009): For an explanation of the financial crisis from a financial perspective, have a look at this excellent infographic

Image by i ♥ happy!! from Wikimedia Commons, licensed under the Creative Commons Attribution 2.0 License.