The New Empire of Debt: The Rise and Fall of an Epic Financial Bubble (37 page)

New Yorker
columnist James Surowiecki’s book,
The Wisdom of Crowds,
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makes the point that two heads are better than one. Groups of people can be smarter than individuals. A market, theoretically, can do a better job of finding the right price for a thing. A market is supposed to aggregate the private opinions and independent judgments of thousands of individuals. Generally it succeeds. But on occasion, the market slips into crowd-like behavior—whipped to excess by the financial media or the financial industry.

And sometimes, the whole market is deceived by its own central planners. Rather than allow lenders and borrowers to decide for themselves what rates they would accept, the central planners at the U.S. Federal Reserve decided for them. How they can know exactly what lending rate such a large and infinitely complex economy needs has never been explained. But, historically, from the Fed’s lowest rate to its highest, there are about 1200 basis points. On those odds alone, they have almost certainly chosen the wrong one.There are times—indeed most of the time—when political leaders prefer easier credit terms than buyers and sellers determine on their own. In setting its key rate, the Open Market Committee tends to set a rate much more to the politicians’ liking than the one offered by Mr. Market. A lower rate, that is. But as Schumpeter points out, any stimulus in excess of actual savings is a fraud.

This artificially low rate gives the illusion that there is more money available than there really is. Hardly anyone ever complains. Consumers feel they have more money to spend than they really have. Producers sense a demand that really isn’t there. Undeserving politicians get reelected. And conniving central bankers are reappointed.

The “information content” of the Fed’s low rate misleads everyone. They proceed happily on the long, slow process of ruining themselves, unaware that they are responding to an imposter. Only much later does the deception become a problem.

Friedrich Hayek explains:

The continuous injection of additional amounts of money at points of the economic system where it creates a temporary demand, which must cease when the increase of money stops or slows down, together with the expectation of a continuing rise in prices, draws labor and other resources into employments which can last only so long as the increase of the quantity of money continues at the same rate—or perhaps even only so long as it continues to accelerate at a given rate . . . would rapidly lead to a disorganization of all economic activity.
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The way it works is simple: An economy is geared to produce for real demand.

Or it is misled by artificially low interest rates to produce for a level of demand that doesn’t exist. The deceit can go on for a long time. But, eventually, some form of adjustment must take place—usually, a recession restores order by reducing both production and consumption. Generally, the correction is equal to the deception that preceded it.

But the Bank of Alan Greenspan thought it could avoid these periodic bouts of sanity. Fed Governor Ben Bernanke proposed “global cooperation” in a November 21, 2002, speech. Then, in May 2003, he went to Japan urging concerted action. The Fed was prepared to sacrifice the solvency of American consumers, he told the Japanese. Tax cuts and low interest rates could still induce them to buy things they didn’t need with money they didn’t have. But Japan had to help hold down U.S. interest rates—by buying up dollars and dollar-denominated assets, notably U.S.Treasury bonds.

This is what happened next, according to Richard Duncan: “In 2003, and the first quarter of 2004, Japan carried out a remarkable experiment in monetary policy—remarkable in the impact it had on the global economy and equally remarkable in that it went almost entirely unnoticed in the financial press. Over those 15 months, monetary authorities in Japan created ¥35 trillion. To put that into perspective, ¥35 trillion is approximately 1 percent of the world’s annual economic output. It is roughly the size of Japan’s annual tax revenue base or nearly as large as the loan book of UFJ, one of Japan’s four largest banks. ¥35 trillion amounts to the equivalent of $2,500 for every person in Japan and, in fact, would amount to $50 per person if distributed equally among the entire population of the planet. In short, it was money creation on a scale never before attempted during peacetime.”
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Why did the Japanese create so much money? Because they needed to buy from their citizens the dollars they had accumulated by selling things to Americans. Had they not done so, their currency would have gone up—making their products less competitive on the U.S. market. Had they not done so, the dollar would have fallen much further against other currencies. Had they not done so, the Japanese would not have had the dollars to buy U.S.Treasury bonds. And had they not bought so many of them, U.S. interest rates would have risen, consumers would have had less money to spend, and probably the whole world would have had an economic crisis.

“Intentionally or otherwise,” Duncan continues, “by creating and lending the equivalent of $320 billion to the United States, the Bank of Japan and the Japanese Ministry of Finance counteracted a private sector run on the dollar and, at the same time, financed the U.S. tax cuts that reflated the global economy, all this while holding U.S. long bond yields down near historically low levels.

“In 2004, the global economy grew at the fastest rate in 30 years. Money creation by the Bank of Japan on an unprecedented scale was perhaps the most important factor responsible for that growth. In fact, ¥35 trillion could have made the difference between global reflation and global deflation. How odd that it went unnoticed.”
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As the empire matured, Americans developed new ideas and attitudes to go with it.We have already shown how they took on the beliefs of an imperial race, ready to mind everyone’s business but their own. Financially, their beliefs changed, too; people switched their attention from assets to cash flow, from balance sheets to monthly operating statements, from long-term wealth-building to paycheck-to-paycheck financing, from saving to spending, and from “just in case” to “just in time.”

It was a flight to hazard that became more hazardous with every take-off and landing.

It was as if a strange new trade wind had been stirred up in the Pacific and blew across the country. Year after year, it blew stronger, until practically every tree and street sign, all across the country, leaned toward empire. Gradually, all of America’s institutions and attitudes were bent by the new wind.

The federal government ran a fairly tight ship until the Johnson and Reagan years, and then the wind caught it. Soon, it was under full sail, flying toward record deficits and unheard-of debts.

The Federal Reserve braced itself under the iron hand of Paul Volcker (1981-1987).Then, it was Alan Greenspan’s turn at the helm. Soon, the Fed was not only bent over along with everyone else, but actually flapping away itself—increasing the blow.

Consumers had a hard time keeping their feet on the ground. Every time they ventured outdoors, the strong wind pushed them toward more and more dangerous debt.Where once they considered a heavy mortgage a risky thing, they came to see it as no risk at all.The gush of air picked up their houses and lightened the load. As interest rates dropped, they couldn’t wait to refinance and then refinance again, each time “taking out” a little more equity.

The wind bent consumers’ attitudes toward debt and twisted the lending industry into such comely new forms: How could they resist?

In the spring of 2005,
Grant’s Interest Rate Observer
paused to observe something unusual: Rarer even than a banker with a heart, it had discovered one with a brain.

The late Vernon W. Hill was a banker from a small town that must be in a gully; the winds of modern debt-financing didn’t seem to reach it.

“We feel the U.S. is in trouble, with major weaknesses and unpleasantness ahead,” he said. “Whether inflation or deflation lies ahead, or some kind of both, we believe many borrowers will be unable to repay their loans as scheduled.” None of the reasons Mr. Hill mentioned were original: little savings, little investment in productive industry (much of what was invested went into short-lived software), and the illusion of wealth that accompanies rising house prices. With little real investment in new factories or new methods of production, few good-paying new jobs were created. In such an economy, a banker without a brain walked lightly and lent heavily. For the president of Monroe County Bank, on the other hand, you got the impression that every step toward a new loan was uphill. He lent almost reluctantly, wondering how borrowers would be able to repay.

While other bankers were moving more and more of their money into real estate loans, Mr. Hill was warily reducing his bank’s exposure—especially to residential property. Home mortgages were less than a third of commercial bank loans in 1980. Now they were nearly two-thirds. Other bankers lent to anyone who could sign his name, provided he was buying a house. Mr. Hill wanted to know how the borrower would be able to pay back his loan if—heaven forfend—his house didn’t go up in price by 20 percent per year.

These were not the sort of practices that would make Mr. Hill’s establishment the “Bank of the Year” or get his photo on the cover of
BusinessWeek.
Not in the year 2005. His was not the Bank of the Present. It may have been the Bank of the Past.That it might also be the Bank of the Future was in nobody’s mind.

Not only was the Monroe County Bank out of step with most other lending institutions, it seemed to be marching in the opposite direction—back to the future.We had never met the man or visited his office in Forsyth, Georgia. But had we to entered the bank, we would have expected to find a man behind an old-fashioned ledger at an oak desk . . . and a spittoon in the corner. Were we to ask for a loan, we would have expected a disapproving look, followed by a polite, but severe inquiry into our personal finances. No, these were not the methods of the typical banker in the eighteenth year of Alan Greenspan’s reign at the Federal Reserve System.

Nor was Mr. Hill’s approach to the credit industry particularly profitable. He admitted he would have earned more money by doing what other bankers did. Most bankers borrow short and lend long. As long as long rates are higher than short rates—and he does his math right—he will make money. Mr. Hill’s approach, borrowing long and lending short, was a curiosity in the banking industry. It forwent current profits, in favor of a more solid balance sheet. And when long rates rose, which they will do, sooner or later—both Mr. Hill and your authors were sure of it—Mr. Hill would have the last laugh. Compared with most bankers, it would be far easier for him to collect his credits and pay his liabilities.

Stocks are buoyed up or thrown down as the market’s view of the firm’s value changes. Profit-making enterprises’ value depends on how much profit they make, a figure subject to both change and speculation. But the value of a house changes little over time.Year after year, it is the same roof, the same walls, the same cozy warmth and convenience. The value that an owner-occupied house gives cannot be amended, jiggled, bent, written down, cooked up, or restated. No clever CFO can smooth its earnings. No fast-talking promoter can hype up next year’s sales. It is what it appears to be and nothing more: home sweet home.

But with the complicity of the entire credit industry, except for one bank in Forsyth, Georgia, Americans came to believe that the very same dull and lifeless bricks they knew so well—along with the fading paint, the stained carpets, the leaking taps, and cracking driveways—had a near-magical quality; they could make them rich. They believed that the house was an “investment,” different from stocks only in that it was safer and more profitable. They knew from their own, direct experience that the house is not a profit center, but a cost center. Each month, the place must be maintained. Money must be spent on it. They also knew that—other than the aforementioned service the house renders to its occupants—there is no output. There is nothing that comes out the back door that can be sold. As a business, it is a losing proposition, and they knew it. It produces nothing; no revenues are realized. No profits are earned.

And yet, the homeowner also believed that he could go to friendly lenders from time to time and “take out” cash—as if the place had been accumulating earnings. What he was taking out, he believed was merely surplus equity. He figured that if last year he had, say, $200,000 worth of house, this year he must have $250,000 worth of house. He could “take out” the $50,000 extra and spend it—just as if the house had earned $50,000 in profit—and still have his $200,000 worth of house.

He did not ask himself where that $50,000 came from. He did not find it at all extraordinary that an item he knew to be a cost center could also produce more in “profits” each year than he earns in income! Nor did he wonder how there could be so much untapped value locked up in his house, when he knew full well that he and his family used every room.

Mr. Vernon W. Hill considered this wealth an illusion, as we did. He believed it would lead to big problems among both borrowers and lenders. To avoid the big problems personally, Mr. Hill, like Warren Buffett, lived in the same house he bought nearly 40 years ago.

Mr. Hill required prospective borrowers to show him their finances without considering the house they lived in.Whatever value there is in the lived-in house, he said, is “inactive.” It doesn’t really earn any money for you; if you were to sell it, you would just have to buy another one. And you can’t ship it to China to pay for your flat-screen TVs or to Japan to pay for your SUV.

It was not that Mr. Hill was necessarily opposed to the great empire; he just didn’t seem to care. But a view more typical of the average lender, and average economist, was expressed by a pair of economists, mentioned briefly earlier, writing in the
International Herald Tribune.
Mr. David H. Levey was formerly managing director of Moody’s Sovereign Ratings Service. Stuart S. Brown is a professor of economics and international relations at Syracuse University.The two argued that “U.S. Hegemony Has a Strong Foundation.” The two were talking big. They were talking macroeconomics, with no trace of Mr. Hill’s modest insights, or his private knowledge, or his 37 years of experience lending money, or the keen and immediate attention of having his own money at stake.