Is the U.S. Bailout Perpetuating the Credit Bubble?
By Peter D. Schiff
Guest Columnist
Money Morning
In a speech before the London School of Economics a week ago, U.S. Federal Reserve Chairman Ben S. Bernanke offered a perverse economic theory in his quest to gather support for never-ending Wall Street bailouts.
Said Bernanke: "This disparate treatment, unappealing as it is, appears unavoidable. Our economic system is critically dependent on the free flow of credit, and the consequences for the broader economy of financial instability are thus powerful and quickly felt."
In other words, credit is the lifeblood of our economy, and the continued operation of credit providers is actually an issue of national security.
In truth, not all economies run on credit. But over the last decade, the United States became a bubble economy that needed unlimited credit to keep from collapsing. In a legitimate economy, it is not credit that fuels spending and investment, but simply income and savings. It’s too bad our Fed chairman does not understand the difference.
That American families now routinely rely on credit to make every-day purchases is a habit that needs to be broken – not encouraged. What we need in America is more restraint and less indulgence.
For example, Americans in the current economy should not go into debt to buy new cars. Given the level of debt that weighs down the typical family, Americans should defer such purchases until they have paid down existing debt, or have replenished their savings to the point where they can afford to pay cash. Until that time, Americans should continue driving their old cars. In the meantime, the untapped savings could be made available to local businesses that would use it to finance badly needed capital investments.
But such a drastic reversal in financial culture represents the kind of change that no one in the outgoing or incoming White House administrations appears willing to consider. By providing perpetual support to lenders that have bankrupted themselves through bad loans, the government merely guarantees that bad economic behavior will continue.
Credit is indeed vital to an economy, but it does not constitute an economy within itself. The important thing to remember is that credit is scarce, and is limited by the stock of savings. Obviously, savings loaned to one individual is not available to be loaned to another until it the outstanding debt is repaid. If it is never repaid, the savings are lost.
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Loans to consumers not only crowd out more productive loans that might have been made to business, they have a far greater likelihood of ending in default. In addition, while business loans increase our capital stock and lead to greater productivity, loans made to consumers are merely spent, and do not create conditions that will make repayment easier.
When businesses borrow to fund capital investments, the extra cash flows that result are used to repay the loans. When individuals borrow to spend, loans can only be repaid out of reduced future consumption.
One of the reasons we are in such dire straits is that consumers have already borrowed and spent too much. Many did so based on the false belief that ever-appreciating real estate would ultimately provide the means to repay their debts and finance their lifestyles. Now that reality has finally set in, why should the spending spree continue?
The fact that our gross domestic product (GDP) – 70% of which is consumption-driven – is currently contracting should not surprise anyone. In fact, such a contraction is long overdue and the government should not do anything to interfere.
In trying to perpetuate the illusion, the government wants to revive the spending spree that has led us to this disaster. But how can such actions possibly help? How will more debt improve the economy? Wouldn’t our circumstances be vastly improved if we paid off some of our debts and replenished our savings? Wouldn’t we be in better shape if instead of buying more stuff we concentrated on producing it?
The unpleasant reality is that years of bad monetary and fiscal policy have encumbered our economy with debt and undermined our industrial capacity. The sooner we can begin to repair the damages, the sooner we can right the ship. If instead we merely administer more of the same, the ship will sink in a sea of inflation.
[Editor's Note: Peter D. Schiff, Euro Pacific Capital Inc.'s president and chief global strategist, is a well-known author and commentator, and is a periodic contributor toMoney Morning. Schiff is the author of two best sellers: "The Little Book of Bull Moves in Bear Markets," and "Crash Proof: How to Profit from the Coming Economic Collapse." For a more-detailed analysis of the nation's financial problems, and the inherent dangers that these problems pose for both the U.S. economy and for dollar-denominated investments, click here to download Euro Pacific's new financial-research report, "The Collapsing Dollar: The Powerful Case for Investing in Foreign Securities." The report is free of charge. To find out how to get a free copy of the bestseller, “Crash Proof,” please click here.]
News and Related Story Links:
- Money Morning:
An Open Letter to President-Elect Barack Obama: How a Regulatory Makeover Can Fix the Financial Crisis.
- Wikipedia:
Credit (Finance).
- Wikipedia:
Bubble Economy.
Comment by Richard Shurgot on 23 January 2009:
Very nicely described the fundamental problem Peter. I agree with all you said to the letter.
Now, the question is what may be the solution.
I am not suggesting any particular solution (I am in a research/thinking stage myself), but has anyone considered Islamic financing that appears to (1) discourage hard interest, (2) promote profit sharing between lender and borrower in an asset-backed security, and (3) promote a more human interaction between the parties. After all, Islamic financing thrived for centuries in its golden age, and many of the concepts used in finance were invented in this period.
Review these sources for the basics on Islamic financing:
http://www.economist.com/sponsor/qfc/index.cfm?pageid=article104
http://en.wikipedia.org/wiki/Islamic_banking
Comment by David Spence III on 23 January 2009:
This is clearly more of the same BS. Credit is NOT based on savings. Credit is based on credibility ONLY. Like fiat money that is worth only what someone will give you for it. Credit was hugely hedged, then just like money, unhooked from the collateral, so it became worthless. Banks have been loaning out money that is non existant for decades. Some call it counterfeiting. Wasn’t it Thomas Jefferson who said that banks are more dangerous than standing armies?
Comment by Myron Martin on 24 January 2009:
Most people have not been taught “critical thinking” consequently they are vulnerable to bad influences from politicians and bankers who encourage use of credit (which is a misnomer) since in actuality they encourage DEBT to facilitate FASTER acquisition of WANTS rather than encouraging SAVINGS that defer purchases until they have actually been EARNED!
Few grasp the fine line that connects the two, savings are the basis on which loans are made (bank reserves) so if there is a LACK of savings banks are restricted in their lending. When that happens,because banks MUST lend or die, they look for ways to circumvent reasonable and prudent rules and so we end up with liars loans, collaterlized debt obligations, other cretive derivatives, sub-prime mortgages etc. that become a dangerous deck of cards that collapses the whole system!
Until we return to a system of HONEST money with intrinsic value such as gold and silver which have stood the test of time for over 5000 years of dependable purchasing power and store of value we will just have to suffer the consequences of a FAILED experiment with fiat currencies that is now unravelling.
Comment by Pete Murphy on 25 January 2009:
I’m disappointed that Peter neglected the role of the trade deficit in making the U.S. dependent on credit. The trade deficit is financed by a sell-off of American assets, some of which is treasuries that adds to the national debt. And the loss of jobs through the trade deficit has put downward pressure on incomes for decades, forcing Americans to draw down their assets and turn more toward debt to maintain their lifestyles. The only way to break our dependency on debt is to restore a balance of trade.
Pete Murphy
Author, “Five Short Blasts”
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Comment by Wribneeby on 24 April 2009:
I’m the only one in this world. Can please someone join me in this life? Or maybe death…