Consumer Debt: Not an American Monopoly

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The
sheer scale of consumer debt has made millions of households extremely
vulnerable to shocks in the economy, both from fiscal mismanagement
and external factors such as oil price rises, acts of terrorism
and wars. A downturn in the economy would create serious economic
and social problems for the fifteen million people who struggle
with debt repayments. Debt is a time-bomb which could be triggered
by any number of shocks to the economy, at any time.

~
Griffiths Commission on Personal
Debt
(March 21, 2005)

In
a story released to the press on March 21 and published on Yahoo
and in English-speaking outlets around the world, the Conservative
Party warned of rising consumer debt in Great Britain. What caught
my eye was the author: Lord
Brian Griffiths. Before he became a peer, Dr. Griffiths was Dean
of the Business School at the City University of London until 1985,
the year he became the head of Mrs. Thatcher’s policy unit.

I
remember this all too well. I was sitting in his office on the day
he got the offer. That cost me an important taped interview that
I had flown to London to conduct. One day earlier, and I would have
recorded a classic — "the one that got away." From that
day on, he became too famous to give interviews as explicit as the
one I would have conducted. He had to turn me down. I saw him again
in the late 1980s. My parting words were, "Let me know when
you’re a nobody again. I still want that interview." So far,
he’s still a somebody. No interview.

UK
faces consumer debt "time bomb"

The
UK faces a potential consumer debt time bomb that could be triggered
by an external "shock" such as rising oil prices or
from rising interest rates, a report from the UK’s Conservative
Party said.

Britain’s
consumer borrowing has reached the 1 trillion pound mark and a
sudden shock could impact on 15 million people, the report said.

The
report, compiled by Goldman Sachs International vice-chairman
and Conservative Brian Griffiths, said credit in the UK has been
"too easily available and marketed far too aggressively."

Griffiths
called for the voluntary Banking Code to be replaced with a statutory
"customers charter" to help tackle the spiraling household
debt problem. This would outlaw aggressive marketing practices
and increase transparency of credit card charges.

"There
is a real need to improve the quality of information made available
to borrowers (who) need better support once they get into financial
difficulties and independent advice to restore their financial
stability," Griffiths said.

He
told a news conference that the sheer scale of consumer debt has
made millions of households vulnerable to external economic shocks
such as rising oil prices, wars and terrorism.

He
also criticized the Bank of England for being "too sanguine"
about the level of debt, adding that as the debt-to-income ratio
had gone from just under 100pc to 140pc in recent years it had
become a "time-bomb which could be triggered by any number
of shocks to the economy at any time."

Griffiths
is not just an academic economist. He oversaw much of Mrs. Thatcher’s
de-regulation program, which transferred many of the state-run monopolies
to the private sector. She made him a life peer in 1990.

He
then became Vice-Chairman of Goldman Sachs International. This is
one of the major investment banking houses in the world. In the
United States, Goldman Sachs is considered one of the Establishment
investment banking firms.

That
is why I regard his authorship of the report as important. This
is not simply a policy paper issued by a party out of power that
may be facing an election in May, if Blair calls one, as is expected.
Griffiths is putting his reputation on the line: academically and
professionally.

Unlike
most economists, Griffiths brings an explicitly moral perspective
to his economic analyses. He is the author of two books, Morality
and the Market Place
and The
Creation of Wealth: A Christian’s Case for Capitalism
. It
was these that I had hoped to interview him about. He told me at
the time that my 1973 book, An
Introduction to Christian Economics
, was the first one he
had read on the topic.

Having
followed his career from a distance for over two decades, I conclude
that he is not raising a false alarm for publicity’s sake. The threat
of a debt crisis is real.

POSITIVE
FEEDBACK AND MASS INFLATION

Under
a gold coin standard, there is negative feedback on the expansion
of credit. If bankers create too much money, depositors will come
down and demand gold coins for their checks or banknotes. A bank
that cannot redeem these notes is declared bankrupt.

Without
a commodity standard with redemption on demand, the monetary system
moves into positive feedback. Here is an example. During the French
Revolution, the government confiscated the church’s lands. Then
it issued paper money against the value of these lands. The bills
were called assignats. No one could redeem assignats for a specified
piece of land. But the government promised to restrict the issue
of assignats by the value of the land.

This
created a positive feedback condition. The price of land was measured
in assignats. The more assignats the government issued, the higher
the price of the land went. But the higher the price of the land
went, the more assignats this authorized the government to issue.
Within two years, all prices were soaring. The economy went to barter
or black marketing. The currency was ultimately destroyed. The story
of this disaster was written almost a century ago by Cornell University’s
Andrew Dickson White, "Fiat Money Inflation in France."
You can get in free online.

When
the dollar was removed from the citizen’s gold standard in 1933,
abolishing citizens’ right to own gold, and again in 1971, when
convertibility on demand at $35/oz was abolished for central banks,
the interest rate, especially in the bond markets, became the only
major limiting factor on the Federal Reserve System’s ability to
inflate the money supply. Fear of interest rate increases, meaning
fear of falling bond prices, became the restraining factor. This
fear kept Bill Clinton’s spending plans tightly in check — a fact
he learned in his first few days as President.

In
the housing market, there is a positive feedback condition. The
size of the loan is limited by the appraised value of the house.
But if mortgage interest rates drop, then a borrower can afford
to borrow more money and still make his monthly mortgage payments.
More borrowers show up for loans because more people become eligible
at the entry level.

They
start bidding against each other. Up go home prices. Appraisers
tell lenders that prices are up. Lenders are then willing to loan
more money to buy these more expensive houses. The spiral begins.

Now there is evidence that some
appraisers have committed fraud
, reporting higher than market
prices to lenders, so that lenders could extend even more credit
to home buyers and re-financing owners. This has placed lenders
and borrowers at risk during an economic recession.

How
high can it go? The median price of a home in California is $465,000.
Incomes did not rise to keep pace with these prices. Marginal buyers
are driving up the price of those few homes that are offered for
sale. The high price received by these marginal homes is imputed
to all homes by the appraisers. All home prices go up, not just
those offered for sale.

The
two negative factors are these: (1) the number of people who can
afford to buy an entry-level home; (2) interest rates, which affect
#1. Until these kick in, a region can experience a housing boom.
It can become a mania.

In
the United States, housing on the two coasts have been bid up beyond
the ability of most entry-level couples to buy. Florida housing
is also appreciating fast. A man I know has equity profits of well
over half a million dollars in three years. He is taking his money
and running. He will move to Kerrville, the hill country of Texas,
which was cheap a decade ago, but not now.

People
not in these boom areas are locked out from them. They cannot afford
to move in. Population will flow out, especially among younger workers.
Businesses will locate in the heartland, where housing prices are
lower. They will be able to hire talent cheaper.

But
in high-priced areas, housing prices will not fall back to what
they were a decade ago unless mortgage interest rates soar. The
ratchet will have its effect.

THE
RATCHET

We
know what a ratchet is: a geared cog with teeth that are designed
to be locked in place by a lever. A spring is attached to the cog.
The tighter the spring, the more tension is on the cog. As you turn
the cog against the spring, it gets more resistant. Raise the lever
above the teeth, or else let go of the cog’s crank handle before
you lock in the next tooth, and the cog will whirl in the opposite
direction. Woe unto whatever is on the pulley that is attached to
the cog. The higher it is up the pulley, the farther its fall to
the earth.

The
commercial banking system is the cog. The central bank keeps cranking
this cog: buying T-bills.

As
with any ratchet, there are two ultimate limits: the
tension on the spring and the resistance of the spring’s metal.
At some point, the spring snaps. In monetary affairs, this is mass
inflation. Ludwig von Mises called this the crack-up boom, when
money dies. The other limit is tension — in the case, interest
rates. At some point, the spring can’t be cranked any tighter without
driving short-term rates up and causing recession.

Move
the cog up one more notch, and the lever may break loose mid-lock.
The cog will spin backward like a propeller. That’s called depression/deflation.
That’s what happened 1929—33.

Short
of a gridlocked banking system, where leveraged debts cannot be
paid off, the greater risk today is inflation. The FED keeps cranking
the cog. Debts keep getting agreed to at ever-higher prices.

THE
COILED SPRING

Most
people have entered into multiple debt agreements. They think that
prices will not fall. If prices do fall, owners’ equity will disappear.
The appraisers will then have to report lower prices, which will
lower the loan value of property.

The
entire economy today is way up the pulley. Contracts are made at
one level up the pulley, and then it rises higher. What if this
process reverses? It did in Tokyo real estate, 1990—2005.

The
FED has created a boom by expanding the money supply. Now it is
trying to unwind the boom’s low-interest foundations without jeopardizing
the boom. It is slowing the creation of money. But it does not want
to create an unsprung ratchet.

The
FED is tightening money. A handy way to follow this is to go to
a newly created blog site, created by one of my readers. This
blog site serves as a good model. It is run for free on blogspot.com.

He
offers several handy links on the right-hand side. Click MZM, money
of zero maturity. MZM is down at an annual rate of almost 3% since
mid-January. Since early June, 2004, it is up 0.9%.

Using
the Median CPI figure, price inflation is up 2.4% for the last 12
months.

There
is a ratchet. Prices do not fall. But by slowing the creation of
money by restricting its purchases of T-bills, the FED has restricted
this upward ratchet move.

But
remember: this ratchet never falls here. When it threatens to fall,
the FED inflates money. Look at the adjusted monetary base since
late January. It is now in the 10% range, despite some backing off
over the last few weeks. (Adj. Monetary Base 2) Over the last four
years, the move is relentlessly upward. (Adj. Monetary Base #1)

THE
CONSUMER DEBT RATCHET

Consumers
have bid up the prices of goods with fiat money. Then they go into
further debt to buy more of these goodies. This is a ratchet phenomenon.
The restraining factor is upward interest rates. This process has
begun in the short-term debt markets in the United States, but it
has not yet affected consumers’ desire to buy more goodies by going
into more debt.

The
decisions of millions of consumers, all over the world, to raise
their level of debt has created what the Griffiths Committee calls
time-bomb conditions. England is not alone. Consider
this report from Canada.

Some
finance experts are warning Canadians must wean themselves off
debt, otherwise they face a major shock if interest rates rise.

"It
could be catastrophic in terms of the whole economy," says
financial counselor Allen MacLeod.

Interest
rates have been quite low in Canada for the past several years.

But
Canadian paycheques have grown very slowly. To prop up their standard
of living, many Canadians have resorted to cheap credit and stopped
saving money.

Lines
of credit have grown at a record pace in Canada, up 30 per in
2004 alone.

Holly
McIntosh and Frank Lestage’s bank offered them a line of credit
a few years ago.

"They
just give you the money and people spend and spend," Lestage
said. "It doesn’t take long to get it under control, but
you have to realize what you’re doing and that takes a while.
You have to get in trouble to realize what’s going on." .
. .

"I
think as things have gotten more expensive, we’ve (become) a need-to-have-now
generation," says Cindy Cassidy.

And
that’s part of the problem, says consumer advocate Mel Fruitman:
"Consumer debt as a whole in Canada exceeds consumer assets.
That means we’re on the brink."

MacLeod
says personal bankruptcies are up more than 10 per cent since
January.

The
article goes on to say that TD bank says there is no problem. Obviously,
not many bankers are going to sound the alarm.

CONCLUSION

Consumers
worldwide are being lured into more and more debt. They will have
to reduce spending. This has not happened yet. But as the FED tightens
money, allowing short-term demand for loans to push up rates, the
traditional response is a falling stock market.

I
think we’re there.

March
31, 2005

Gary
North [send him mail] is the
author of Mises
on Money
. Visit http://www.freebooks.com.

Gary
North Archives

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