Tuesday, April 15, 2008

Pop! Is the debt party over?

Some are predicting the end of the US's 30-year party with debt. The debt fling was in part a result of foreigners' willingness to lend us extraordinary amounts of money. This willingness has kept the dollar artificially high relative to other currencies, especially the Asian ones. The US has an almost unique combination of strong growth, political stability, and lack of corruption. So it's the perfect place for foreigners to park their money.

But in the last year, the Fed has lowered short-term interest rates so low, well below European rates (which are kept high by the European Central Bank's fear of inflation), that US credit markets are no longer so attractive to foreigner investors. Easy credit is getting harder. Of course, the crazy real estate bubble of 2002-2007 also featured reckless lending to subpar borrowers, and banks have now become skittish about new lending. Foreigners might want Euros instead, not because the Euro zone has great growth prospects (it doesn't), but for simple safety. If that became a persistent and widespread trend, it would spell the end of the US dollar's 60-plus-year long role as the world's reserve currency.

It's not clear if that will happen in the near future. More likely is a split world, where dollars, euros, yen, and yuan more or less share the space as reserve currencies. A nearly-as-dramatic change almost happened in the late 70s, during the Great Inflation and rapid decline of the dollar's value. The taming of inflation, begun in 1979 by then-Fed chairman Paul Volcker and backed by both presidents Carter and Reagan, turned that situation around. The price was that the US federal government went from printing money to borrowing it. But because the dollar's value held relative to other currencies (also rapidly depreciating with inflation in the same period), the dollar's role as reserve currency also held.*

But the larger debt party - which began in the 1970s with the first great postwar real estate bubble and the first wave of Silent Generation/Boomer home buyers, then spread to investment markets and governments in the 80s and 90s - is probably coming to an end.** Each wave of bubbles - smaller but still significant in the 70s and 80s, larger in the 90s stock bubble, and larger still with the housing bubble of the 00s - has imposed larger and larger costs of post-bubble clean-up. To keep the post-bubble bursts from being too painful, the Fed has three times in the last 15 years (1995-1999, 2002-2005, and now) opened the cheap credit spigot, keeping interest rates low and putting a large strain on the dollar. Fundamental (microeconomic) reasons for the bubbles are left unaddressed: herd psychology, grandiose expectations, bad lending practices, and the federal government's hard-sell (via Fannie, Freddie, and so on) of house-owning to people who can't afford it. Thus the feds end up becoming, more than ever, guarantors and rescuers of bad financial decisions, encouraging more of the same in the future.

Sebastian Mallaby of the Washington Post has a recent column on just this topic. Along the way, he brings up the disappointment of investors in markets that don't behave as the standard financial theory says they should. The "Gaussian random walk, efficient market" theory is dazzling, but it's also dead.
Debt also seemed not to be too risky because financiers had excessive faith in their statistical models. These suggested that their investments would never lose more than a small percentage of their value: Hence a thin capital cushion would suffice. But since its invention in the 1960s, financial economics has overestimated the efficiency of markets and underestimated their tendency to swing viciously. Along with the authorities' successive rescues and savers' confidence in American assets, this error kept the debt party going.
Here is another major reason investors and lenders are souring on risk: they're starting to realize that they don't understand it as well as they thought. It's time to go back to the drawing board, and also to impose tougher capital reserve requirements on banks and other lending institutions. The financial black swans are always out there, waiting.
* The relative value is all that matters in the short term. In the long term, the mix of stability, non-corruption, and decent growth is more important.

** You sometimes hear it falsely claimed that the debt party started in the 80s. It didn't; it started in the 70s. The 80s did see much more American borrowing from foreigners. The fact that the debt party started in the 70s is linked to the Great Inflation: inflation makes debt attractive to borrowers, because they pay back their debt in dollars worth less and less each year.

The serious inflation that ran from the late 60s to the early 80s was the single most important reason Americans, Boomers especially, became addicted to debt in the first place. It also pushed investors into far riskier investments (savings and loan institutions with overpriced real estate; major bank loans to Latin America, for example) in order to get higher returns that would beat the inflation.

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