From the point of view of the lenders, most of their customers have become a risk. If you are upside down on your mortgage, you have no assets to liquidate even if you are able to make the payments. With the horrible loses on 401Ks and other investments, many people are unable to borrow from those sources either.
However as risk averse as they became, this is even a riskier proposition.
As I pointed out before, the savings rate of the American public is neutral or negative. We came out of the 2001 recession not by creating wealth but by creating the illusion of wealth trough credit expansion. The reality is that not only the country itself is broke (in the sense that it couldn’t face her current obligations were it asked to do so by her debtors), but most Americans are broke as well.
So, the current tightening of credit (by the way, do you remember when I said that there was no way for forcing the banks to actually lend the money in the bailout package? My paranoia is giving me great results lately.) will give as a result a large reduction of consumer spending, which in turn will force more bankruptcies and put pressure on the economic downward spiral.
At some point, it is my guess, that the government will have to intervene by forcing the banks that are recipients of bailout money to reduce interest rates and even principal in credit card debt, or perhaps open the Fed’s lending to the public with fixed interest rates below 5% in order to refinance their debt.
Either way, that will trash the dollar, and scare away international lenders who will request higher interest rates for the money they lend us, which in turn will increase both the prices of imported commodities and goods, and the base interest rate for any future transaction, creating the psychological conditions for runaway inflation.
If the government, however, does not intervene in the credit markets, and goes ahead with job creation programs, we will suffer a protracted deep recession (depression) with inflation in commodities (think oil, food, electricity) as China moves more money from saving into spending to sustain their internal economy.
Historically, these kinds of overproduction crises were solved by destroying means of production until finding a balance. As the most important mean of production is the worker, it usually meant large global wars with millions of deaths.
There is perhaps an alternative in creating both jobs program and intervening the credit markets while at the same time trying to reduce deficits. For that to actually work, we would need to do several historical things at once:
Reduce energy consumption
Replace imported energy with national energy
Replace imported goods with national goods
Reduce government spending while spending in infrastructure and job creation
The problem with this scenario is that it would imply a reduction of the military spending while telling the rest of the world that we will no longer be the biggest buyer of their goods, which will create some nasty international situations.
Yet another possibility, is that the government intervenes deeply in the markets forcing lenders to reduce standards and to lend money by law, imposes price controls, regulates every single aspect of the economy, and reduces their participation as the economy unwinds.
Whichever the way of the future president, we will live indeed during interesting times.
Franklin @ August 15, 2008