Credit is the lifeblood of an economy. But too much of a good thing can lead to excess and disaster. That's the lesson you'll draw from Steven Gjerstad and Vernon L. Smith's excellent piece in yesterday's Wall Street Journal. Gierstad and Smith want to know why some asset bubbles (i.e., tech stocks) pop without bringing broader economic collapse, while others (i.e, real estate) do. Their provisional answer:
In the equities-market downturn early in this decade, declining assets were held by institutional and individual investors that either owned the assets outright, or held only a small fraction on margin, so losses were absorbed by their owners. In the current crisis, declining housing assets were often, in effect, purchased between 90% and 100% on margin. In some of the cities hit hardest, borrowers who purchased in the low-price tier at the peak of the bubble have seen their home value decline 50% or more. Over the past 18 months as housing prices have fallen, millions of homes became worth less than the loans on them, huge losses have been transmitted to lending institutions, investment banks, investors in mortgage-backed securities, sellers of credit default swaps, and the insurer of last resort, the U.S. Treasury. In an important paper in 1983, Ben Bernanke argued that during the Depression, severe damage to the financial system impeded its ability to perform its economic role of lending to households for durable goods consumption and to firms for production and trade. We are seeing this process playing out now as loan funds for automobile purchases have withered. Auto sales fell 41% between February 2008 and February 2009. Retail and labor markets too are now part of the collateral damage from the housing debacle. Housing peaked in early 2006. Losses from the mortgage market began to infect the financial system in 2006; asset prices in that sector began to decline at the end of 2006. Meanwhile, equities and the broader economy were performing well, but as the financial sector deteriorated, its problems blindsided the rest of the economy.
Consumer and institutional indebtedness, in other words, were the means by which losses in the real estate sector were transmitted throughout the economy. And something similar happened 80 years ago:
The events of the past 10 years have an eerie similarity to the period leading up to the Great Depression. Total mortgage debt outstanding increased from $9.35 billion in 1920 to $29.44 billion in 1929. In 1920, residential mortgage debt was 10.2% of household wealth; by 1929, it was 27.2% of household wealth. The Great Depression has been attributed to excessive speculation on Wall Street, especially between the spring of 1927 and the fall of 1929. Had the difficulties of the banking system been caused by losses on brokers' loans for margin purchases in 1929, the results should have been felt in the banks immediately after the stock market crash. But the banking system did not show serious strains until the fall of 1930. Bank earnings reached a record $729 million in 1929. Yet bank exposures to real estate were substantial; as the decline in real estate prices accelerated, foreclosures wiped out banks by the thousands.
The difference between now and then is that the Depression-era Federal Reserve contracted the money supply, whereas the Obama-era Fed has greatly expanded it. Gjerstad and Smith appear skeptical that increases in the money supply, or "quantitative easing," will be enough to stop the contraction. America spent the last 20 years piling up debt - personal, commercial, public - and the bill has come due. Nothing changes that fact. The Great Deleveraging has begun.