“We were steadily gaining in prosperity. Advances in science and invention opened vast vistas of new progress. Being prosperous, we became optimistic – all of us. From optimism some of us went to over-expansion in anticipation of the future, and from over-expansion to reckless speculation, and abuse of financial power”.
US President Herbert Hoover (1929-1933) in 1932
This week’s crisis on Wall St is a direct consequence of the huge expansion in credit during the past 30 years. Far too much money has been lent to individuals who cannot service their debts.
The massive growth in United States debt is reminiscent of the 1920s but there is unlikely to be a repeat of the 1930s depression because monetary authorities are now in a much better position to deal with a major financial crisis.
Nevertheless, recent developments will have a major impact on the world economy, finance sector regulation and, more importantly, our attitude to debt.
The 1920s was a period of incredible prosperity and confidence, coinciding with the introduction of several mass-produced items, including cars, radios and refrigerators.
US credit expanded dramatically from about 175 per cent of GDP in 1920 to 300 per cent just after the 1929 Wall St crash. A large proportion of the borrowings were used to buy shares.
In the four months after the 1929 crash, the Federal Reserve lowered interest rates from 6 to 4 per cent but became hopelessly indecisive after its February 1930 rate cut.
The Fed reduced the sums it pumped into the system and raised interest rates twice during the 1932 banking crisis. Republican President Herbert Hoover continued to support a balanced budget strategy and believed Government support for the economy was unnecessary.
Not surprisingly, he was trounced by Franklin D. Roosevelt in the 1932 presidential election.
Credit contracted sharply after the 1929 crash, with US money supply falling 31 per cent between 1919 and 1933 as the world economy endured a once-in-a-lifetime depression.
It took nearly 20 years before the deleveraging was completed and the total US debt to GDP ratio stabilised below 150 per cent. Not surprisingly, there was a strong aversion to debt from 1950 to 1980: memories of the 1920s and 1930s were still fresh.
But the appetite for debt increased in the 1980s as the 1930s depression was forgotten. Companies started borrowing but individuals picked up the momentum after the 1987 worldwide sharemarket crash when many companies collapsed under the weight of too much debt.
Personal debt has soared in recent years, mainly to finance house purchases.
As the accompanying table shows, the US internal debt to GDP ratio has risen from 150 per cent in 1980 to nearly 350 per cent.
The debt binge has been driven by great prosperity, confidence and several major technological advances, particularly in communications. This has been a phenomenon shared by most western countries.
A central bank’s role is to curb excessive credit expansion and stimulate the financial sector when credit contraction is hurting an economy. William McChesney Martin Jnr, the Federal Reserve Board chairman from 1951 to 1970, said the Fed’s job was “to take away the punch bowl just as the party gets going”.
Alan Greenspan, Fed chairman from 1986 to 2006, has been accused of delivering additional punch bowls to the party as the drinks ran out. He kept interest rates low during the early 2000s and the massive expansion in US credit occurred under his watch.
The credit expansion has been boosted by industry deregulation and financial engineering, particularly by the large US investment banks. They invented more ways to lend money through complex securitised debt and derivatives’ products.
Lending structures have become increasingly complex and high risk. A large number of loans, particularly on residential property, were made to individuals who had little hope of meeting interest and repayments.
The major US investment banks at the beginning of the year – Goldman Sachs, with assets of US$1061 billion, ($1579 billion) Morgan Stanley US$1045 billion, Merrill Lynch US$1020 billion, Lehman Brothers US$689 billion and Bear Stearns US$424 billion – have collapsed, found a partner or want a partner.
Their problems, perceived and real, are having a big effect on the financial system because they are huge, have millions of counterparty transactions with other institutions and will be forced to dump significant securities on to markets as they deleverage.
Fed chairman Ben Bernanke, an expert on the 1930s depression, is working overtime to ensure the mistakes of 70-plus years ago aren’t repeated. He is bailing out banks, brokering merger deals for ailing companies and pumping money into the system. Several other central banks are also injecting huge amounts of liquidity into their economies.
The debt to GDP ratio is falling as the US and world economy deleverages. Bernanke aims to ensure the downward line in the graph is, unlike the 1930s, more horizontal than vertical and doesn’t fall as far as it did during the Great Depression.
Wall St’s problems are hitting here because we joined the great global credit boom. In the decade ended July, major financial institutions boosted overseas borrowings from $33.3 billion to $118.2 billion or from 23.7 per cent of total borrowings to 34 per cent.
We have become increasingly dependent on overseas funds to fuel the residential property boom.
The problem with this is twofold:
* International borrowing rates have risen as the credit crisis deepens. This means mortgage interest rates are unlikely to fall until the crunch eases.
* The credit contraction means there will be some debt rationing.
This is not good news for asset prices, especially property, where purchases have been predominantly funded by borrowings.
Reserve Bank Governor Alan Bollard and his predecessor, Don Brash, repeatedly warned that this borrowing strategy was unwise.
The warnings fell on deaf ears because of the unbounded confidence that house prices would always rise and the willingness of individuals to borrow more and more even though domestic interest rates were well above the world average.
This over-confidence, which leads to excessive borrowing, is the exception rather than the rule and was present on Wall St in the 1920s and throughout most of the world’s housing markets in recent years.
Major central banks’ actions in the past few days should ensure we don’t have a major global recession. But we cannot discount a repeat of Japan’s recent experience.
It had a debt-fuelled property boom in the late 1980s that led to huge banking problems in the early 1990s.
Since then, the Japanese have curtailed their spending and borrowings, even though lending rates have been were as low as 1 per cent, and house prices declined for 15 consecutive years between 1990 and 2005.
Even a partial repeat of the Japanese experience in this country would have a profound impact on consumer behaviour, our willingness to borrow and on asset prices.
Gross United States Internal Debt to GDP