I outlined in the last post the problem on the consumer debt level. So what happened?
- Eventually the market realized income levels couldn't support the liabilities. As a result the loan market dried up. Fewer loans meant less money flowing into various asset classes, which led to a corresponding devaluation of those assets that were artificially inflated by the excessive leverage, creating a cycle in which it continued to feed upon itself. It follows that industries, which were dining at the bubble table, began to contract.
- Aside from purchasing assets, funds from those loans were also being used for consumption. No new loans meant far less consumption. Further, the depressed asset values depressed the psyche of the consumer, from one of exuberant consumption to one of saving at best and desperation at worst.
As illustrated above, the aftermath of a “deleveraging” cycle is fewer loans supplied and demanded. This in turn negatively impacts growth going forward and leads to uneven economic outcomes as households and financial institutions lick their wounds, and repair their balance sheets.
So why did this happen? There are a multiple of reasons, but my favorites are listed below:
- Ultra low interest rates from 2001 to 2005 led to a misallocation of capital into various asset classes, artificially inflating their value.
- De-regulation of the financial services industry assisted in allowing for higher leverage, opaque markets, and increased risk taking. Regulators, legislatures, and the Fed made this possible, then fell also asleep at the wheel.
- Decreased lending standards.
- Low interest rates had a negative effect on money managers, who given the low rates had to stretch for yield. This was facilitated by ratings agencies rubber stamping AAA ratings on questionable tranches of debt , and the widely held assumption that markets are efficient.
- Moral hazard and the “Too Big to Fail” mentality. This can be traced back to Chrysler and LTCM.
- Psychology of the American Dream – everyone stretching for the next best thing.
I have outlined the problem, what went wrong, and how we got to that point. The last post will be how we fix it.
