The dry rot at the heart of the credit crisis

The dry rot at the heart of the credit crisis
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First Published: Sat, Mar 29 2008. 02 17 AM IST
Updated: Sat, Mar 29 2008. 02 17 AM IST
The usual explanation for the credit crisis in the developed countries is that they were the result of “excesses” either by banks or by the central banks or by speculators. Once these excesses are wrung out of the system by a purging process, so goes the received wisdom, things will be back to normal, or at least approaching normality. But what if these excesses are part and parcel of the system? Is it possible that the credit crisis is a reflection, not just of a mania, but of underlying changes in the structure of the global economy and the attempts of the developed countries to deny that change?
At the heart of the current crisis lies a huge build-up of debt. You could quibble over whether it’s Alan Greenspan who’s responsible for this state of affairs, or bankers who relaxed their lending standards, or you could lay the blame for the huge rise in credit and credit-related instruments on the derivatives revolution, labelling them as Warren Buffett did, financial weapons of mass destruction. But the fact remains that leverage, both of the US consumer and for financial institutions, has increased exponentially.
Two reasons are often given for this rise in indebtedness — one, very low interest rates and two, the propensity of the US consumer to consume rather than save. The rot, however, could have far deeper roots. What if it’s not the profligacy of the US consumer, but his desperate attempt to maintain living standards that was the reason for his taking on more and more debt? As Peter Bernstein, celebrated author of Against the Gods: the Remarkable Story of Risk, has recently pointed out, “the savings rate has been suppressed by a slowdown in the growth of household incomes. The shortfall between income and outlay has been met by borrowing, and in particular by borrowing against the family real estate.”
Further evidence is provided by a recent research paper from the Bank for International Settlements — Globalisation and the determinants of domestic inflation by William R. White — which says, “the secular decline in inflation in the industrialized countries has been coincident with a period of great restraint in nominal wage growth and that unit labour costs also moderated commensurately. The share of wages in total factor incomes has also been trending downwards for a long period of time, albeit subject to the influence of cyclical factors.”
The threat of shifting factories and jobs to low-wage countries has had a strong restraining effect on wage growth in the developed world. For instance, White writes, “In Germany, a number of large firms have negotiated both real wage cuts and changes in working practices in exchange for shelving plans to relocate plants to central and eastern Europe. In Japan, wage shares have been reduced most aggressively in those industrial sectors that have most actively expanded their production potential in South-East Asia.”
As for the US, data from the Bureau of Labour Statistics show that the record for average real weekly earnings for the private sector was $315.44 in 1972 (calculated in 1982 dollars), while in February 2008, after 36 years, average real weekly earnings were $279.06 (around Rs11,190), a fall of 11.5%. And even after the phenomenal boom of the last few years, the growth in real weekly earnings has been all of 4.4% in the last decade.
Faced with stagnating demand, how did the US economy manage to grow? One way out is to increase exports, but globalization has resulted in a large number of low-cost producers of goods and services and US costs are hardly competitive. The easier route is to increase credit to households, enabling them to consume more. At the same time, the fall in the proportion of wages in national income meant that there was more money available to invest.
Yet as a proportion of GDP, corporate investment in the US has stayed very weak since the end of the dotcom boom. White points out that there was a virtual collapse of corporate investment in Germany after the expansion fuelled by German reunification. The same thing happened in Japan after the collapse of its bubble in the 1980s.
In South-East Asia too, investment levels fell sharply after the Asian crisis and, with the exception of China, have not yet recovered fully.
Faced with all these constraints, the money went into speculation and into providing “financial services”. The phenomenal rise of financial assets and the exponential growth of hedge funds are proof of this trend. The securitization and derivatives explosion was a direct result of the need for more financial “products”.
In short, far from being a cyclical phenomenon caused by the ebb and flow of credit, a look at the underlying reasons suggests that the problem could be a structural one, an unintended fall-out of globalization. The build-up of debt may be the logical result of the stagnation of real wages in the US economy. The lack of growth in real wages could be the worm in the bud, the dry rot sapping the foundations. Instead of cutting the US economy down to size to suit its changed position in the global economy, it has been kept going by pumping in steroids.
Today’s blow-up is the reaction to that overdose. Deprived of its fix of credit, the US consumer is now in danger of collapsing. It’s no wonder then that the US Conference Board’s gauge of consumer expectations has slumped to its lowest level since December 1973.
Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome at
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First Published: Sat, Mar 29 2008. 02 17 AM IST