"A world addicted to easy credit must go cold turkey "

This article by Jeff Randall in the Telegraph does a nice job of looking at the causes of our credit mess and articulating implications. And he quotes my hero Paul Volcker (do you know that he stayed at the Fed fixing the economy even though his wife was very sick and he was having trouble paying the medical bills on his meager government salary? He had sterling reasons to get out of the pressure cooker and get a more lucrative private sector job, yet he saw his program through).

I found this piece colorful, pointed, and on the money.

From the Telegraph:

When dealers arrive at their desks tomorrow morning, the first question will be: Who’s next? Is it just Bear Stearns that has run out of cash, or are other great institutions staring into empty coffers? Investors are already betting that Lehman Brothers, another premier league player, has its financials caught in a mangle.

The US locomotive, for so long the engine of global consumption, is not just grinding to a halt, it is falling apart. The New York Times reports this weekend: “Everything seems to be going wrong… People are buying less, but most things are costing more. Mortgage rates are rising, the dollar is falling and prices of key commodities are leaping from one record high to the next.”

Where now are the financiers, regulators and politicians who peddled the inanity, “we mustn’t talk ourselves into recession”? Of all the vacuous comments made by officialdom, this one, given the rapid spread of financial disruption, grates more than most. Nobody is talking anyone into anything – it’s too late for that. Our jeopardy is very real. Recession, if it comes, will be the result not of idle chatter but a conspiracy of silence. It underpinned the fantasy.

For too long, those who warned that the borrowing bubble would burst with terrible consequences were dismissed as congenital gloomsters. Greedy lenders, their irresponsible customers and incompetent ministers formed an unholy alliance to perpetuate a myth: that consumers, companies and governments could keep spending more than they earned and suffer no penalty.

We heard new and intriguing justifications for excess. Banks seemed able to acquire rubbish and recycle it as triple-A securities. It was a sophisticated version of the second-hand shop that advertises: “We buy unwanted junk and sell valuable antiques.” Instruments of financial leverage became so complicated that even those trading them did not fully understand how the system worked. All they cared about was the potency of magic that enabled welfare claimants to borrow five or six times the income they were not earning and still make the numbers add up.

So clever were the designers of this wizardry that, though it failed the common sense test, they were able to fool supervisors, credit committees, external auditors, shareholders and regulators – even themselves! Disbelief was suspended by all concerned.

An important pre-condition for a faith in easy money is a complete disregard for the lessons of history. The bulls at Bear Stearns, it seems, were too busy spending their jackpot bonuses to read how and why boom turned to bust at Barings. Picking through the wreckage of his family’s bank, two years after it went under, Peter Baring told a Bank of England inquiry that while Nick Leeson was making extraordinary (and wholly illusory) profits, the company’s directors concluded that “it was not actually terribly difficult to make money in the securities business”.

For securities in the Nineties, read sub-prime in the Noughties. When it looks too good to be true, it usually is. Bear Stearns has suffered crippling losses on mortgage-linked investments. In the same way that Northern Rock lost the confidence of British savers, Bear Stearns eventually exhausted the trust of hedge funds and its other commercial lenders. For a bank that trades by borrowing 30 times its equity base, this was the kiss of death.

Three years ago, Paul Volcker, a former chairman of the Federal Reserve, warned that the US was “an economy on thin ice”. In particular he was worried that Americans had become hooked on living imprudently by using their homes as cash machines. He wrote in The Washington Post: “Personal savings in the United States have practically disappeared… we are buying a lot of housing at rising prices, but home ownership has become a vehicle for borrowing as much as a source of financial security.”

Does that sound familiar? I’m afraid so. Here in the United Kingdom we have been living a similar dream. Unable to fund all spending ambitions from income, too many Britons have cashed in part of their bricks and mortar for a blast of instant gratification. Worse still, so has the Government. Unwilling to live within its means, even with revenues of about £600 billion a year, Gordon Brown’s Circus and its troupe of performing puppets must borrow more than £40 billion next year to make ends meet. Its budgetary indiscipline makes us all more vulnerable to a sharp downturn.

Credit markets have frozen because it is unclear how many more of the big banks, if any, are bluffing. Nobody wants to be caught out trading with a loser. So cash is being hoarded. At the start of last week, the boss of Bear Stearns told the market that his firm was safe. But when lenders called that bluff, the cupboard was bare.

Central banks are trying to calm jitters by pouring billions of dollars into money markets to increase liquidity. Last week another $200 billion was dropped into the system. That was quickly swallowed up amidst screams for yet more emergency injections. Debt junkies, like heroin addicts, demand ever bigger fixes.

And this brings us to the heart of the matter. The rational response to financial pain is risk reduction. But if the pain is removed, or even suppressed, then so is fear. When individuals or institutions believe they will always be bailed out, they lose the incentive to reform. Delinquency is, in effect, encouraged.

In the end, the patient is so full of painkillers that they become part of the problem. The only way forward is for all palliatives to be washed out of the system. Sooner or later borrowers and lenders must address the real cause of discomfort. For many of Wall Street’s finest, it will feel like cold turkey.

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  1. Expat

    Aw, the Telegraph is so cute when it tries to be morallly upright and economically sound.

    Gee, if everyone just stopped fighting and started loving, we would not have any more wars. Hunger? Let’s some food to the poor. See how easy it is to fix problems.

    Forget it. You can’t take it back from the rich and powerful. They won’t let you. If you try, they will conjure up a war, draft you , and have you blown up on some foreign shore.

    Shocked and appalled that government and big business lies to us? Gee, really?

  2. Yves Smith

    I wouldn’t be so confident the wings of the rich won’t be clipped. The Great Depression wiped out quite a few formerly wealthy people, and income taxes became steeply progressive for the next two generations.

  3. Anonymous

    Wonderful piece! Financials caught in a mangle indeed!

    Nineties to Noughties.

    This writer can turn a phrase to look better than Marilyn’s haunches.

  4. rexl

    people don’t save money because it does not pay. perhaps they are not the idiots everyone assumes. housing was appreciating at 20% per year in some markets, while cd’s and savings paid 1-5% at most.
    the key was to have cashed out in time. the profit difference was a no brainer.
    if the powers that be want more savings then encourage it with real incentives, interest paid, not insipid moralizing.

  5. Lune

    Since everyone seems to be making analogies between bankers and addicts these days and about how we must go cold turkey, let me just add a wrinkle. In the actual world of drug addiction, it’s not so simple. There are certain drugs from which you absolutely do not want to go “cold turkey” from, because the withdrawal can literally kill you.

    For example, if an alcoholic comes into a detox center, they’re admitted, monitored closely, and treated with drugs to bring them off slowly, because a cold turkey approach can cause delirium tremens and rapid death.

    Other drugs, including such “serious” drugs as cocaine will not kill you if you go cold turkey (although the effects can be so bad that you often want to kill yourself, and indeed suicide attempts are one of the things detox centers must monitor for).

    So, is withdrawal from the drug of easy credit more like alcohol withdrawal, which requires careful monitoring and intervention by the “doctor” during the process lest you end up with a dead patient, or more like cocaine withdrawal, where you ignore the cries of misery knowing that, as bad as it may seem, the quickest way to get through it is to continue cold turkey?

  6. Anonymous

    Yves is right, you know.
    When officials repeat reassuring words almost verbatim from speeches of Herbert Hoover, then I know we’re in trouble.
    But we never learn; we have to hurt to understand; then we have to get by the best we can.

  7. Francois

    “You can’t take it back from the rich and powerful. They won’t let you. If you try, they will conjure up a war, draft you , and have you blown up on some foreign shore.”


    Tell that to the elites whose heads fell under the couperet of the guillotine.

    History is replete with examples of the rich taken to the woodshed and beaten silly.

    This is very unlikely to happen here. But elections can be a very good non-violent proxy. Just look what happened after the Great Depression…common sense got back into vogue in DC.

    It can happen again.

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