TCS Daily

Bringing Down the House

By Alvaro Vargas Llosa - August 27, 2007 12:00 AM

In 1993, the government of British Prime Minister John Major launched a campaign under a motto borrowed from the world of pop music -- "Back to Basics." As I watch the worldwide financial crisis triggered by the wave of mortgage defaults in the United States, I am reminded that at the heart of the problem is the departure on the part of the U.S. government and American consumers from basic economic principles.

Major's campaign referred to moral rather than economic issues, but the association is still relevant. Considering the consequences suffered by many ordinary people, there is something immoral about having disregarded basic economic notions for quite some time.

In recent years, many people forgot that in order to consume and invest, one needs to save. This elementary truth was lost as millions of people responded to perverse government-generated incentives by living beyond their means. What we are seeing today is nothing less than the inevitable price of behaving irresponsibly.

As is often the case with a financial crisis, the original sin behind the current turmoil has to do with government policy. Since 2001, the Federal Reserve has kept interest rates absurdly low in order to prevent a recession. Between 2003 and 2004 the rate at which the Fed allowed banks to lend to each other overnight was 1 percent! This convinced people that there was abundant money for anyone who wanted it. Easy money begets extravagance on the part of those who lend and on the part of those who borrow. So financial institutions came up with irresistible offers, including mortgages that required no down payment and adjustable-rate loans that charged low interest in the early years.

Borrowers went wild, often taking out second mortgages or multiple consumer loans simply because they could.

The theory was that the days of saving were over. The "new economy" was supposed to rest on the creation of asset value as reflected, for instance, in the skyrocketing price of houses. In such a context, financial institutions came up with slick instruments by converting debt into securities. Those sophisticated instruments passed from one hand to another in a trading dynamic that was supposed to allocate risk efficiently. In fact, because the origin of these securities was in many cases bad debt, the whirlwind of security trading concealed the high risk involved.

Why should we save, many Americans thought, if foreigners are doing the saving for us? Government policy reinforced the economy's irrational exuberance. Fiscal deficits didn't matter, the authorities claimed, because there was plenty of foreign capital investing in U.S. assets. A short-term mentality drove many American consumers at the expense of long-term thrift -- a mentality so resilient that even when the U.S. dollar started to depreciate, people continued to buy imports on a massive scale. Apparently, they were thinking that the price of their homes would continue to rise forever.

So here we are, in the midst of a financial crunch. I think the U.S.economy is so productive that the crisis will pass, thanks to an innovative segment of society that keeps inventing new ways of producing more with less.

But what is happening today is an indication that prosperity cannot be taken for granted. If those responsible for the current turmoil suffered the full consequences of their actions, perhaps the nation would get back to basics soon. Yet these sort of economic lessons are hard to come by because governments step in to bail the victims out. Even the European Central Bank, a supposedly inflexible monetary guardian, has thrown lots of money into the system, and Germany's government has rescued IKB Deutsche Industriebank AG because of losses related to subprime mortgages -- an illustration of how global this crisis has become.

Don't get me wrong here. The explosion of sophisticated financial instruments has provided liquidity to many markets that would otherwise not exist, and private equity funds have boosted entrepreneurial activity in extraordinary ways. The spread of risk around the world through the international sale of debt instruments is also a very good thing. The problem is that those blessings can easily turn to tears when people lose sight of the basic principle that prosperity depends on the capacity to sustain investment and consumption in the long term -- which in turn depends on the capacity to save for the future.

It is time, then, to go back to basics.


Step One
Federal and state governments currently tax interest and dividends earned and capital gains (penalize savings) and allow deductibility of interest expense (encourage borrowing). This seems intuitively backwards, if the intent is to encourage savings.

What am I missing?

Wake up
The so-called "subprime" turmoil has precious little to do with mortgage rates. If people would take a break from moralizing against borrowers, maybe for just a bit, then they could discover where the real problems lie. Congress, with help from the Comptroller of the Currency, has nullified the usury laws of 47 states. As a result, credit card companies can and do charge punitive interest rates of 33 percent when a borrower commits the slightest breach of the credit terms. It is debt at these 33 percent rates that are causing consumers to buckle--not the petty movement of mortgage rates from 2 percen to 6 percent. Wake up.

if you don't like the interest rate, don't get the card.

Saving vs Spending
Being debt free is the solution. I like most Americans have a mortgage. However, I bought well within my means and maintain minimal extra debt. My thrust is to pay off the house very quickly. I want to be debt free.

This notion we should borrow for everything is reflected in our politics. Free medicine, tax the rich, the welfare state are all symptoms of a spoiled society that refuses personal responsibility and risk.

There is something wrong when the average person has a credit card debt of 9900.00 last time I looked (or whatever it is today).

Taxing spending and consumption vs income would help a lot.
We should encourage the building of wealth. Instead the parties, especially Democrats, encourage taxation and vilify those who accumulater wealth as greedy robber barons.

I wonder if the Democrats will bail us all out when SSI goes bankrupt?

Then why is it that the crisis is occuring because people are defaulting on their mortgages? Borrowers rather idiotically borrowed money at a low VARIABLE interest rate. As interest has gone up, their payments go up, and they find they cannot pay their mortgages. They did this because the variable rate was even lower than the fixed rate. I have no sympathy for someone who is so stupid that they don't know that interest rates are only going to go up from 3 or 4%, and that it makes more sense, and is cheaper over the long run, to take out a fixed rate at a percent higher. As a consequence, I am paying the same money for my mortgage now as I was six months ago, while others are losing their houses because they don't have a bit of common sense. Of course, those of us who did do the right thing with our mortgages will now have to suffer because of th idiots who didn't should we have to move and subsequently buy a new house. Which may be the position I'll be in in a year or so. So forgive me if I have no pity for any moron who was too stupid to know how to take out a mortgage that wouldn't cause him to lose his house. They deserve the punishment they are getting -- maybe they'll learn something for a change. Certainly coddling them won't make them learn a thing.

The Democrats won't ever bail out anyone. They'll pass a law to force you to do it. They find it much easier to be generous with other people's money than with their own. Just ask Washington, D.C. waitresses who they prefer to wait on: Republicans or Democrats?

Desmond Lachman, have you read this?
Low interest rates are the cause of the problem. If the Fed continues to lower interest rates, as you have recommended more than once, to 'fix' the current crunch, the eventual cost to the economy will be exponentially higher. Doesn't anyone remember the S&L crunch? Does the term 'moral hazard' mean anything to you?

back to basics
The author suggest people go back to basics. Does he mean the quaint old fashioned notion of living within your means? But how can we expect people to do that when they're used to having a nanny state bail them out on so many counts? Many people are so spoilt rotten and decadent that they think it's now an entitlement to live beyond their means.

Bad Bailouts
Paying to rebuild houses and infrastructure in the same location after hurricanes or floods. So far the condos built on sand bars on the west coast of Florida have been lucky, but like New Orleans, it's only a matter of time.

Economic virtues
The mortgage situation parodies other aspects of living in a society of willfully incontinent fools who deliberately deny themselves both the knowledge and virtues required to live well, fully expecting others to pay the Piper when he comes round to collect his due because human compassion requires such.

It seems, then, that although capitalism requires risk-taking, those taking the risks must be knowledgeable, well-informed and thoroughly possessed of the virtues of economic rationalism. But as behavioral economists have shown us, economic man is an anthropological myth ginned up by economists to make their theories work in the real world.

I find this one of the most persuasive arguments against wealth redistribution because capitalism's dynamic power to create wealth through "creative destruction" will loose its steam if capital is put in the hands of those who only know how to affect "stupid destruction". In other words, we're all best off when capital accumulates in the hands of those who are best at creating more of it.

In fact Queen Hillary wants us to bail these people out.
The Democrats are the party of no responsibility. No matter what you did, how you did it or how bad it was it is not your fault and the state will save you if you only vote for Hillary and clan.

Falling Down
If we do not get our house in order the economy, like all balanced systems, will get it in order for us.

I wonder how Americans will feel when they have not only no nanny state to bail them out but they have no opportunity to bail themselves out either.

The next Depression will look like a party compared to a modern depression. People today, unlike the 1930's, have no discipline and no moral foundations. We will see crime, riots, ad nasium.

I never thought I would ive to see a nation of spoiled children who feel prosperity is a right.

Everyone mocks Mormons. The Mormons have a standing rule for all members. "Get your affairs in order and get out of debt".

Who's the fool?

Brilliant Post

Risk Takers
A true story:

I don't know if he's still doing this, but back in the 1990s there was a professional tightrope walker who would do thing such as tightrope walk over the Grand Canyon without a net.

A journalist asked him how he got up the nerve to do such risky things.

The walker was stunned by the question and replied that he had not taken any risk, because he would spend an entire year of full time preparation prior to doing a walk. "I rarely take risks," he told the journalist.

The journalist then asked him what the riskiest thing he had ever done was.

The walker replied, "Getting married".

they will save you by using other people's money.

A Democrat "bail out" just means giving you back a portion, usually a small portion, of your money that they stole from you.

I believe the Mormon's also strongly encourage their members to have a year's worth of food on hand.

Also starting to sound like a smart move.

Yes, my spouse is LDS and they do. Were working on that actually ourselves. Not a bad idea.

Ain't that the truth ...
A woman is one thing you can never know enough about and damn sure should never try to control ...

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