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Thursday, April 2, 2009

Credit and Its Distortions

A common thread running through the dialogue on the current economic crisis is the role of excessive debt levels, for government, businesses, and consumers, in the United States. Joe Scarborough, for example, commented recently on MSNBC’s Morning Joe program that we are witnessing the consequences of “25 years of leverage,” leverage being just a fancy word for debt. And numerous pundits have commented that, collectively, we are experiencing a terrible hangover as a result of a massive debt binge over the past several decades.

It doesn’t take a rocket scientist to understand the effects that excessive debt can have on the economy. When goods and services can be purchased with debt rather than bought outright for cash, two things happen: (1) middlemen are introduced into the process, which creates markups that may be in excess of any objective added value, and (2) suppliers who know that their customers do not have to make an immediate, out-of-pocket payment-in-full know that they can charge higher prices.

When access to credit is easier, demand also increases, which in turn has an inflationary impact on price that, again, can create prices in excess of objective asset values. Among the empirical studies that have demonstrated this is one by Nada Mora of the American University of Beirut, whose paper “The Effect of Bank Credit on Asset Prices” found that, in the Japanese real estate market of the 1980s, a one percent increase in real estate lending correlated with a 14-20 percent increase in land inflation. In hindsight, we see that this example was prophetic of what happened in the recent housing bubble in the U.S.

Common-knowledge examples of this effect are legion in other industries as well, higher education among them. It’s well known that college tuitions have increased well beyond the rate of inflation over the past several decades. This is undoubtedly due in no small part to the understanding among the institutions that many students and their families are not paying tuition out of pocket but are relying on loans and other forms of financial aid. In the higher education domain, the increased role of credit has helped create an environment in which the concept of “working one’s way through college” is a distant memory.

Credit of course has an important, legitimate role to play in the economy, but a market correction of excesses of the past several decades is undoubtedly a major factor in our current situation. However painful the experience may be, many businesses and families are being forced to learn to live with less credit, and perhaps in the long run that will be a good thing. Moderation of the use of credit, and a retooling of the role of credit in transactions, will hopefully smooth out some of the distortions that have been created and drive prices toward a more accurate reflection of objective asset value. Sphere: Related Content

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