For the economy, kicking the credit habit is sobering



Sobering up isn't easy, and that's what our economy is doing these days.

The cause of our queasiness in this analogy is the cessation of easy credit, which in economic terms has been a far more potent drug than alcohol. Real estate and other sectors that were really hooked on debt are clearly suffering the worst hangovers.

The process is painful, but the notion that we can make it easier by taking a little nip of easier credit -- as in the hair of the dog that bit you -- only makes sense if we plan to hit the bottle heavily again.

That's so tempting that even President Bush, an experienced businessman who knows better, has been forced by politics to repeatedly urge regulators to ease up on bank lending standards; he's also supported the adoption of more forgiving accounting treatments of bank balance sheets. That could be a recipe for financial hemlock.

In the early 1980s, the economy suffered from excess inflation, and the Federal Reserve Board's resolve to sweat these pricing excesses out of the economy helped launch the deep recession of 1981 and 1982.

In the early 1990s, the economy is suffering from excess debt, and the process of exorcising this devil explains a lot about why the economy is so sluggish and the recovery so weak and elusive.

This is not rocket science. We're broke, and we have to make some solid progress in repaying our debts if the recovery is to be based on any kind of solid foundation.

Edward Yardeni, my favorite Wall Street economist, recently noted that the ratio between debt and gross national product (GNP) had been remarkably consistent over the years leading up to the 1980s, averaging about 1.4. That means about $1.40 of debt was associated with $1 of output; if you believe in a causal relationship, it means it took $1.40 of debt to produce $1 of output.

In the 1980s, the ratio of debt to GNP soared, reaching 1.90 by 1990. Here, charted for all to painfully see, are the unadjusted figures in trillions of dollars of our debt, GNP and the rising ratio:

All this extra debt apparently didn't produce much in the way of extra economic output. And it was a crushing burden to borrowers. The cash flow from $1 of goods and services no longer had to service $1.40 of debt but $1.90! No wonder corporate balance sheets collapsed.

And, if this extra debt wasn't supporting real economic activity, Mr. Yardeni properly asks, what was it doing? Simple. It was showing up in inflated values for real estate, corporate takeovers and other assets.

Now, we are playing a painful game of Pay Back. Debts must either be repaid, restructured or written off. Lenders are borrowers, too, so any loan failures inevitably have had animpact on other institutions, leading to a kind of debt implosion.

Our financial institutions are being restructured, and our government is taking a huge hit in the form of bailout payments for savings and loans and, down the road, quite possibly for some banks as well.

Even "healthy" debt-laden companies and individuals drag down current economic performance by diverting so much of their resources into paying off debt instead of making more productive capital investments or even consumer purchases.

So, when the Fed lowers key interest rates, there simply is no noticeable surge in borrowings. The economy remains sluggish. And banks remain cautious lenders -- a bad risk at 10 percent doesn't magically become safe at 8 percent.

Baltimore Sun Articles
Please note the green-lined linked article text has been applied commercially without any involvement from our newsroom editors, reporters or any other editorial staff.