As I sat watching the NHL playoffs this week, it became quite apparent to me just how comfortable we as Americans have become with this concept of credit. A commercial came on during the first intermission that showed every American family’s dream. Picture this: A beautiful home, white picket fence, a healthy green lawn. The summer sun is shinning down on the children as they run toward a brand new jungle gym and swing set. As if this American dream could get any sweeter! But hold the press, Jimmy’s Jungle Gym Emporium is prepared to offer you free financing on your brand new slice of the American dream.
It set my mind in motion imagining the average family that stands to benefit from taking full advantage of Jimmy’s generous offer to finance their dream. Lets call our average American family the Smiths. Mr. Smith is a small business owner who’s entrepreneurial spirit has afforded his family a very comfortable life. It started with a great idea, a small loan from a bank, and a lot of hard work. The Smiths were gradually paying off the loan for the business, and saving as much as they could for the future. This savings could easily have gone to paying off the loan, but why should it? The cash flow being generated from the small business was more than enough to service their debt. It could be saved to buy a home.
Once the Smiths had saved enough money for a down payment, it was time for them to start building equity in the home of their dreams. The business was still going strong and bringing in enough money to pay the business loan, build equity in their home, and still manage to put a little savings aside. The Smiths were making all of the right moves. Between their savings and a home equity loan, a new location for their business, a few cars, and a few children soon followed. You can see where this is headed.
The Smiths love the idea of adding a jungle gym and swing set to their yard for their kids to enjoy. They also love the idea of managing their family’s and small business’s cash flow by utilizing Jimmy’s free financing. Since their businesses are booming, they can continue to re-invest money back into their small business. Everyone wins.
Credit is something that we as American’s have become extremely comfortable with. It makes our every day lives more manageable. Credit is something we all strive for: a good credit score, a high credit limit. These terms imply that we are credit worthy. To “have credit” carries a positive connotation. So surely the very basic concept of credit is not a bad thing, right? Debt on the other hand brings a negative connotation in our society. Carrying a lot of debt sounds like a bad thing, even if you have the ability to pay that debt. In a sense, these are two sides to the same coin. The story of the Smiths leads to an interesting question, “is there a point in time when the positive attributes of credit are outweighed by our inability to use the credit productively?”
At the very beginning of the Smith’s story, it is quite clear the loan taken for the small business is being used in a productive manner as evidenced by the cash flow it generated. If you wanted to quantify this, one could easily divide the amount of loan by the amount of cash flow generated. The smaller the number, the better.
Simple math shows that either the smaller the number on top, or the larger the number on the bottom of the equation, the more productive the Smiths are. By the end of the story, the loans have piled up. The number on top has gotten larger. This is not necessarily a bad thing, as long as the number on bottom grew either proportionally or quicker. As you can imagine, the more items that you add on credit such as cars and jungle gyms, the worse the Smiths number looks.
I enjoy trying to over simplify things to break them down to see if basic assumptions can be made and if these assumptions can hold water. So for the sake of wrapping this post up, here we go. We won't got back to the Tulip Mania, South Sea Bubble, or Mississippi Mis-hap just yet, but we'll start here in the 1920s. While the cause of the great depression can and will be debated here, we will simply admit there was indeed a great depression resulting from an unwind of the stock market and in general, leverage. As a result, the earliest semblance of our current well-fare states was formed in order to save the un-employed victims of this unexplained phenomena. As a result of the well-fare state, monetary easing (and possibly a war), many, MANY years of "stability" followed. Until a few hiccups in the 70s were easily overcome (easy because I didn't live through it), followed by a pesky savings and loan crisis in the 80s, the Russian Crisis in the late 90s which lead to the invention of the terms "too big to fail" (or today as it has evolved "I'll Be Gone, You'll Be Gone" speculation). The Russian Crisis lead to the failure of the hedge fund Long Term Capital Management. Followed by the Dot-com crash of the early 2000s. Less than a decade of tranquility later, we have the mortgage finance crash accompanied by more Wall Street liquidity issues. All the while, our nation is prospering.
Maybe these bouts are coming closer and faster, maybe they aren't. What does seem indisputable however is that Government spending in the form of entitlements is up, and tax revenues are down. After doubling Mortgage Finance Debt which culminated in the crisis of '07-'08, we have doubled Government Finance since then. The only question that most people don't seem to want to ask themselves is why these things are happening. Could it be that much like the Smiths from the story above, our country's economy has reach a limit of diminishing returns on credit expansion? Again, one thing seems certain to me, the economy does appear to be having a hard time finding its equilibrium! In order to try to find answers, we are going to have start at the crux of the issue and question even the very basic maxims on which we base our knowledge. Let's explore this idea of equilibrium in the near future.
In the spirit of this post, I leave you with this...
