David Wessel wrote an insightful article in today's Wall Street Journal about the credit market, which he refers to, "the lifeblood of modern economy." It was only more than a month ago when the Federal Reserve declared, "The upside risks to inflation roughly balance the downside risks to growth." The argument now is whether growth slows in early 2008 with unemployment increasing a little
or if there is a recession in which unemployment increases substantially.
The U.S. has experienced recession only 16 months in the past 25 years and in the previous 25 year period there were 64 months of recession.
Banks and investors have been loaning money freely for many years, while taking big risk with little reward, which is known as, "low risk premiums." Lately they are hoarding cash and are even refraining from lending to each other more more than a few days. In August 2005, Greenspan warned, "History has not dealt kindly with the aftermath of prolonged periods of "low risk premiums."
The credit problems the U.S. is having today go further than just subprime mortgages, but alsoinclude increasing delinquencies on credit cards, auto loans and home equity loans as well. To further exacerbate the problem, banks are now having to dip into their cash reserves in order to cover growing losses.
Eventually banks will have to pull back on loans to consumers and businesses. Wessel goes on to define "leverage" as the factor by which a lever multiplies a force and in finance it allows, "The bold to make bets that pay off handsomely when times are good." The problem we now have is that is that this same force magnifies losses when things go bad.
Wessel further explains that economists refer to recent decades as the, "Great Moderation
," in which inflation was low and recessions were scarce. He now believes that this era may be giving way to a new one, the "Grand Deleveraging
." He makes his point even clearer when he quotes Commentator John Mauldin, "However...we see a few fire trucks starting to gather and those sirens are telling us that more are on the way. There is smoke coming from the building. Attention must be paid."
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