Debtor Nation

[Debtor Nation: The History of America in Red Ink • By Louis Hyman • Princeton University Press, 2011 • 392 pages]

“The author doesn’t make the distinction between accumulated real capital and cheap credit created through a banking system cartelized by the Federal Reserve.”

The debate in Washington over the nation’s debt and debt ceiling has President Obama announcing to the White House press corps, “What we need to do is to do our jobs, and we have to do it the same way a family would do it. A family, if they get overextended and their credit card is too high, they don’t just stop paying their bills.”

Extending the president’s analogy, FoxNews.com’s Jake Gibson cobbles together government data to determine that the typical American has debt totaling 89 percent of yearly income. Meanwhile the US government’s debt is 162 percent of annual revenue, making the average American appear positively debt shy.

What would it actually take to pay the bill? The current GDP is $14.12 trillion. The government could loot the whole country immediately — everything nailed down or not — and pay the whole tab. It would be a debt-free stone age!

No, the bill can’t be paid and won’t be paid. That much should be obvious. But denying the obvious is a mental trait built into the structure of the system. The economic crisis of 2008, which continues to produce shock waves, was really just the realization that the consumer-debt load at the time was unsustainable.

Washington was the head cheerleader for, and architect of, the entire racket. The culprits weren’t Wall Street, Bear Stearns, and Lehman Brothers; the real driving force was decades of government policies that “expanded the numbers of Americans in debt and legitimated borrowing as an alternative to saving,” writes Louis Hyman in his extraordinary book Debtor Nation: The History of America in Red Ink.

The author takes us back to a time when retailers provided credit. We’ve all seen western movies where the farm wife charges her provisions at the general store, with the tab presumably to be paid when the crops are harvested and sold.

Credit and income information was hard to obtain just after the turn of the century, thus credit was granted to those known and trusted. John Mackey built what would become Household Finance Company, lending small amounts of money at monthly interest rates of 10 percent. The cost of collection was high, and there was no Federal Reserve spewing forth liquidity. Mackey had plenty of customers because banks didn’t lend to consumers.

Usury laws began to pop up, setting maximum rates at a fraction of what Mackey was charging, but as Hyman points out, the laws only served to send working class people to loan sharks charging between 60 and 480 percent per year.

Most credit was secured by household goods, because few people owned homes. And when Detroit began to crank out cars, auto finance was born. Companies like GE finance and GMAC were created to provide retail and wholesale finance, allowing consumers to borrow as never before. These installment credits were not subject to usury laws because judges ruled that installment purchases were luxuries and not necessities. And the threat of a visit from the repo man kept people diligent with their payments.

The availability of credit began to blur class distinctions as people’s consumption converged. Women were the target of installment credit because it was believed they couldn’t resist buying dresses on installment to look their best. Credit managers were thought to provide control over borrowers, keeping them from overextending themselves. “The vicious chain of being in debt … was forged when I married and set up a home,” an anonymous housewife wrote in Collier’s.

Government swung into full gear in support of housing finance during FDR’s New Deal. While Hyman innocently calls New Deal policies a “practical harnessing of private capital for social ends,” the Federal Housing Association (FHA) standardized housing and its finance, leading to standardized, suburbanized, government-loving, overindebted Americans.

Short-term balloon notes were replaced with a government policy encouraging long-term debt, “partially because the government language reframed mortgages not as a heavy debt, but as responsible long-term investments for the borrower,” writes Hyman. “Americans were encouraged to become comfortable with long-term debt in a way they never had before.”

Homes in America weren’t a ball and chain anymore, but a wise investment, to be funded with ever more “residential finance filtered from distant investors through federally made markets.” Government had extinguished the stigma of debt; and one now had to convince, not George Bailey down the street, but “large, impersonal corporations” as to one’s creditworthiness.

However, as the author points out, “The real owners [of these homes] were the banks and insurance companies, who found a safe source of income in the midst of the Depression.”

On the heels of state-sanctioned mortgage finance, banks barreled into consumer lending with the help of the FHA’s Title I program. “The guarantee of profits through federal insurance mitigated bankers’ suspicions about consumer lending, and bankers opened FHA Title I loan departments.”

For the first time, bankers looked beyond business for avenues to make loans. With a lack of creditworthy commercial borrowers to lend to, bankers eagerly embraced the Title I program.

After unleashing this torrent of credit, FDR’s administration looked to tamp down the resulting price inflation with “Regulation W,” birthed from “a contorted reading of the Trading With the Enemy Act.” Reg. W sought to regulate how much, and under what terms, consumers could borrow. The unintended result was the creation of revolving credit, allowing consumers to borrow as never before.

Hyman’s most enlightening chapter is entitled “Securing Debt.” After decades of urging the American public to borrow and banks to lend, in the 1960s the government planted the securitization seed that would grow to tip the financial system over in 2008. LBJ’s Great Society looked to push capital into decaying cities, but the buying and selling of individual mortgages was cumbersome. Mortgage paper needed to be bondlike, and the Housing Act of 1968 implemented this vision, remaking “the American mortgage system in a way that had not been done since the New Deal.”

Along with “privatizing” Fannie Mae, the bill created the mortgage-backed security, directed mortgage funds toward low-income borrowers, and authorized the Treasury to be the buyer of last resort to the market. The federal government’s intrusion in the housing market continued to grow. The idea that Fannie Mae was suddenly cast adrift to market forces is fallacious. Fannie was required to buy low-income mortgages and its “larger market actions would remain partially under government control.”

With the passage of the Emergency Home Finance Act of 1970, Congress then created a secondary market for conventional mortgages, which “drew on the mortgage-backed security financing techniques developed in the Housing Act of 1968.”

Although the government’s backstopping of the market didn’t cover the entirety of Fannie and Freddie’s portfolios, it was close enough to suit investors. “Dangling promises, diversified portfolios, and foreclosable houses convinced many investors.” As Hyman explains, actuaries calculated that default rates were three times higher for a 95 percent mortgage versus a 90 percent mortgage, “but investors trusted the U.S. government to make good on the payments, even when the American borrowers could not.”

Freddie Mac teamed up with Lewis Ranieri‘s Salomon Brothers and First Bank of Boston to create collateralized mortgage obligations (CMOs) in 1983. CMOs could be split into slices (tranches) allowing buyers to satisfy whatever risk appetite they had. “With the right math, a mortgage could be turned into anything.”

The same model was used to bundle credit-card receivables. In 1994, the Financial Accounting Standards Board (FASB) fielded a proposal that would have required that banks hold reserves against securitized revolving debt receivables. The proposal was voted down decisively.

While the Basel Accord regulations required banks to increase their capital ratios, securitized debt obligations and mortgage-backed securities required no capital to be maintained against these investments, unlike individual loans.

Securitizing the debt allowed banks to make as many credit-card loans, or mortgage loans, as they possibly wanted, as if they were treasury bonds. The capital requirements meant to hedge risk simply pushed banks toward securitization rather than reducing their lending.

From there, lenders packaged mortgages and credit card loans that were underwritten using automated risk-modeling programs based on very thin data, enabling “more inexperienced lenders to be overconfident, taking the model for reality.” Quoting a senior project manager for Fair Isaac‘s Horizon system, Hyman writes, “’the borrowers who tend to go bankrupt look just like a lender’s most profitable customers.’”

Mr. Hyman lectures at Harvard in the field of history, and his rich and detailed chronicling of the government’s fostering of consumer debt makes Debtor Nation an outstanding book. However, in his epilogue, the author reveals himself to be somewhat of a frustrated Marxist, who has resigned himself to the notion that America runs on capitalism and the present financial crisis, “occurred not because capitalism failed, but because it succeeded in doing what it does best: profits and inequality.”

He writes that government is needed to channel capital to social good, which “is the best way to solve the distressing failures of the market economy.” Hyman then goes on to spend time at book’s end fretting about the overaccumulation of capital.

Of course there has been anything but an overaccumulation of capital. And all of these profits he speaks of have evaporated as lenders charge off the bad debts made during the boom. Capital is savings. And there is little of that. Capital can’t be printed. Consumption must be delayed.

The creation of money via the Fed has weakened the savings rate by diverting funds from productive uses. As Frank Shostak explained recently,

If however the flow of real savings is falling, then, regardless of any increase in government outlays and monetary pumping overall, real economic activity cannot be revived. In this case, the more the government spends and the more the central bank pumps, the more will be taken from wealth generators — thereby weakening any prospects for a recovery.

However Hyman does stumble onto this insight while muddling around during his overaccumulation worries: “Without possible productive investments, investors, who still need to put their money somewhere, are drawn into asset-bubbles and speculation.”

The author doesn’t make the distinction between accumulated real capital and cheap credit created through a banking system cartelized by the Federal Reserve.

Americans today go to great lengths to protect their credit scores. We’ve been convinced that a high credit score speaks for our integrity and goodness as a person. To have no borrowing history makes you suspect. Avoiding debt and saving money doesn’t make you prudent; borrowing and paying back does.

Professor Guido Hülsmann explains where decades of credit stimulation have led us:

The net effect of the recent surge in household debt is therefore to throw entire populations into financial dependency. The moral implications are clear. Towering debts are incompatible with financial self-reliance and thus they tend to weaken self-reliance also in all other spheres. The debt-ridden individual eventually adopts the habit of turning to others for help, rather than maturing into an economic and moral anchor of his family, and of his wider community. Wishful thinking and submissiveness replace soberness and independent judgment. And what about the many cases in which families can no longer shoulder the debt load? Then the result is either despair or, alternatively, scorn for all standards of financial sanity.

Hyman sees the current credit system as inherent to capitalism itself. However, fiat money, central banking, and fractional reserves are antithetical to capitalism. It is savers who initiate a “process of civilization,” as Hans Hermann Hoppe points out in Democracy: The God That Failed.

It is the government’s promotion of debt that has made Americans dependent, dispirited, and uncivilized.