The recent (ongoing) crisis in the so-called subprime market has highlighted the immense difficulties of managing an economy that relies heavily on borrowing in order to create spending. The US and, perhaps even more so, the global economy is seemingly in fine shape. In the States, however, this is in great part due to increased spending made possible through the use of debt. People have had easy access to borrowed money thanks to the historically low interest rate of the past few years.
As the interest rate gradually began to rise, however, paying back these loans has become increasingly difficult. The subprime mortgage crisis is not a sub - as the name might suggest - but rather a prime example of this. Since a subprime loan is a loan that is given to people with a bad credit record, who therefore don't qualify for market interest rates and must pay a much higher rate, it is naturally mostly the poorer people who make use of it. The large number of people with subprime mortgages suddenly found that with the decreasing value of their houses, they were unable to pay the mortgage. And if you can't even pay your mortgage, you surely won't be able to spend on much else, which would cause a problem for the economy.
This poses a dilemma, as the economy must continue to be boosted through spending, but not at all costs. People need to understand that borrowed money needs to be paid back; it is not free money. This should serve as a wake up call to American consumers that relying too heavily on debt is too great of a risk. Sadly, there are always - including now - strong voices advocating debt forgiveness. Surely it cannot be so that consumers are taught that accumulating debt to the point of being unable to repay it comes without consequences? The message that big trouble will arise with too much debt must be hit home hard, once and for all. Better now, while the economy is reasonably stable, than later, when debt will only accumulate further, causing a potentially cataclysmic economic downfall of unknown proportions if China's possible bubble were to collapse.
There is some good news on the horizon, however, in the Fed's failure to take serious steps (i.e. have the central bank lower its benchmark federal funds rate from 5.25 percent) to help those affected by the crisis. It appears that Federal Reserve Chairman Ben Bernanke is trying to "teach investors a lesson," namely that the Fed will not bail out their poor decisions. This is not to say that there is no help whatsoever. The Fed has already injected tens of billions of dollars into the banking system and lowered its discount rate (the charge on its loans to commercial banks). Furthermore, President George Bush announced a plan to help struggling subprime mortgage borrowers to keep their homes via changes to the tax code.
Let's hope that a fair balance is found between the honest need to help those hardest hit and teaching a very wrong and dangerous lesson. Sometimes it is best to set an example to future potential defaulters by acting very harshly (though some would say justly as well) towards those involved now.
As the interest rate gradually began to rise, however, paying back these loans has become increasingly difficult. The subprime mortgage crisis is not a sub - as the name might suggest - but rather a prime example of this. Since a subprime loan is a loan that is given to people with a bad credit record, who therefore don't qualify for market interest rates and must pay a much higher rate, it is naturally mostly the poorer people who make use of it. The large number of people with subprime mortgages suddenly found that with the decreasing value of their houses, they were unable to pay the mortgage. And if you can't even pay your mortgage, you surely won't be able to spend on much else, which would cause a problem for the economy.
This poses a dilemma, as the economy must continue to be boosted through spending, but not at all costs. People need to understand that borrowed money needs to be paid back; it is not free money. This should serve as a wake up call to American consumers that relying too heavily on debt is too great of a risk. Sadly, there are always - including now - strong voices advocating debt forgiveness. Surely it cannot be so that consumers are taught that accumulating debt to the point of being unable to repay it comes without consequences? The message that big trouble will arise with too much debt must be hit home hard, once and for all. Better now, while the economy is reasonably stable, than later, when debt will only accumulate further, causing a potentially cataclysmic economic downfall of unknown proportions if China's possible bubble were to collapse.
There is some good news on the horizon, however, in the Fed's failure to take serious steps (i.e. have the central bank lower its benchmark federal funds rate from 5.25 percent) to help those affected by the crisis. It appears that Federal Reserve Chairman Ben Bernanke is trying to "teach investors a lesson," namely that the Fed will not bail out their poor decisions. This is not to say that there is no help whatsoever. The Fed has already injected tens of billions of dollars into the banking system and lowered its discount rate (the charge on its loans to commercial banks). Furthermore, President George Bush announced a plan to help struggling subprime mortgage borrowers to keep their homes via changes to the tax code.
Let's hope that a fair balance is found between the honest need to help those hardest hit and teaching a very wrong and dangerous lesson. Sometimes it is best to set an example to future potential defaulters by acting very harshly (though some would say justly as well) towards those involved now.
4 comments:
Thank you very much for yet another elucidating article. Finally I understand the problem and the solution. However, your article is interesting also because it raises questions - in an economy built on debt, are we not building sand castles? How can it ever be stable?
Hi to all,
if you have any thoughts on what will the FED do on September, 18th on the light of the recent market turmoil, please feel free to leave your vote on my blog's poll at:
http://www.thedailyeconomist.blogspot.com/
best,
Bernardo
"People need to understand that borrowed money needs to be paid back; it is not free money."
The thing is this economy only grows off of borrowed money. It will never pay off its debts. The economy is driven by debt and borrowed money thanks to that multiplier effect (aka Geometric Series) and the banking system.
To the owner of this blog, how far youve come?
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