Saturday, December 27, 2008

The Credit Card Fallacy

Every boom and bust cycle is based on a fallacy, a simple gimmicky idea that seems reasonable at the time but is ridiculed in retrospect. In the recent mania that hit its peak in 2005 before starting to fall apart piece by piece, people (and especially major banks) were falling all over themselves to try to “own” as much consumer credit as they could. This was focused especially on consumer discretionary items — credit card purchases such as electronics, clothes, exercise equipment, and vacations. The real estate bubble didn’t level off until after consumers got in credit card trouble. The bankruptcy reform that made it virtually impossible for consumers to go bankrupt made lenders more overconfident than they already were. After that, it didn’t take much for the top-heavy credit card pile to topple.

In my opinion, it was the May 2008 stimulus payments that finally caused the credit market to break. The sudden load of extra U.S. government debt squeezed the credit market at the same time that manufacturers and retailers were overextending to try to catch the stimulus wave that never quite reached them. The Wall Street bailout in the fall and the Fed rate cuts were just further blows to an economy that was already reeling. But none of these panicky reactions should be blamed for causing the financial crisis.

Similarly, we may have made too much of the mortgage rate adjustments, medical expenses, and divorces that were the triggering events for home foreclosures. The real cause, in many cases, was credit card debt.

For more than half a century it was thought that consumers had to continually consume more to keep the economy operating. I do not believe that was ever really necessary, but in any case, that strategy seems to have run its course.