On top of that, consumers need either increased income from some source or access to loans in order to demand more goods and services. But employment is going down, not up, and the banks are cutting back on loans while the credit card companies are increasing interest rates on their credit cards.
In the absence of increased wages, which we aren't going to see without an increase in the economy (which requires the increased demand to trigger) loans are the only possible source of funds for consumers.
So Paul Krugman explains why there will be no increase in loans. What started out as a crisis in subprime mortgage loans has taken the entire financial industry largely out of the business of making loans of almost any kind. Why? Because those loans are based on trust between the lender and the borrowers, and that trust is gone.
...this week the state of Michigan suspended a major student-loan program because of the sudden collapse of another $300 billion market you’ve never heard of, the market for auction-rate securities.So when I hear some spokes person saying that the financial crisis that America has been in since before last Summer will be mild and short, I've got to ask what that person knows about the economic forces that will change the current direction of the economy? Consumers have to start spending more, and to do that they have to somehow get more to spend. Where does it come from?
Why has a crisis that began with loans to a limited group of home buyers ended up disrupting so much of the financial system? Because, ultimately, it’s more than a subprime crisis; indeed, it’s more than a housing crisis. It’s a crisis of faith. [Snip]
Like many of the financial innovations that are now being called into question, auction-rate securities are complicated deals that seemed to offer something for nothing.
They seemed to offer the borrowers — typically local governments or quasi-governmental agencies, like the Port Authority of New York and New Jersey and the Michigan Higher Education Student Loan Authority — a way to borrow long term without paying the relatively high interest rates investors usually demand on long-term loans.
At the same time, they seemed to offer investors an asset that was as good as cash — readily available whenever needed — but paid higher interest rates than bank deposits.
The operative word in all of this, of course, is “seemed.”
Auction-rate securities seemed as good as cash because they involve regular, well, auctions, held as often as once a week, in which investors wanting out sell their positions to investors wanting in. In principle, it was always possible for auctions to fail for lack of enough willing buyers — but that wasn’t ever supposed to happen.
Meanwhile, these securities seemed like a good deal for borrowers despite the fact that they contain a penalty clause: if an auction fails, the interest rate the borrower pays jumps up. (The Port Authority, which had a failed auction last week, just saw the interest rate it pays leap from 4.3 percent to 20 percent.) You see, there weren’t ever supposed to be failed auctions, so the penalties weren’t supposed to be relevant.
Now, what wasn’t ever supposed to happen has. In the last few weeks, a series of auctions have failed, leaving investors who thought they had ready access to their cash stuck, even as borrowers find themselves paying penalty rates.
The collapse of the auction-rate security market doesn’t reflect newly discovered problems with the borrowers: the Port Authority is as financially sound today as it was a month ago. Instead, it’s contagion from the broader credit crisis.
One channel of contagion involves monoline bond insurers, the specialized insurance companies that are supposed to guarantee debt. These companies insured buyers of local government debt against losses — but they also guaranteed a lot of subprime-related investments, which makes everyone wonder whether they’ll actually have the money to compensate losers in other markets.
More important, however, is the way the ever-widening financial crisis has shaken investors’ faith in the whole system. People no longer trust assurances that fancy financial instruments will function the way they’re supposed to — after all, they know what happened to people who thought their subprime-backed securities were safe, AAA-rated investments. Why, then, should they believe that auction-rate securities are as good as cash?
And loss of trust can be a self-fulfilling prophecy. Now that new investors won’t buy auction-rate securities because they no longer believe that they’re as good as cash, those securities become a much worse investment. [Snip]
One simple measure of the seriousness of the credit problem is this: although the Federal Reserve has sharply cut the interest rate it controls over the past few weeks, the borrowing costs facing many companies and households have actually gone up.
And the financial contagion is still spreading. What market is next?
And forget supply side economics. Businesses already have plenty of cash in reserve to invest. They simply can't find good investments to spend the money on. Giving government money to businesses will not change the lack of consumer demand that would generate new investments. It will just give the companies more money to provide bonuses to their failed managers or to invest overseas somewhere outside the U.S.
The financial theories that underpinned the credit instruments that no longer work have not been corrected, nor are there new ideas to replace the old, failed ones. Without trust in those instruments, the investors will not lend money because they are afraid they will lose it.
This is not a prediction of deep dark financial gloom forever. There will be some lending done that works, other lenders will observe it over time, and the early lenders will make big money, attracting more lenders and borrowers to that market. But "over time" means more than six months to a year.
In the meantime, our economy is in for a bumpy ride, and sweet words will not change that. They'll just sucker some lenders into markets that aren't ready to work yet, causing them to either not be able to make deals or the deals that are made will fail.
That's where we are right now. And a lot of the problem is, as Krugman said, based on a failure of trust in the lending markets.
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