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Home > Editorials > Op/Ed: Lessons of the 1970's International Credit Crisis

Op/Ed: Lessons of the 1970's International Credit Crisis

Reckless lending and the bursting of the ‘Super Bubble'

(NEW YORK - Novmber 14, 2008) -  The following is my attempt to point out how we got into the financial crisis of 2008.  It all began in the 1970's...

Banks were all about safety after the 1930's.  Then, in the 1970's, things started to change when a new breed of bankers emerged who concentrated primarily on the bottom line.  With this new breed of bankers came an explosion of international credit (1973-79), which caused the inflation boom of the 1970's and, ultimately, the first international credit crisis. 

International lending in the 1970's, and lending to America and Americans in the 2000's, grew so fast that the banks involved became over-extended and their capital and reserves couldn't keep pace with their balance sheets.  Their loan portfolios, however, were strong, at least on the surface.  This was possible because, during the 1970's, the borrowing countries - like the American people during our recent credit crisis - continued to meet traditional requirements used to determine credit worthiness, even as their overall debt burdens grew.  In both eras, the key to the process was very low, and eventually negative, real interest rates.  Similarly, in both eras it was the flux of foreign surpluses that helped to ignite the credit expansion, and in both eras monetary policy of the U.S. remained relaxed.  As a consequence, the dollar depreciated in both eras and interest rates failed to keep up with rising prices.  The decline in real interest rates made the borrowers of the 1970's and the borrowers of today more credit worthy, and it also made both more eager to borrow.  On the surface, the expansion of credit in both eras stimulated the world economy.  Nevertheless, the credit worthiness of the borrowers in both eras was illusionary. As long as the lending continued, the world economy remained prosperous - consumption was high while savings was discouraged by low or negative interest rates.

Furthermore, investments during both eras were stimulated by cheap loans; the combination of high consumption and strong investment manipulated both eras; credit expansion kept the demand for energy growing; and even the U.S. presidents of both eras had the same flawed policies, believing lower taxes would stimulate economic growth and that the deficit would be reduced by cutting government spending.  In both eras, however, an increase in military/defense spending made a balanced budget unattainable.

In the 1970's, the OPEC nations had so much money they didn't know what to do with it.  Meanwhile, the governments of the industrialized nations failed to help them recycle petrodollars, and as a consequence the job was left to the banks, which gladly stepped in to manage the money and become aggressive lenders.  In our current crisis, it was the major exporting nations, including China, Japan, India, and again the OPEC nations, who had an abundance of dollars that needed to be recycled.  America and American banks got involved to help manage the money, and America officially became the "borrower of last resort." 

The banks, like in the 1970's, helped the surplus nations invest their money by loaning it out - the only difference: In the 1970's the money was loaned to emerging countries, whereas beginning in the 1980's it was loaned to America and the American people.  The creditworthiness of both borrowers, however, was illusionary because it was based on continued access to credit.  And the only thing preventing banks of either era from creating an unlimited supply of credit was self-restraint.  Unfortunately, lending was far too profitable for caution, and competition kept lending rates down.  

To recap, international lending of the 1970's - and lending to America and Americans during the 2000's - became the easiest and most profitable of banking activities.  Banks were so anxious to drum up business that they asked too few questions.  This leads me to the next phenomenon I believe we will experience in the 2000's that will be similar to the 1970's: the issue not of ability to repay debt, but willingness.  Credit is so tight right now that the relevance to keeping up with payments on depreciating assets will become nonexistent.  During the international credit crisis of the 1970's, debtor-countries never had a problem paying on their debt because they were always able to borrow.  Thus, as long as any debtor is able to continue to borrow, their willingness to repay is never in question.  Lenders use debt ratios to measure a borrower's ability to pay.  To measure willingness is quite different. The variable is not debt service, but net resource transfer, which measures the difference between debt service and the inflow of new credit.  As long as today's borrowers are able to get new credit, their willingness to pay will not come into question.  If, however, Americans are unable to get credit in the future, their willingness to pay past debts will be the next shoe to drop. 

It has been the flawed policy of banks during both eras to "grow their way out" of bad debts.  We saw the U.S. become the ‘borrower of last resort' during the 1980's, and as a result it began receiving funds that were once being allocated to less developed nations.  In the current crisis, the U.S. has become the ‘lender of last resort,' bailing out financial institutions in the hope of them re-lending to Americans.  At the risk of oversimplifying these events, here is what I believe: (1) the bailout after the international lending crisis of the 1970's directly led to the savings and loan crisis of the 1980's; (2) the bailout of the savings and loan crisis led to the dot.com bubble of the 1990's; and (3) the bailout of the dot.com bubble led to the housing crisis and the reckless lending problems of today.  And inevitably, the current bailouts will cause further, severe and unintended negative consequences.  We have characterized this build-up as the "super bubble" or the "mother-of-all-bubbles," of which we are witnessing the beginning of the burst.  U.S. growth since 1982 has been illusionary; asset prices have climbed on the ability of the banks willingness to lend.  With credit soon a thing of the past, U.S. stocks, growth and standard of living will continue their tumble until credit is priced out.  The government, by printing more money and propping the markets up, is simply delaying the inevitable hit we must take, which is living without credit.

In conclusion, the current banking system and the banking system of the 1970's would have collapsed without the intervention of global authorities.  What this tells us is that the banks have never considered themselves responsible for the soundness of the system; it has been the job of the central banks to prevent shortages and excesses.  Commercial banks have a strict view towards maximizing profits and have proven unable to police themselves.  Realistically, financial markets must be supervised.  A forewarning from central banks could prevent these cycles, or at least minimize their harm before it's too late, by responsibly managing access to credit. 

For whatever it is worth, I have written this commentary with a view towards creating awareness about the problems facing our economy and promoting a stronger, more stable financial system.

 

Troy Holland

Black Taurus Capital Management

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