Michael Hudson and Michael Hudson are often mistaken for each other. Along with sharing a name, they share an interest in the creative ways that some people help themselves to other people's money. Michael Hudson the economist is the author of such books as Super Imperialism. Michael W. Hudson the reporter is a staff writer at the Center for Public Integrity and author of a new book, The Monster: How a Gang of Predatory Lenders and Wall Street Bankers Fleeced America, and Spawned a Global Crisis.
This is Part 3 of a 3-part conversation between the two Michael Hudsons. Part 1 can be found here and Part 2 can be found here.
Michael Hudson, economist:
By 2005 it was clear to me that the economy was painting itself into a debt corner. To the extent that a real estate bubble is debt-financed, it simply increases the economy's debt overhead. From the outset of my graduate economic studies, back in the 1960s, my mentor Terence McCarthy had urged me to concentrate on the debt problem. That has been the main focus of my studies all my professional life.
Here's the problem as it pertains to real estate: A property is worth whatever banks will lend. "Loosening" lending terms mean increasing the degree of debt leverage. The result is that debts rise beyond the ability of people to pay. This is the case not only with homeowners, but indebted students, corporations, cities and states as well.
Solving this debt problem by writing down debts strikes many people as unimaginable. There is a moralizing tendency to imagine that all debts can be paid -- and that if they are not paid, it must be the debtor's fault. This is an ideology well popularized by the financial sector. You might call it the opposite of "truth in lending." It encourages gullibility. The prospective borrower is treated as a "counterparty" -- itself a rather hostile term.
Thinking that debts can't be paid strikes most people as cognitive dissonance. Yet Adam Smith wrote in The Wealth of Nations that no government ever had paid off the public debt. The "magic of compound interest" makes it impossible for all debts to be paid over time.
The Chicago School talks about "money," but not of debt. Yet all money and credit is debt. That is a basic balance-sheet relationship. I often wish that economics students be taught accounting so that they see that savings = debt, and also money = debt. When you factor in the mathematics of compound interest, you see why financial crises occur: debts tend to outstrip the ability to pay.
At the University of Missouri-Kansas City, where I teach, we focus on the theories of Hyman Minsky. It is clear that economies develop bubbles as a means of carrying their debts. Banks lend borrowers the money to pay the interest, and this increases the debts that new buyers of real estate need to take on. The process becomes economy-wide, affecting industry and agriculture, and government itself. So crises are inevitable.
The question is, how will society resolve these crises? Who is going to lose? There are only two choices: either to bring the debt burden back within the ability to pay, by wiping out debt; or let creditors foreclose, transferring property from debtors to creditors.
Given the rising political power of financial wealth, economies are opting for the foreclosure option. But that slows economic growth and results in shrinkage over time.
Michael W. Hudson, reporter:
However preordained the financial crisis was, it's remarkable how long its architects kept the game going. They managed to sustain the unsustainable for five years -- roughly from 2002 into late 2006. As I was trying to write a new book on consumer debt, I came to see how the financial and mortgage markets had come to resemble a giant Ponzi scheme -- or a least a vast collection of interlocking mini-Ponzis. The key to keeping the thing going was to keep more and more money flowing in, giving everyone wiggle room to cover up the fact that underlying transactions -- mortgages and various investment vehicles such as "CDOs" -- were based on smoke and mirrors.
Lenders created the illusion of low default rates by refinancing customers whenever their low initial "teaser" interest rates began climbing upward, rendering the monthly payments unaffordable. The refinancing extinguished the old loan -- allowing it to go on the books as paid off, "successful" transaction -- and provided a new loan that was temporarily affordable thanks to a new teaser rate. A homeowner trapped in this process of serial refinancings might take out five loans in as many years before finally collapsing under the growing weight of the fees that the lenders slipped into each new transaction. This process would go down in the books as four successful loans and one foreclosure. The truth was, though, that all five transactions had been bad loans, doomed to fail from the start.
The lenders also hid their reckless lending by outrunning their bad loans, growing their mortgage volume so rapidly that their customers' rates of default were obscured. Thanks to teaser rates, it might take a year or two before borrowers ran into trouble and, even then, they might be able to stave off failure another few months by shifting money out of their 401(k)'s or borrowing from pawnshops or relatives. As lenders doubled or tripled their loan volumes every year or two -- Ameriquest, for example, grew from $6 billion in loans in 2001 to $82 billion in 2004 -- borrowers' defaults from previous years began to look like statistical blips. They represented a tiny percentage of what had become a much enlarged pool of loans.
All the refinancings and exponential growth was possible so long as housing values continued to climb higher and higher. It was only when the real estate prices leveled out, and then began to fall, that the hidden, slow-moving disasters for millions of families became a crisis for us all.
Michael Hudson, economist:
The constraint on this Ponzi scheme was the ability of income to carry the rising debt. As long as interest rates were falling, a given rental revenue or equivalent homeowners' value could carry a rising debt. But once interest rates reached their minimum, by 2006, there was no more leeway left. Homeowners had to pay debts out of their take-home wages, which have not risen in real terms for over thirty years now. The debt charade no longer could be concealed.
This leaves us with the problem of where we go from here. The Obama Administration's "solution" is for the economy to "borrow its way out of debt." The Fed is flooding the economy with credit to get the banks lending again - in the hope that new mortgage lending will restore high prices (that is, high housing costs to new buyers), saving the banks' balance sheets.
But with much of US real estate already in negative equity, banks are not going to start lending again on a large scale. The government doesn't want to confront the fact that we have entered a period of debt deflation. When debtors pay their creditors, they have less to spend on goods and services. So market demand shrinks, corporate profits fall, investment declines and unemployment rises.
To mainstream economists, this is an anomaly. This shows the extent to which creditor-friendly views have swamped common sense in academic economics as well as in Congress. It reflects the power of financial lobbyists to persuade many policymakers to embrace illusion over reality.