By Daniel Griffith, Carnegie Mellon University
This is part 2 of a 4 part series covering the recession, its causes, and potential future. This is the first in-depth description of the financial crisis Bulls & Bears has provided.
For years, the Federal Reserve has measured domestic credit with “Private Credit Aggregate”. The number measures the total credit issued to the private, non-financial sector (including everything from household debt, non-financial company debt- such as mortgages, auto loans, and corporate bonds) within the U.S. economy. This number is usually measured and compared to nominal GDP, and taken into account to set monetary policies. The theory is this: in a period of steady growth, the Private Credit Aggregate should equal nominal GDP- indicating that non-financial companies are not over consuming, but are still spending (through investments made with debt). One important aspect of this number’s relevance is as follows: as more private debt becomes securitized (as I described in Part 1 of the series), it is left out of the monetary aggregates, making those figures less significant- and less useful. Monetary aggregates include checkable deposits, time and savings deposits- all of which make up commercial bank funding, and were traditionally used to calculate inflation as well as monetary velocity. This serves as a valid indicator of bank lending and credit, but as the shadow banking system grew (Lehman Brothers, Bear Stearns, etc), monetary aggregates (i.e. M1, M2, M3) made up less of the total domestic debt. The private credit aggregate remained accurate since it takes into account both securitized and balance sheet debt.
From 1952 to 1984, the private credit aggregate grew at the same rate as the nominal GDP, the figures in 1984 being $3.5 Trillion nominal GDP and $3.5 Trillion in private credit outstanding. The problem arises between 1984 and 2007 – in 2007 nominal GDP was $14 Trillion, while the private credit aggregate was $25 Trillion. This means the total credit the private and non-financial sector held by 2007 totaled $25 Trillion (a significant portion of this was due to the increase in home prices), but the country as a whole (financial institutions included) was only producing $14 Trillion. In hindsight, these numbers are alarming- the relationship represents the amount of credit being underfunded by assets (essentially, the $11 Trillion of credit above the GDP is seen as unproductive debt- which would never be paid back). This was perceived to be acceptable at the time because housing prices were rising faster than debt levels (thus lulling economists into believing the debt was sustainable), but few expected prices to stop rising. It was only a matter of time before the credit gap closed, and creditors tightened their requirements- the system was hit even harder by the decline in real estate values. Many ignored the widening gap between credit and GDP, and as a result, omitted the numbers from econometric models used to analyze monetary policy.
This significant increase in leverage did not trigger any alarms, primarily because it did not increase inflation. This was due to increasing globalization throughout the 90s. As international markets opened up, a huge demand arose for U.S. fixed income securities. With this inflow of capital, the U.S. was able to sustain huge account deficits, without affecting domestic inflation (since global demand was met by an increasing supply of U.S. debt). And since monetary indicators were more highly regarded than the private debt sector, the increase in shadow banking kept issues under the radar.
In addition to the increase in private sector debt, mergers and acquisition played a minor role in the current financial situation- primarily the auto industry. Although the two terms are normally used interchangeably, there is a key difference between the two actions. Acquisitions occur when a company outright buys another, effecting ending the acquired company’s independent existence. It becomes a part of the larger organization (such as when J.P. Morgan acquired Banc One Corp in 2004). The new entity is simply larger, with the same name, and management. A merger takes place when two companies agree to proceed as a single organization, such as Glaxo Wellcome Plc. and SmithKline Beecham Plc. yielding GlaxoSmithKline in 2000. Another example is the creation of Daimler-Chrysler in 1999 (following Daimler-Benz’s takeover of Chrysler).
The 1999 merger of Daimler-Benz and Chrysler led to a restructuring of the worldwide auto industry by bridging the gap between one of the largest car manufacturers in the U.S. and Europe. The combined value after the merger was $130 Billion, and opened up new markets for the respective brands. Chrysler’s sales were relatively flat, but the company hoped to expand into European markets, and Daimler-Benz saw nothing but potential profit from the American market it had just gained access to. The problem which became clear in the mid 2000s was that the company had essentially become too big to fail, and when its sales tanked (and when Benz was unable to improve upon Chrysler models to gain U.S. market share), Daimler sold Chrysler for a massive loss, and company filed for Chapter 11 Bankruptcy in 2009. This fragmenting of the auto industry proves that globalization provided manufacturers with a false sense of security. While globalization served the greater good through the 80s and 90s, here was some of the first major evidence that it may have been detrimental to the global economy.
Article 3 will cover the events which unfolded during the peak of the recession (i.e. bank closures and bankruptcies).
