Politics D11

Page D11

Politics The Town Voice Balanced

Credit Crisis in Review

By Arlon Staywell RICHMOND — Just as recent health care reform indicates many people fail to grasp the math and science of health care, the problems with the credit crisis indicate many people fail to grasp the math and science of economics. There does apppear some effort to explain the change of party in the White House from Republican to Democrat as arising from economic troubles rather than the military in 1992 and 2008. But there is more to it than that at this point, therefore a brief primer is in order.
Interest rates and risk
Many complaints about the practices of financial institutions lately focus on the high risks taken. But there is a relationship between risk and interest rates. Higher risks justify higher interest rates. If some of the loans go into default the lender still has an average return similar to less risky lenders. Many people have long been aware that being a low risk can mean a lower interest rate. What many fail to understand lately is that the higher rates aren't really fair unless some loans go into default. It doesn't make sense to complain about risks when higher interest rates presume some loans will go into default. Of course how much risk should be associated with what interset is always a reasonable question, but higher rates usually presume some default. Highly aggressive attempts to collect every penny on high interest loans are therefore not justified.
Economic growth and the money supply
A good question throughout the ages has been what interest rate should be associated with no risk at all, zero percent? Well studied interpretations of the Bible suggest that an absence of all interest or "usury" is possible. What can change those equations in some cases is economic growth.
There is no more clear example of what economic growth can do to an economy than the United States which grew from 13 rural states to 50 highly industrialised ones. What became clear is that there needs to be a supply of money commensurate with the size of the economy. Without the strains the massive growth of the United States put on the meager supply of gold and silver there would likely never have been the conversion to fiat money here. But it is now widely accepted when growth in the economy occurs a growth in the supply of money might be required to sustain it.
Blue sky laws and paper
However simple the term "money supply" appears it is quite the complicated thing. And whatever problem might occur with a money supply too small there are serious problems that can occur with a money supply too large. Older than the United States is the problem of papers passing as money. In theory and actual practice the excessive creation and trading of various papers like stocks, bonds, IOUs, loan agreements, and other various promissory notes can seriously diminish the confidence in the value of any paper money. Because money is supposed to represent goods or services there has to be some point at which goods or services can be collected for it. That might never happen if every piece of paper is answered by another piece of paper. That is the problem known well as inflation. Therefore blue sky laws were written to regulate all those papers.
One problem can solve another
It doesn't happen often, but it can happen. Consider the two problems, massive economic growth and paper creation. One strains the economy by making the money supply too small and the other too large. Can some balance be achieved? That it might be balanced is the heart of existing banking regulation in the United States and around the world. And the fundamental idea of a "stock" is that its value is tied quite directly to the economic growth.
Here appears the answer to the previous question about what interest rate should be associated with no risk at all. It is found that a "good" interest rate, one that maintains economic stability, avoids inflation and deflation, is the same as the percentage of "economic growth." That is generally speaking and of course a multitude of factors could mean rates above or even below that. Already noted here was the factor risk adds. Simple and beautiful though that solution might seem, it is in reality quite difficult and complicated. Economic growth, though clearly evident in United States' history, is not readily measured. And there are many unsettled issues such as whether things that don't grow should ever cost more. For example, is it right to pay much more for a loaf of bread that is just like, at their respective times of purchase anyway, the loaf of bread made fifty years ago?
Natural growth
Many students of economics use an annual "natural growth rate" of about 3.5 to 3.8 percent in their math problems. The evidence suggests that on the whole that number seems to work out well. And people who follow economics often interpret troubles as arising from actual or percieved deviations from about that rate. Remember please that highly refined measurements are not possible and there can be much argument. And there can be significant variations in real growth in various years.
Problem today
But the dominant argument today causing the most trouble for politicians and various financial institutions and regulators concerns the relationship between interest rates and risk and what needs to be done about loans in default. If the natural growth rate of the economy is about 3.8 percent why pay 9 percent on a mortgage or 29 percent on credit card debt? Of the many factors, and there are quite many, that determine those rates the most important is the higher risk. Things bought with credit cards cannot be resold at all or if at all not for the same recovery percentage as houses. And those rates are for more risky borroweres.
The reasonable search for justifiable interest rates will ever continue, but that must include the understanding that at some point higher interest rates presume defaults. And the operative term for the day is "presume."
Unless a very strong majority grasps these concepts democracy cannot work. Not all sales mean real growth, they can mean too much paper.

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