What Can You Do To Help Solve The Credit Crisis?

Much has been said about the $700 billion bailout. Our financial news is filled with complex terms like “credit default swaps” and “collateralized debt obligations.” Instead of overwhelming you with financial terminology and fear, this blog post is designed to help you figure out what you can do with your money to help solve the credit crisis…yourself.

This is a long post, but I urge you to take the time to read it if you want to know how you can help stop the credit crisis.

Henry Hazlitt Explains The Bailout

Perhaps the most succinct and understandable explanation of the bailout plan is highlighted by Henry Hazlitt in his book Economics in One Lesson. Chapter 14 of his book is called “Saving the X Industry,” and explains an example of a government bailout. It begins as follows:

“The lobbies of Congress are crowded with representatives of the X industry. The X industry is sick. The X industry is dying. It must be saved. It can be saved only by a tariff, by higher prices, or by a subsidy. If it is allowed to die, workers will be thrown on the streets. Their landlords, grocers, butchers, clothing stores and local motion picture theaters will lose business, and depression will spread in ever-widening circles.

But if the X industry, by the prompt action of Congress, is saved–ah then! it will buy equipment from other industries; more men will be employed; they will give more business to the butchers, bakers, and neon-light makers, and then it is prosperity that will spread in ever-widening circles.”

The Argument For The Bailout

Hazlitt goes on to point out:

“We are concerned only with a single argument for saving the X industry–that if it is allowed to shrink in size or perish through the forces of free competition…it will pull down the general economy with it, and that if it is artificially kept alive it will help everybody else.”

This should be easily seen as the argument of those who are in favor of the bailout. In fact, George W. Bush was recently quoted as saying, “With this strong and decisive legislation, we will help restart the flow of credit so American families can meet their daily needs and American businesses can make purchases, ship goods and meet their payrolls. I’m confident that this rescue plan, along with other measures taken by the Treasury Department and the Federal Reserve, will begin to restore strength and stability to America’s financial system and overall economy.”

You might be surprised, then, to know that Henry Hazlitt wrote Economics in One Lesson, not recently, but in 1946.

When Hazlitt was writing this book, a similar proposal was making its rounds in the U.S. government, called “save silver.” The bill was passed…and here’s what happened:

“The United States Treasury was compelled to acquire, at ridiculous prices for above the market level, hoards of unnecessary silver, and store it in vaults.”

Quite like our modern-day equivalent of acquiring worthless mortgages…

What Happens If The Bailout Passes?

Don’t let today’s “no” vote on the bailout mislead you; this isn’t over yet.

As Hazlitt points out, the money must come from somewhere: “The taxpayers must lose precisely as much as the people in X industry gained.” $700 billion is a little over $2000 for every taxpayer in the U.S. That $2000 must come out of your pocket at some point. That is $2000 less than you had before, to spend, save, or invest.

Hazlitt continues: “It is equally clear that, as a consequence, other industries must lose what the X industry gains.” Many of those new taxes, which will be paid by businesses, will mean that those businesses no longer have working capital to invest in new equipment, salaries, or processes. Billions of dollars that could otherwise be used in productive, profitable industries will now be forcibly taken by our government and handed to an industry that cannot survive in its current incarnation.

If you think that jobs will be lost if businesses cannot get the credit they need from the banks, and thus, that this bailout is needed…I assure you that it is guaranteed that jobs will be lost and our economy will falter if this bailout passes, since ultimately it is every one of us who will pay the cost in higher taxes.

What Happens If The Bailout Doesn’t Pass?

This is where it gets more interesting.

Let’s take a step back. Representatives of our government are saying that banks will not be able to lend if they do not have the capital to lend, and that this $700 billion will help them be able to lend again.

Banks make money by taking deposits and then lending the money that has been deposited out to businesses and consumers so they can buy new equipment, such as houses, cars, and machinery.

The Federal Reserve dropped interest rates to a low of 1% in 2003 to try to stimulate the economy. This had the effect of lowering the cost to borrow. It also had the secondary effect of making money in a savings account nearly worthless, since many savings accounts were not even beating inflation.

What did this do? It caused a massive wealth transfer from deposit accounts (such as savings accounts and CDs) to tangible assets such as land, houses, and even art and wine. Many of us shrugged and stopped saving. What was the point? Our money wouldn’t even be worth as much next year as it was this year. But houses, collectibles, gold and silver would. In particular, this caused a massive housing bubble, as housing was one market that was considered nearly infallible.

Banks rode the wave. After all, they were making plenty of money giving everyone mortgages. The homeownership rate hit a historic high of 69% in the mid-2000s, up from 64.2% in 1990 and 55% in 1950. All of those people buying homes (and refinancing since rates were at a lifetime historic low) kept the money rolling into banks. Deposits were dwindling, but the banks didn’t care, since there was more money to be made by selling those same people mortgages.

Ultimately, in 2007, when many of those mortgages went bad, banks had to shore up their loss reserves, and turned to their depositors. The seeping away of bank deposits had gone largely unnoticed. But now banks needed those depositors’ money! That’s why, in 2007, many banks started offering high deposit and CD rates (sometimes as much as 5.75%) to lock in money and shore up their accounts.

The FDIC stepped in when certain banks had so many losses that they could no longer meet minimum Federal requirements for loss reserves. The FDIC helped arrange the sale of several banks, including Washington Mutual, to institutions that desperately wanted to buy depositors (like Chase.)

Banks became afraid to lend to each other since they didn’t know how many unrecognized losses they had in their mortgage portfolios. In the absence of more depositors, the Federal Reserve stepped in and lent short-term money to banks to ensure they would have money to then lend out to businesses and consumers.

How YOU Can Help Resolve The Credit Crisis

I want to give you an example of how we can work our way out of this mess ourselves.

Scenario 1: Hypothetical consumer Ann, in 2006, takes out a $30,000 loan from her local bank in order to make home improvements, such as buying a new roof and installing central air conditioning. Ann agrees to repay the loan over 10 years, giving her a (approximately) $320/month obligation for the next 10 years. The bank now has an additional $30,000 liability, and must carry more deposits to meet loan loss reserve requirements.

Scenario 2: Hypothetical consumer Bev, in 2009, decides her house needs a new roof, and heads to her local bank. Because the value of her house has gone down since she purchased it in 2004, she is denied the loan. Bev decides to take a different track. Instead of applying for a loan, she decides to save $500 a month in a high-yield savings account. Her new roof won’t go on for a few years, but her bank now has thousands of dollars to lend out to another business. At some point (perhaps in 4-5 years), banks reach an equilibrium and loosen lending standards.

Remember, banks make money by lending out their deposits. They may take fewer credit risks than they did in the past few years, but if they have the deposits, they will lend. The problem right now is that we’re stuck in a strange zone where banks have few, if any, deposits, and a lot of bad lending debt.

What About Complicated Financial Instruments such as Derivatives?

I am not arguing that credit default swaps and derivatives aren’t part of the problem. Certainly, a lot of investment banks adopted a “can’t lose” attitude in the past few years, and conjured up overcomplicated financial instruments to pass a debt burden to other companies.

But I also think that in order for us to feel we have control over the situation, we must look at what we can all do differently. Most of us did not save anything over the past few years. We are in debt up to our eyeballs. Is it really going to hurt us that badly if we have to save a few extra years for a new TV or a new appliance? Yes, that means that appliance won’t get purchased right away, but it will still be purchased.

Some of us will lose houses that we couldn’t afford to begin with. But then we will rent, for less money, and have extra money every month to save, invest, or spend. If hypothetical consumer Cara goes into foreclosure on a $2000/month mortgage payment and decides to rent an equivalent house for $1400/month, don’t forget that Cara now has an additional $600/month. If Cara decides to put that money in a safe investment such as a high-yield savings account or a CD, that bank can then lend Cara’s money to another business or consumer. And if Cara decides to spend it, that means more money for many businesses who will benefit from her spending.

We can solve this credit crisis on our own. No one forced us to buy a house or take out loans. We created this crisis by going into debt and ignoring our savings, and we can fix it by starting to save again and by speaking out against insane amounts of debt.

Yes, I acknowledge that that means there will be pain for many of us over the next few years. But ultimately, I believe that a more sound financial system can be built from the ground up out of this crisis — one where we buy what we can afford, and learn to love what we have instead of seeking to constantly acquire more.

Let’s solve this crisis ourselves. Take action! Please Digg this post or recommend it on StumbleUpon. It will only take a few seconds, and it will help others realize that we hold the solution to this problem.

Recommended Reading:

• Economics in One Lesson. Henry Hazlitt explains many common myths about economics. A must-read if you want to know more about governments and bailouts.
• How To Start A Business With No Money. Starting a business doesn’t have to mean a huge capital outlay. Here’s how you can start a business even if you don’t have money to work with.
• Three Business Ideas That Will Help You Thrive During A Recession. Three specific businesses that will do well during a time of cutbacks and belt-tightening.