Tuesday, February 18, 2014

Subprime Nation

(This graph is a modified version of one I posted earlier.  I think it is worth revisiting as I get back to actively blogging after a hiatus.)

Since the financial crisis in 2008, we have known that one of the key reasons for the collapse was that the new breed of subprime mortgages and their derivatives were completely misunderstood and assumed to be as safe as mortgages had historically been.  (There's an old joke about what happens when you assume...)  Rather than treat these new subprime beasts as risky and different, the prevailing assumption was that they would behave just like the old 30 year fixed rate mortgages had, when borrowers had real income, real assets, real down payments, and real equity.  Big mistake.

We may be living a repeat of this kind of error, only this time it has to do with government spending.  Since 2008, Ben Bernanke's Fed and Barack Obama's government have presided over an historical explosion in government spending as a percent of the private sector.  Like subprime mortgages and derivatives back in 2007, we have no historical basis for understanding this kind of explosion in peacetime spending.  Even during the Great Depression nothing like this happened.

Two other times in history reveal large bursts in government spending - WWI and WWII.  The difference is, after both those wars the US enjoyed an unchallenged perch atop the world economy - Europe lay in ruin as did Japan after WWII. China was yet to be a world economic power.  That's not the case now.

Another issue:  What has been achieved by all the spending?  In WWs I and II,  we achieved something of lasting value - survival, peace, victory.  Today we are spending at world war levels and achieving little more than an illusion of prosperity.  The politics make sense if not the economics.  By delaying the effects of runaway spending, politicians are shielded from ever being associated with the borrowing and money creation catastrophes they've created.    

What all this means is that we are in uncharted waters.  Just like subprime mortgages in 2007, the conventional assumption is that there is nothing dangerous about peacetime spending at this level and we will be able to taper or unwind without incident.  I was a skeptic back in 2007 during the subprime boom.  I'm a skeptic now too.

(Note on the graph:  Quantitative Easing is included as government spending in the years it occurred, 2008 - 2013.  That's because it is government spending!)          


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