The Big (Stupid) Idea: Universal Personal Bankruptcy to Save America's Economy

by Gary North

Recently by Gary North: Mass Inflation, Yes; Hyperinflation, No

I have just read the most monumentally stupid article in the history of financial journalism. Nothing else I have ever read comes anywhere near it. It is not just stupid. It is magnificently stupid. It is something so incomparably stupid that Paul Krugman could only dream of writing something like it.

It was written by Brett Arends.

I have gone after Mr. Arends before. But I never dreamed that he could write anything as bad as this. I never dreamed that anyone could.

Here is the headline: Massive default is best way to fix the economy. Then there is the subhead: Clearing away the debt is the only way forward

What debt is he talking about? All mortgage debt. Also, a few trillion in consumer debt.

Not the government's debt? Oh, no. Not that. That was never mentioned. Just private consumer debt. All of it.

You want to fix this economic crisis? You want to put people back to work? You want to light a fire under the economy?

There's a way to do it. Fast. And relatively simple.

But you're not going to like it. You're not going to like it at all.

Default. A national Chapter 11 bankruptcy.

He's right. I do not like it. Let me tell you why. This may take time. Stick with me. You are about to go down the rabbit hole. You are about to go through the looking glass. You are about to enter the Twilight Zone.

The fastest way to fix this mess is to see tens of millions of homeowners default on their mortgages and other debts, and millions more file for bankruptcy.

Isn't that up to the home owners? Haven't they resisted doing this? Isn't this why the scenario he wants has not taken place? In other words, aren't the decisions of individual families opposed to what Mr. Arends proposes? And if they are, why does he think he is wiser than the individual debtors?

F. A. Hayek had a phrase for this collectivist arrogance: the fatal conceit.

He is implicitly arguing that there is something wrong with the free market. The fastest way out of the supposed debt crisis is for a mass default. But the free market is not producing this result: clogged courts, wiped-out credit ratings of ex-home owners, and houses at 50% of today's prices. He never mentions these results. He never utters the free market's key phrase: "At what price?"

I told you that you wouldn't like it.

I don't like it much either. It sticks in the craw that people got to borrow all that money and won't have to pay it back.

But you know what? The time to stop that was five or 10 years ago, when the money was being lent.

It's gone.

The money for everything we own is long gone. Once we buy it, the money is gone. So what? The asset still has some value.

In a mortgage loan, the collateral is not gone. The house has some value. In any case, the home owner's credit rating is not gone. This is a crucial form of capital. If he defaults, it will be gone.

It is obvious what Mr. Arends is really after: universal default, leaving every defaulter's credit rating equal to the others. There is supposedly safety in numbers.

I will tell you something else there would be: tens of millions of new renters with poor credit ratings. How soon would they get back into home ownership?

And mass Chapter 11 is, by far, the least obnoxious solution to our problems.

That's because the real cause of our economic slump isn't too much government or too little government. It isn't red tape, high taxes, low taxes, the growing divide between the rich and the poor, too much government debt, too little government debt, corporations, poor people, "greed," "socialism," China, Greece, or the legalization of gay marriage. It isn't, in short, any of the things all the various nitwits say it is.

NITWIT

When it comes to economic nitwits, no one matches Brett Arends. Let me prove this to you.

It's the debt, stupid.

Let us not miss the main point. It is the point Mr. Arends has missed. "It's the credit, stupid." (1) The creditors are wiped out if the home owners get to keep the houses, or (2) the home owners' credit ratings are wiped out if they declare bankruptcy and are evicted. Take your pick. Mr. Arends never says which scenario he is describing.

Clarity is not his long suit. Neither is economic logic.

We're hocked up to the eyeballs, and then some. We're at the bottom of a lake of debt, lashed to an anchor. American households today owe $13.3 trillion. That has quadrupled in a generation. It has doubled just in the last 11 years. We owe more than any other nation, ever. And for all the yakking about how people are "repairing their balance sheets," they're not. From the peak, four years ago, they've cut their debts by a grand total of 4%.

It is time for you to see the statistics that Mr. Arends has obviously never seen. These are published by the Federal Reserve System. The FED traces household debt repayment as a percentage of disposable income. What we find is that the percentage of monthly debt repayment does not fall below 15% or go above 19%. It is down to about 16.4% for home owners. You can see the figures back to 1980 here. In short, there is no household debt crisis. Mr. Arends is trying to deal with a crisis that does not exist.

More than a quarter of American mortgages are underwater. Many are deeply underwater. In states like Nevada and Florida the figures are astronomical.

This is true. But at least one third of houses are owned free and clear. Of the 66% that aren't, one quarter are underwater. That means that 75% aren't – 75% of 66% of the houses.

The key thing to understand is that most of that money has gone to what a fund manager friend of mine calls "money heaven."

Then on what basis do the lenders – mainly the Federal Reserve System and investment funds – keep these "money heaven" loans on their books at face value? This is fraud on a massive basis. We are not facing a crisis of national consumer debt. We are in the middle of a fraudulent banking system crisis. Mr. Arends does not mention this crisis. He thinks that universal bankruptcy will provide a comparatively cost-free solution to a non-existent personal debt crisis. It would instead collapse the credit markets.

Most of these debts will never, ever be repaid in real money. Not gonna happen.

Who is to say? I know! How about the borrowers? Shouldn't they say? Shouldn't they have the legal right to say? Aren't they saying, loud and clear, by not defaulting? Why would anyone think that he has a better idea, unless he is suffering from the fatal conceit?

Think how corporations handle this kind of situation.

Yes. Let's.

It happens all the time.

On the contrary, it rarely happens. This is why there is still a capital market for debt. If it happened all the time, we would be living in the stone age.

Banks and bondholders find they have lent, say, $1 billion to a company whose assets and earning capacity will only repay, say, $300 million. What happens? Does the company soldier on with $1 billion in debt it can never repay? Do the stockholders send back their dividend checks? Do they sell their homes to pay off the bonds?

Not a chance. The company goes through Chapter 11. The creditors 'fess up to their blunder, they face up to their losses, and they fix it. They write down the loans and take the equity instead. The balance sheet is cleaned up, and the company starts again.

The company can start over again only because there is still a capital market. To move from the individual case to mass overnight national bankruptcy is a fatal conceit. If all the creditors get stiffed, they will not lend again at low rates . . . not to American private borrowers, anyway. But he ignores this.

Why not homeowners?

Most of the objections to this idea are well-meant, but misinformed.

It is Mr. Arends who is misinformed – misinformed on a scale that makes all other financial commentators look like Warren Buffett.

A fund manager I asked raised the issue of "moral hazard." Why should anyone pay their mortgage if some people were getting a pass, he asked?

The answer: For the same reason GE and Verizon kept paying the coupon on their bonds while Lehman Brothers defaulted. You want to keep your credit standing. And you want to keep your equity.

Lehman Brothers defaulted, but if every other bank had defaulted, there would have been a catastrophe. Lehman defaulted all by its lonely, over-leveraged self.

If a company defaults, the stockholders get wiped out. If a homeowner defaults, the bank takes the home. I like keeping my home, as well as my savings, and my credit rating. Most people are the same.

But what if they all defaulted at once, even when they did not have to, as Mr. Arends advises home owners to do? Then there would be a collapse of the American economy on a scale never before seen. Or, alternatively, there would be inflation by the Federal Reserve on a scale never before seen.

Some will say the financial impact would be terrible. But the banks would just be facing up to reality. And a lot of these mortgages are already trading at distressed levels.

Reality is that 75% of home owners with mortgages are not underwater, and of those few who are, the vast majority are paying off their mortgages.

Some will say, "why should people get away with borrowing imprudently?" The response: Why should the banks get away with lending imprudently?

Answer: because the blithering idiots who ran Fannie Mae and Freddie Mac put the U.S. government's guarantee on the loans. The government let them get away with this. The banks handed off the mortgages to the idiotic packagers, who sold to them to the trusting investors.

It's not the banks, stupid. It's the Federal government, which implicitly underwrote the entire stinking housing mess, and then nationalized the mortgage market exactly three years ago.

There's no point telling people not to borrow money. They always will. I have yet to see a Wall Street executive turn down free money. I have yet to see a company in an IPO say, "Don't give us so much money!" People like money. They will take as much as they are offered.

This man thinks that lots of loan money will be offered to newly bankrupt borrowers by shell-shocked creditors after a $13 trillion default.

There is only one way that such a widespread, overnight default could take place: by U. S. government decree.

In a free economy, the people who are supposed to ration the loans are the lenders. Banks are supposed to lend carefully and responsibly. What else are they paid for? Accepting deposits? You could hire people on minimum wage to do that.

Once again, the bankers did not do this. Sophisticated investors did, after the credit-ratings agencies gave subprime loans a AAA rating. Fannie Mae and Freddie Mac put together the rotten investments. Banks merely brokered the packages.

Fact: there will be few loans after the national Chapter 11 – not to the U.S. private sector, anyway. This is my main point. The loans will then go to the U.S. government, which Mr. Arends exempts from the Chapter 11 cure-all. He never mentions the Federal government's debt.

Some will say, "it's immoral" for borrowers to default. Alas, most of these people are being inconsistent. They are usually the first ones to defend a company when it closes down a factory and ships the jobs to China, or pays the CEO $50 million for doing a bad job, on the grounds that "this ain't morality, pal, this is business!"

No, it's not business. It's a massive transfer of wealth. (1) The creditors get the property of the defaulted borrowers. They get the houses, the assets, everything. That is why home owners keep paying their debts. They do not want this transfer. Or (2) the creditors get nothing. This would be contract violation on an historic scale.

But when Main Street wants to do the same thing, they start screaming "Morality! Morality!"

We don't live in an economy based on morals and fairness.

National Chapter 11 for all mortgages could be done fast only if the U.S. government passed legislation allowing it. This would be the largest transfer of wealth in American history. If anyone claiming to be in need of deliverance is delivered, 100%, then there would be no more mortgages and no more consumer debt.

There would also be no more capital markets.

T Mobile doesn't charge me what's "fair" each month. They charge me what's on the contract.

CONTRACT

At long last, he gets to the key word: contract.

His T-mobile contract is renewable each month. If Mr. Arends stops paying, he will be "evicted" by T-Mobile.

He is calling for one of two outcomes:

1. The transfer of all mortgaged houses to the creditors
2. The 100% expropriation of the creditors

He thinks one of these would cure the American economy of its woes. He never says which one.

Your employer doesn't pay you more if you need more. He pays you your economic value. Did Dick Grasso give back his bonus? Bob Nardelli? Dick Fuld? We operate in an economy based very firmly on contracts, and nothing else. Companies, and the wealthy, live by the letter of the law.

Exactly! And Mr. Arends is calling for the greatest single violation of contract in American history – a true social revolution.

American mortgage contracts allow for default. Half of the states in this country are "non-recourse," which broadly speaking means you can send in the keys and walk away from a bad loan. The other half are sort of "semi-recourse." The bank can come after you for any shortfall, but only in a limited way. Broadly speaking they can't touch retirement accounts and basic assets. You can typically keep your car, personal effects, often things like life insurance.

Most of the people who are deeply underwater don't have that much anyway.

It's tempting to say, "if someone borrows money, they should repay it." Generally speaking, I agree. I pay all my debts. But while that makes sense when applied to any individual, it doesn't work so well when it's applied to everyone.

THE PARADOX OF THRIFT

Here it is: Keynesianism's bait and switch. Usually, it is applied to thrift. It is called the paradox of thrift. If everyone saved more, we are told, it would cripple the economy. But the point of the free market is that individuals decide. They do not make the same decisions at the same time.

When most home owners are paying their mortgages, then any theory of the benefits of universal default leads to a highly destructive scenario. It is hypothetical: "cures the economy fast, fast, fast." But it cures it in a way that destroys the law of contracts and therefore the predictability of long-term capital.

We have tens of millions who cannot repay their debts. But they are all trying to. That sucks huge amounts of money out of the economy. And that means these people cannot function properly as consumers or workers. That's the reason people aren't coming into your restaurant. It's the reason people aren't taking your yoga class. It's the reason they haven't hired you to redo the kitchen.

This is a reworked version of the paradox of thrift. It is nutty, just like the paradox of thrift is.

I owe you $100. I pay you back at $5 a month. You spend the money: investing it or buying consumer goods. Arends says that my paying you your $5 "sucks . . . money out of the economy." Sorry, but Mr. Arends is not making any economic sense. That is because he has bought into the Keynesian grab-bag of errors. Debt repayment does not suck money out of the economy.

And so tens or hundreds of millions of perfectly responsible business owners and employees are also suffering from this slump. That's the reason we have a shortage of demand. That's the reason no one is hiring.

THE BROKEN WINDOW

In Bastiat's 1850 metaphor of the broken window, breaking a window provides jobs and economic growth. This is Mr. Arends' update of Bastiat's metaphor. He argues that paying off your contract for the replaced window hurts the economy.

Is this nuts? It surely is.

Even worse: People who are underwater on their mortgage, but who do not want to default, cannot move to where the jobs are either. They are stuck with their home.

I see. They do not want to default. Imagine that! But Mr. Arends thinks they are silly not to default. He is proposing universal default. He thinks it will help the economy.

Think through what it would do to the market value of Freddie Mac and Fannie Mae bonds. Oh, my. The FED holds over a trillion dollars worth of these bonds. Oh, my, oh, my.

You want to break this logjam? Try Chapter 11 for the nation. Massive defaults. Clear the decks, clean the books.

Mr. Arends forgets what happens to anyone navigating on a river when he is located downstream from a logjam. This is where the nation's creditors are located.

What are the alternatives?

Government cutbacks, higher taxes, and a balanced budget? In a normal economy, fine. But in this situation, when the private sector is also slashing its spending, that could lead to absolute catastrophe. That's what happened in the Great Depression. And our debt levels are worse than in the Great Depression.

Here it is again: the Keynesian paradox of thrift. Under his scenario, the economy will surely get less thrift. When the creditors are stiffed in one huge default, there will be lots less thrift. What little there is will go to the Federal government or foreign markets.

Government borrowing? That's the Keynesian solution. "The consumer can no longer borrow like a crazy person," says the Keynesian, "so Uncle Sam has to do so instead." It's just transferring private madness to public madness.

Having adopted pure Keynesianism, he now warns against Keynesianism.

Inflation? That's probably the least bad alternative. But it's just default by another name. And instead of taking money from the imprudent banks that caused the problem, it robs grandma's savings.

So, the next best alternative to universal mortgage and consumer debt default is . . . universal currency default.

I would hate to think of his even less desirable alternatives. Maybe World War III.

Twice before, advanced economies have gone through what we are going through now – namely a massive hangover after a massive debt binge.

The first was the U.S. in the 1930s, the second was Japan in the 1990s.

The U.S. didn't get out of it until the 1940s unleashed inflation and reduced the debt's value in real terms.

Japan still hasn't gotten out of it. They have deflation, while government debt has skyrocketed.

Japan has had no price deflation. This is a standard myth promoted by journalists who have never looked at the data. See for yourself here.

The correct moral hazard is to punish the banks who lent imprudently by making them eat their own losses.

It's not the banks, stupid. It's the Federal government, which now owns Fannie and Freddie.

CONCLUSION

He concludes:

I told you that you wouldn't like it. I don't either. But the alternatives are worse.

So, there you have it. The stupidest article in the history of financial journalism.

He was right. I didn't like it.

September 14, 2011

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

Copyright © 2011 Gary North

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