The ripple effect has been used very effectively to rally support for the banking bail-out in the US. The argument goes as follows, “bail-out the banks now otherwise the financial sector, the very heart of capitalism, will fail and doom will befall all that walk the earth!”. This argument is entirely false and here is why.
Bank lending has boomed over the last two decades fuelled by ever increasing house prices. Banks were falling over each other to write mortgage business and lend to the consumer via credit cards and other short-term loan instruments. There were very low defaults as times were good and house prices were rising. Profits were high and there was a ready after-market for these loans that were packaged together and sold to bond investors greedy for the returns that they promised.
Now, with house prices having reached such extraordinary heights, there are no more suckers out there who want to buy a home at these prices. Demand for mortgages fell off a cliff as house prices turned. This is the end of the game. Even if leending was available, the demand isn’t there.
The banking sector grew massively over the last two decades as new banks sprung up and existing banks expanded their balance sheets. All were chasing the significant profits and return on equity available in the financial sector.
What we are seeing now is a sector that was artificially supported by ever rising house prices suddenly see things turn the other way. It is only natural that such a strong lobby group looks for help. What however are the consequences for the financial sector and the wider economy of no bail-out?
The demand for lending has flallne away with the falls in the housing market. There are too many banks chasing too few chairs when the music stops. It is a good thing that we have some failing and others consolidating.
The impact on the wider economy of a reduction in the balance sheets of the financial sector is minimal because the demand for loans has fallen. This recession is not caused by the credit crunch but by households over extending themselves and buying property at inflated prices – a typical credit driven boom. How many of these have to happen before people understand that they are fragile?
Demand for loans has fallen, households are focused on cutting spending and we are going in to a recession – no $700bn of distressed asset purchases is going to stop that.