Mr Credit Card from www.askmrcreditcard.com is writing a guest post today for us. Today, he is going to write about how easy credit is destroying America. Mr Credit reviews lots of credit cards and there are lots of credit card offers on his site. If you are in the market for a credit card, he has also compiled a list of the best credit card offers and deals.
The after effects of the 2008 financial crisis that originated from the sub prime crisis still lingers on for many folks in the US. Lots of finger pointing and lots of blame to pass around. But at the root of the crisis, one variable stands out – and that is the amount of debt and leverage in our economy. This applies to both the federal government and individuals. At the root of the problem is easy monetary policy and our tax policies towards debt and I’ll go on to explain other factors that made us such a debt dependent country.
Policies that reward debt
In the US, taxation policies are geared towards taking on debt, taxing equity and not taxing consumption. If we think about things logically, one should not be taxing capital but instead be taxing consumption. But here is the US, it is really lopsided. Capital is taxed. So if you have a capital tax gain, you pay a capital gain tax. If you receive dividends, you pay a tax! The interest that you make on your bank’s savings account is taxed! If you own a “C Corporation”, you are taxed twice! First at a corporate level, and then at an individual level! Talk about work incentives!
But the US taxation policy towards debt is totally reversed! You actually get tax deductions for interest payment on debt! On an individual level, your mortgage interest is tax deductible!
The result of these policies is an incentive to take on excessive debt. In the area of economic studies the Miller Modigliani theory states that there is an optimal cost of capital in a tax neutral world. A corporation having 100% equity in their capital structure can lower its cost of capital (up to a point) by taking on some debt. In the world of taxation where equity is taxed and debt interest is given deductions, it skews US corporations to have more debt than necessary.
Generous Tax Policies on Mortgage and Home
In the United States, policies are geared towards encouraging home ownership. Interest payments on mortgage interest is a tax deductible item. There is also no capital gains taxes on the first $500,000 for your primary residence. Most major developed nations have no such policies that reward home owners. Yet, they have similar home ownership as the United States.
Creation of Fannie Mae and Freddie Mac
Fannie Mae and Freddie Mac were created to buy home loans from banks who underwrote mortgages. Banks underwrite mortgages within certain guidelines and standards and sell them to Fannie and Freddie who then sell bonds to investors. The United States has the largest mortgage market in the bond market. No other country even has a mortgage market to trade (well, Europe has one but is small and mainly bonds from Germany and France). Hence, by being able to offset their risk to investors, mortgage rates remained artificially low. Not only that, because mortgages were traded by Wall Street and bought by investors, home owners were able to get a fixed rate on their mortgages. In many countries, there is no such thing as fixed rates on mortgages. It’s all floating rate pegged to a key interest rate because banks in other countries do not off load their mortgages in the form of bonds to other investors (who manage the prepayment risk).
US Dollar As The World’s Global Currency Becomes A Curse
I have explained this issue in another guest post here. But here is a brief recap. Because the US dollar is the world’s global currency in trade and commerce, countries who export more than they import have savings and these savings are in US Dollars. Those dollars have to be invested and they are typically invested in US treasury bills. That is the reason why we are able to have low rates even if we are constantly running a budget deficit and have tons of debt.
Move away from the Gold Standard
In the early 70s, Nixon moved the US (and de facto the world) away from the Gold standard because of the run on gold in Fort Knox. This meant that whenever, our economy faced a recession, we simply lowered interest rates and printed money. Our Federal Reserve Bank has a policy of maintaining a low rate of inflation (not no inflation, but slow inflation). That essentially means that over the course of decades, our currency weakens and prices go up tremendously.
Effects of these Easy Monetary Policies and Favorable Debt Policies
The effects of all of the above and easy monetary policy has resulted in an America that has too much debt and is too leveraged.
Corporations have too much debt – Yes, US corporations have too much debt. There are very few companies who are rated Triple A by the rating agencies anymore. That is because the tax deductions on interest payment means companies will achieve a lower cost of capital if they incur more debt. At one extreme are cash rich software companies like Microsoft and Oracle who do not need debt and generate massive cash flows. At the other end are deadbeats like General Motors who require constant debt financing just to survive!
Individuals have too much personal debt – Financial innovation and easy access to things like Home Equity Line of Credit made Americans borrow against their home equity for things like vacation, kitchen renovations! A home equity line of credit is almost unheard of in most countries. In most other places, if you need to renovate your kitchen, you pay cash for it. Here in the US, taking a home equity line of credit seems to be the solution.
Or they would simply carry credit card debt! Card holders made sure they got low interest credit cards. And when the interest payment got too high, they would do a credit card balance transfer and transfer their balances to a 0% balance transfer offer. As far as I know, these types of offers are seldom seem anywhere else in the world!
There is a market for sub prime sector – The term sub prime is only commonly used here in the US. In most other countries, if you do not have good credit, the only market you can go to is the loan shark market, which charged ridiculous rates like over 20% (it also appears that credit card companies now are doing the same thing – should we call them loan sharks?).
An example of this would be the presence of store credit cards. For example, if you went to Home Depot, the cashier might ask you to apply for a home depot credit card. People here use them to “finance” their purchases. Furniture stores offer 0% financing for even up to 24 months! Unreal! The big problem here really is that people should not even be financing things like “furniture” or a “washing machine”! So still folks do that here.
All this has created is a society and economy where when credit dries up, businesses will be failing left, right and center. And this is exactly what is happening now.
Yet we are telling the world to follow us!
The biggest irony of it all is that the US is telling the world to follow us! We tell China to have more “safety net” (ie become more socialistic!) and tell them to get their consumers to spend more and save less! All against the advice of sound personal finance! If it were me, I would tell China to not listen to us, continue to save more than you spend (ie export more than import), and have emergency funds (ie foreign exchange reserves unlike the US).
So I will end by saying that in terms of finance, do not follow what the US is doing. We are over spending and not saving enough, and that will have potentially serious consequences. We depend on China for financing our debt and “social programs”. When pf bloggers get into debt, you will often see them setting up debt reduction plans. I have not heard any US politician utter anything about debt reduction at all! The future is either a massive devaluation of our currency and/or massively higher taxes to fund our liabilities. I’m not too sure which is the lesser of the two evils?