Undemocratic Credit: Finance (Including Banking) Finance Regains Prudence, at a Price

But there are two fundamental differences between insurance and loans. First, insurers get positive cash flow from the start. They begin to collect money from customers today and keep accumulating it in exchange for a promise of paying a set compensation in the future.

There is a reason why professional options traders prefer to write a put, instead of buying a call. In a speculative transaction, the premium charged on the option becomes an extra cushion. Thus, insurers have a pool of money which they invest and on which they earn a return — which is a reason the insurance business remains profitable despite periodic debacles that require large payouts. Bankers, on the contrary, have to lay out a large sum up-front and then begin to get it back in small installments.

The second difference is that insurable events tend to have a low correlation. A fire in one neighborhood doesn’t cause another house, in a different neighborhood, to burn down the next day. The same is true of life insurance, since deadly epidemics are rare in a modern industrial society.

Not so in the banking sector. Since the democratization of credit spread in the 1980s and 1990s, recessions have tended to be mild in the United States and, more important, employment generally continued to grow after every shallow downturn. If we accept it as given that a capitalist economy is cyclical and that recessions play an important salutary role by punishing those who become overextended, then by keeping the economy from a recession the Federal Reserve merely helped problems accumulate and fester, ensuring there was going to be a severe recession some time down the road.

In a recession, especially when it is accompanied by a sudden and painful rise in unemployment as has been the case in the current slump, credit defaults become a chain reaction. Moreover, financial institutions contribute to rising default rates because they often sell repossessed houses at fire sale prices, further depressing an already soft market.

For many years, life insurers have enjoyed nice returns because mortality declined dramatically — and unexpectedly — whereas life expectancy increased across the board. The premiums charged by life insurance companies over decades have been too high. But if now a severe new epidemic — such as the swine flu — suddenly erupted to claim the lives of tens of thousands of previously healthy individuals, it would not only be a national tragedy but it could ruin many life insurance companies.

This is what happened to bankers in the current economic downturn. They can no longer earn easy profits by providing loans to the mass consumer. While bankers are no longer confident that the average consumer can pay them back, consumers are no longer eager to borrow. On the contrary, they want a spending pause in which they can pay down their existing debt.

At the same time, another key link in this chain, the bond investor, no longer wants to buy bonds backed by consumer loans and mortgages, because their risk parameters are no longer easily defined. And, of course, insurers such as AIG are no longer willing to sell credit default swaps, products that protect investors against default.

For now, at least, the democratization of credit has run its course. The Fed and the Obama administration are calling on banks to return to their old democratic ways. But business is very different from politics. Britain has upheld its democratic system even when facing a continent full of triumphant tyrants across the English Channel.

Today, in banking, democracy doesn’t pay and the banks are returning to more prudent practices of the past. This could mean lower interest rates to creditworthy borrowers and no loans to riskier consumers. However, it could also create a deflationary spiral and sharply slow growth in the U.S. economy.