Far Too Low for Far Too Long

by JW Mason

So, what caused the economic and financial crisis of 2007-whenever? It’s an open question. Presumably we’ll continue to argue about it until the next crisis (or until the Moon Men invade.) But right now let’s talk about one possible story, or really family of stories: that the root cause of the crisis is that interest rates were too low for too long.

This is often taken to be a conservative view; one of its more prominent exponents has been John Taylor, who complained last week in in the Wall Street Journal that

the Fed has returned to its discretionary, unpredictable ways, and the results are not good. Starting in 2003-05, it held interest rates too low for too long and thereby encouraged excessive risk-taking and the housing boom.

Rortybomb’s favorite conservative Fed president Thomas Hoenig made a similar argument when he left the FOMC last year:

We as a nation have consumed more than we produced now for well over a decade. Having very low rates for an extended period of time encourages us to continue focusing on consumption, but to correct our imbalances, we have to focus on production. … If I thought zero rates would bring jobs, I’d want it forever. But it distorts the economy. In 2003, when we lowered rates and kept them there because unemployment was 6.5 percent — look at the consequences.

More broadly, this view is associated with so-called Austrian Business cycle theory, which holds that macroeconomic instability is fundamentally due to departures of the market interest rate from the natural rate. (As Don Patinkin pointed out, this would better be called Swedish business cycle theory, since it really originated with Wicksell but came to London “via Austria.”) In this view, an artificially low interest rate encourages investment in assets whose returns are lower than the true social rate of discount; when interest rates return to their natural level, investment will be depressed until this excess stock of physical capital is worked off.

But it’s not only conservatives who argue this. One hears something similar from the global imbalances crowd – most famously, of course Bernanke’s “global savings glut” hypothesis that excessively high savings in Asian countries drove world interest rates excessively low. (I am deliberately leaving unanswered the question of what “excessively” means here.) You can find a whole host of prominent economists making similar arguments, including Martin FeldsteinObstfeld and Rogoff, and Chinn and Frieden. When flows of capital from Asia to the United States (or from northern to southern Europe) pushed down interest rates in the recipient countries, they argue, it was inevitable that the projects funded as a result would be speculative and ultimately wasteful.

You can even find this type of argument among Keynes scholars, like the brilliant Axel Leijonhufvud:

Operating an interest targeting regime keying on the consumer price index (CPI), the Fed was lured into keeping interest rates far too low for far too long. The result was inflation of asset prices combined with a general deterioration of credit quality. This, of course, does not make a Keynesian story. Rather, it is a variation on the Austrian overinvestment (or malinvestment) theme.

In the current crisis, he adds, “The General Theory is not particularly helpful.” (Heresy!) Well, it is certainly true that Keynes wasn’t writing about a situation where the market interest rate was in some sense too low. Indeed he believed that an excessively high rate of interest explained not only crises in rich countries but what would we would today call the underdevelopment of poor ones: “The history of India at all times has provided an example of a country impoverished by a preference for liquidity amounting to so strong a passion that even an enormous and chronic influx of the precious metals has been insufficient to bring down the rate of interest to a level which was compatible with the growth of real wealth.”

One is loath to argue with Leijonhufvud, a far smarter and deeper thinker about the economy than most of us (me certainly included!) can ever hope to be. And yet I can’t shake a nagging feeling that the “far too low for far too long” story doesn’t quite add up.

The first problem is that the different stories, while agreeing that interest rates were in some sense too low, don’t line up with each other. The blame-the-Fed and blame-the-Chinese arguments, while seemingly similar – and even sometimes made by the same people – are actually in tension, if not outright contradictory. After all, if interest rates are set by the Fed, they are not set by international capital flows, and conversely. More precisely, in a world of floating exchange rates and mobile capital – the world we’re normally supposed to live in – expansionary monetary policy should be associated with lower capital inflows, currency depreciation, and a more favorable trade balance. Any macro textbook will tell you that the high interest rates of the early 1980s (supposedly in part due to high federal deficits) were a big factor in the growth of the US trade deficit. So insofar as global imbalances are the issue, looseness at the Fed looks like part of the solution, not part of the problem. There’s a reason why Brazil has called the ultra-loose Fed policy of recent years a form of “currency war.”

There’s also a tension between the Austrians’ version of “far too low for far too long” and Hoenig’s. In the first, after all, the problem with low interest rates is that they result in investment being too high; for the latter, it’s been too low. Since high interest rates are a cost for businesses undertaking investment projects, it’s not at all clear (to me at least) how Hoenig’s version is supposed to work.

Empirically, there are reasons for doubt too. Here is Ed Glaeser, for instance, suggesting that low interest rates can only account for a quarter of the runup of housing prices in the 2000s. More broadly, it is obvious that there have been many times and places where interest rates have been low for prolonged periods, and only some of them have experienced asset bubbles.

But there’s a deeper set of problems here, which it’s not clear that any of the “far too low for far too long” proponents have really grappled with. It’s an article of faith that the private financial system channels society’s investable funds to their best use. That’s why we have a financial system! So if a big increase in funds available for investment – either due to an inflow of foreign savings, or the creation of liquidity by the banking system abetted by the Federal Reserve – flow to activities that are socially useless or worse, what does that tell us?

It seems to me there are only two possible answers. Either we have already invested in everything worth investing in, or the financial system is not doing its job. I cannot see how higher interest rates are an appropriate response in either case.

Let me spell out the thought.

Many of the global imbalancers combine their proposals for less saving in the Asian countries with calls for higher savings in the US. That sounds very reasonable. But on closer examination, there’s something very odd about it. Because if it was excess saving that caused the crisis, why on earth would we want more of it?

Obstfeld and Rogoff, for instance, argue both that the underlying cause of the crisis was the capital inflows from Asia, and that the best outcome would be for the US government to reduce its borrowing. I’m sorry, but this makes no sense. From a macroeconomic standpoint, a reduction in US government borrowing by $100 billion, and a Chinese purchase of $100 billion in Treasury bonds, are identical. Both leave the US private sector holding $100 billion less of treasuries, and both – if you believe the crowding-out stories that are the whole basis, normally, of supporting balanced government budgets – should increase its appetite for private debt by exactly the same amount. In general, the benefit of a more favorable fiscal balance is supposed to be a greater supply of savings available to the private sector, resulting in lower interest rates and higher investment. But if lower interest rates would only lead to asset bubbles, what is the argument for reducing the fiscal deficit? There is no reason to expect the financial system to be any more successful in channeling the savings made available via lower public deficits into productive investment, than it is supposed to have been in channeling the inflow of foreign savings.

I don’t think you can argue that a “savings glut” or low interest rates caused the crisis, and then go on arguing in other, longer-run contexts that higher public and/or private savings are desirable.

People making the argument that, in modern conditions, very low interest rates can only call forth speculative or wasteful investment, have implicitly accepted Keynes’ view that there is finite limit on the capital society requires, so that returns on private investment will fall toward zero as this limit is approached. But they haven’t followed him to the logical conclusion that in such a savings-abundant world, consumption and public expenditure should rise secularly until private investment disappears entirely.

Of course there’s an alternative view, which is that socially useful investment opportunities are far from exhausted, and savings are still scarce, but that the private financial system is no longer adequate for matching the latter with the former. If we were going to go this route, the first step would be to take seriously the idea that there is no “the interest rate,” there are various interest rates, and various degrees of access to credit, and they often don’t move together. And the relationship between the policy rate controlled by the central bank, and those various market rates, depends on the specific institutional and regulatory context.

Has everyone read Ben Bernanke’s classic article, Inside the Black Box? One of the key points he makes there is that in a world where reserve requirements don’t bind, one of the main channels by which monetary policy affects the real economy is via asset prices. Descriptively, I think that’s clearly right; but it’s a pretty crude instrument for steering aggregate activity, especially when you consider the positive feedback that tends to happen in asset markets. What if it turns out that the interest rate compatible with full employment is systematically lower than the interest rate compatible with stable asset prices? Does that mean we have to accept mass unemployment forever? That would seem to be the implication of “far too low for far too long.”

The alternative, of course, means more active management of credit. It means accepting that if we think government has a responsibility to maintain macroeconomic stability, a single policy instrument will not suffice. It means abandoning the conventional wisdom on macropolicy of the past three decades: Leave it to the central bank. It means that it’s not enough to set “the” interest rate, some policymaker will have to decide on the different interest rates for different kinds of borrowers, just like in the old days of European social democracy. (And just like in the old days, we may find that making this effective requires rather stringent limits on cross border financial flows.)

I don’t say this is true; we can debate whether industrial policy is a necessity or not. But I do say that this, or the even less palatable previous alternative, is a logical consequence of the view that the crisis was caused by excessively low interest rates.

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27 Responses to Far Too Low for Far Too Long

  1. Infrastructure, infrastructure, infrastructure. Interest charges on loans that create new business pathways are fine (the assumption being that the new business pathway creates more efficiency), interest rate charges on loans that simply create the 20th way to do something that is already being down, but not necessarily in a better or more efficient way, reckless.

  2. David Beckworth says:

    JW:

    There are more empirical studies than the Ed Glaeser one you cite. And that study ignores international spillover effects of U.S. monetary policy. For example, here are some studies that show the low interest rates in conjunction with financial sector developments did make an meaningful contribution to the housing boom:

    (1) http://www.bankofengland.co.uk/publications/Documents/workingpapers/wp411.pdf
    (2) http://www.ecb.int/pub/pdf/scpwps/ecbwp1178.pdf
    (3) http://www.economics-ejournal.org/economics/journalarticles/2010-12

    And here is a recent post I did that makes the case for the Fed contributing to the housing boom: http://macromarketmusings.blogspot.com/2012/03/bernanke-student-conversation-you.html

  3. JW Mason says:

    David,

    I didn’t focus on the empirical side because I think it’s more important to think through the larger question of what a link from low interest rates to asset bubbles would imply for the macro significance of savings. If everybody agreed that the implication of low rates producing bubbles is that reducing fiscal deficits is pointless and probably in fact harmful, then I’d say it’s time to start looking seriously at the regressions. But if there is no logically coherent view of what it means for low interest rates to contribute to bubble, then it’s not clear how much effort its worth to establish empirically whether or not they do.

  4. Marko says:

    “Many of the global imbalancers combine their proposals for less saving in the Asian countries with calls for higher savings in the US. That sounds very reasonable. But on closer examination, there’s something very odd about it. Because if it was excess saving that caused the crisis, why on earth would we want more of it?”

    Because the global savers ( Asia ) were underconsuming while the U.S. was overconsuming , i.e. levering up. More savings in the U.S. means the necessary delevering is taking place , less saving in Asia makes up for the deficient global demand that would otherwise result. More savings here , less there. What’s odd about that ?

    Savings rates in advanced economies as a share of global savings declined substantially from 2000 , while savings in Asia increased. The Asian savings were facilitated in no small part by our huge trade deficit . The combined stimulus of two wars , tax cuts , and housing ATMs – all put on the debt tab – should have blown the lid off of U.S. GDP growth , but much of it leaked overseas.

    The best discussion I’ve seen of the “savings glut” and how the particular savings preferences of Asian savers contributed to the de-linking of U.S. long-term rates ( and crucially , mortgage rates ) from the Fed funds rate ( aka Greenspan’s conundrum ) is by Heleen Mees :

    http://www.heleenmees.com/PDF/papers/US_Monetary_Policy.pdf

  5. The savings glut thesis is silly and as you said inconsistent with the blame the Fed theory – moreover it relies on a misguided loanable funds view of money, we had a financing boom followed by a financing bust http://www.macroresilience.com/2011/11/22/debunking-the-savings-glut-thesis/

    Having said that I think the ‘far too low for far too long’ story has some merit – the implications it does have is that we need to get away from this idea that monetary policy should be the first choice tool of macroeconomic stimulus. For example, right now we could simultaneously raise rates back to 2%, unwind QE and institute a large money-financed stimulus program.

    More pertinent in my opinion is not so much that rates were too low but that the Fed under Greenspan instituted a commitment that rates would be cut at the first sign of banking distress – the most egregious example being the rate cuts in 1998 during LTCM when the rest of the economy had no need for stimulus whatsoever. A sort of moral hazard in other words, and this distortion was also partially responsible for the malfunctioning nature of our financial system.

    • JW Mason says:

      Having said that I think the ‘far too low for far too long’ story has some merit – the implications it does have is that we need to get away from this idea that monetary policy should be the first choice tool of macroeconomic stimulus.

      Yes, this is where I was trying to end up.

      • Has anyone studied consumer credit card debt versus mortgage debt? The U.S. economy lost between 7 to 10 trillion dollars in home equity in the past 4 years, yet in relation to that loss of home equity, credit card debt has only dropped approximately 10%, and that may be nothing more than write offs and those written off debt are actually still active and being hunted down by collection services and converted into life long debts that keep accruing new interest rate charges every month.

        Bemoaning low interest rate charges while the consumer is still being hit with high interest rate charges on debt they were falsely tricked into acquiring when their home equity lines were falsely inflated doesn’t seem to get discussed much, does it?

        If home equity has dropped 7 to 10 trillion dollars in the past four years, yet consumer credit debt has basically remained flat, the ratio of consumer debt to home equity has basically imploded. This consumer debt to home equity imbalance is further exacerbated by the credit card debt being owned by national banks rather than local banks, so the money does not necessarily recirculate locally.

        Credit Card debt tagged with unreasonably high interest rate charges (and we can add student debt to that equation as well), has done way more to erode the U.S. economy than low interest rates.

        The wealthy should receive the lowest interest rates on their savings should they choose to put them in a bank, the poorest should get the highest interest rates on whatever they can save, and existing consumer debt should be paid off at interest free rates for those who are willing to reduce their overall credit lines.

  6. Marko says:

    I should add that while I do think the U.S. needs to save more , resulting in a declining current account deficit , it’s most important at this time that the private sector repairs its balance sheets , rather than the public sector. Public deficits now will facilitate more rapid private deleveraging , especially if it’s targeted properly.

    Taxing high incomes and wealth , raising the minwage , re-empowering labor , dis-emboweling finance – these are some things that would set both the private and public sectors on the way to better health. Somehow , though , I can’t see this happening anytime soon.

  7. Just another related point – Keynes and Minsky completely understood the dynamic of stabilisation and its long-term strategic implications. Given the malformation of private investment by the interventions needed to preserve the financial system, Keynes preferred the socialisation of investment and Minsky a shift to a high-consumption, low-investment system (Minsky essentially thought that we have become rich enough -a thought that I even find people like Taleb echoing). But the conventional wisdom, which takes MInsky’s tactical advice on stabilisation and ignores his strategic advice on the need to abandon the private investment led strategy, is inconsistent. Either you differ from Minsky (like I do in asserting that small fires need to be allowed to burn) or you follow his logic to its inexorable conclusion. I’ve highlighted a few quotes from Minsky’s excellent book ‘John Maynard Keynes’ on this subject – approximately from pages 163-165:

    “The success of a high-private-investment strategy depends upon the continued growth of relative needs to validate private investment. It also requires that policy be directed to maintain and increase the quasi-rents earned by capital – i.e.,rentier and entrepreneurial income. But such high and increasing quasi-rents are particularly conducive to speculation, especially as these profits are presumably guaranteed by policy. The result is experimentation with liability structures that not only hypothecate increasing proportions of cash receipts but that also depend upon continuous refinancing of asset positions. A high-investment, high-profit strategy for full employment – even with the underpinning of an active fiscal policy and an aware Federal Reserve system – leads to an increasingly unstable financial system, and an increasingly unstable economic performance. Within a short span of time, the policy problem cycles among preventing a deep depression, getting a stagnant economy moving again, reining in an inflation, and offsetting a credit squeeze or crunch…….

    In a sense, the measures undertaken to prevent unemployment and sustain output “fix” the game that is economic life; if such a system is to survive, there must be a consensus that the game has not been unfairly fixed…….

    As high investment and high profits depend upon and induce speculation with respect to liability structures, the expansions become increasingly difficult to control; the choice seems to become whether to accomodate to an increasing inflation or to induce a debt-deflation process that can lead to a serious depression……

    The high-investment, high-profits policy synthesis is associated with giant firms and giant financial institutions, for such an organization of finance and industry seemingly makes large-scale external finance easier to achieve. However, enterprises on the scale of the American giant firms tend to become stagnant and inefficient. A policy strategy that emphasizes high consumption, constraints upon income inequality, and limitations upon permissible liability structures, if wedded to an industrial-organization strategy that limits the power of institutionalized giant firms, should be more conducive to individual initiative and individual enterprise than is the current synthesis.
    As it is now, without controls on how investment is to be financed and without a high-consumption, low private-investment strategy, sustained full employment apparently leads to treadmill affluence, accelerating inflation, and recurring threats of financial crisis.”

    • JW Mason says:

      Right, exactly.

      If you see that efforts to maintain full employment via low interest rates have repeatedly produced asset bubbles, and assuming — not a stretch I think — that the prospect of further bubbles is unacceptable, then you’re left with three choices.

      – Give up on full employment. This is the implicit message of Taylor, etc.

      – Conclude that desired saving at full employment exceeds any practical level level of private investment, so full employment will require a permanently higher share of consumption and/or public expenditure. This is basically where Keynes (and Minsky, as you note) end up.

      – Conclude that there is something wrong with the financial system, because when the supply of savings or liquidity (I am deliberately being agnostic about what is being intermediated) available increases, it is directed to unproductive speculation rather than useful investment. In this case, you need a better system of intermediation. This goes to your argument for the supersession of banks, and my argument that capitalism was more stable when a greater share of corporate cashflow was retained, i.e. when intermediation happened largely within the nonfinancial firm.

      My big point, though, is that you cannot logically argue both that low interest rates were responsible for the crisis, and that higher public and/or private savings are desirable in the future.

      • “you cannot logically argue both that low interest rates were responsible for the crisis, and that higher public and/or private savings are desirable in the future” agreed – if we really want higher rates across the curve, then we need some serious fiscal profligacy! Time to call up an emerging market finance minister if Geithner doesn’t know how to trigger some fiscally-fuelled inflation.

        A point that I have also made many times before – everyone thinks monetary stimulus is more neutral than fiscal stimulus but in its current asset-price obsessed guise, monetary stimulus is dramatically regressive. IMO this is responsible for much of the increased inequality, rents flowing to the 1% etc. Fiscal stimulus can be either targeted or neutral (helicopter drops) and is a much better option.

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  10. It’s interesting that you mention Keynes’ argument about higher interest rates pushing people into riskier endeavours, discouraging investment. Here he is on the 1929 crash:

    “I see no reason to be in the slightest degree doubtful about the initiating causes of the slump….The leading characteristic was an extraordinary willingness to borrow money for the purposes of new real investment at very high rates of interest – rates of interest which were extravagantly high on pre-war standards, rates of interest which have never in the history of the world been earned.”

    Of course, Keynes was not talking about such crude indicators as the base rate and short term rates, but long term interest rates, which are what businesses actually use to make decisions. More here if anyone’s interested:

    http://unlearningeconomics.wordpress.com/2011/11/16/keynes-figured-it-all-out-a-while-ago/

  11. Despite my own verbosity, I constantly encourage my kids to mimic Tim Robbin’s in “The Player” where the elevator pitch of film is absolutely essential, irrespective of the intricate twists and turns of the actual plot. So what is my elevator pitch of the crisis’ causes? “Greed. fraud and myopic self-interest by the whole polity conspires with uber-easy money, globalization, and lax regulation seducing the developed world into an orgy of credit-creation that ends in tears before painful redemption can be achieved”.

    Could it have happened without extended low (and negative real interest rates)? Probably, but a conspiracy by definition (not in the pejorative) has a number of actors (causes). And the co-conspiratorial causes were not orthogonal as the extended low rates reinforced a variety of related behavioural contributors and feedback loops that otherwise might have petered out.

    So parsing the question in unitary terms is likely to be less-than helpful at truly understanding the evolution of the crisis.

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  15. gman says:

    Almost all economists are biased (like most people) toward their benefactors. As someone famously said “it is almost impossible to make a man understand, when his salary depends on him NOT UNDERSTANDING.

    Most economists are endowed in one way or another by rentiers.(Rogoff by Pete Peterson) As a result they will do almost anything to justify high/higher real, risk free, rates of return that their patrons like.

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  17. Peter K. says:

    Very interesting post. I think there is something to the savings glut theory as European countries on the periphery experienced bubbles from capital inflows.

    Conservatives like John Taylor and Steve Forbes point to the low interest rates of 2003-2005, but fail to mention government regulation. Hoenig however is very much a regulatory hawk. Things worked sort of well from WII until the housing bubble (except the savings and loan crisis, dotcom bubble, etc) with the FDIC and Glass-Steagall. Then we had the rise of the unregulated shadow banking system and the housing boom/bubble helped by the global savings glut.

    In 2003 we were facing possible deflation. The Fed was supposed to raise rates in face of that? Dodd-Frank is supposed to address some of these regulatory concerns but I fear it didn’t go far enough. And as far as the supersession of banks go, a lot of large banks did fail or were assimilated: Bear Stearns, Lehman, Washington Mutual, Wacovia, Merrill Lynch, IndyMac, etc. There was a lot of purging and liquidation although I do now believe they should have used the Swedish model and nationalized some of the larger zombie banks and flipped them as they did with Detroit.

  18. Detroit Dan says:

    Very good post and discussion. Thank you…

  19. Eric L says:

    Here’s a problem with low rates you missed: The Fed lowers rates to counter recessions. If they’re already low, then they have less room to act.

    I am of the opinion that low rates are a part of the story, that the Fed isn’t to blame for them, and none of the people you quote get the reason quite right. Hoenig’s version seems the most bizarre to me; I just get this image of the perfect society building warehouse after warehouse to hold the goods they productively create and don’t wastefully consume. Seriously, if we’re under-producing, how is it possible that we over-consume?

    Let’s start with the apparent contradiction between the savings glut hypothesis and the idea that the Fed sets the rates. The savings glut idea is that more savings chasing fewer investments means interest rates come down so that more loans are made. As for the Fed — they don’t exactly “set” the rate, rather, they choose a rate target and then buy or sell enough treasuries to get the market to choose that rate. But the rate isn’t the only thing they affect in the process; they trade interest rates for aggregate demand, and in fact they care about that more than they care about the interest rate. So a savings glut will affect rates, because it affects the choices the Fed has. They had no reason to raise rates; we weren’t at full employment, we didn’t have inflation, so if the Fed had taken action to raise rates (and thereby lower aggregate demand) they probably would have harmed the economy. But Fed action isn’t the only way to get higher rates; deficit spending pushes up both interest rates and aggregate demand. The Fed can’t do that.

    Because if it was excess saving that caused the crisis, why on earth would we want more of it?

    Exactly what I’ve been wondering.

    People making the argument that, in modern conditions, very low interest rates can only call forth speculative or wasteful investment, have implicitly accepted Keynes’ view that there is finite limit on the capital society requires, so that returns on private investment will fall toward zero as this limit is approached. But they haven’t followed him to the logical conclusion that in such a savings-abundant world, consumption and public expenditure should rise secularly until private investment disappears entirely.

    It’s not clear to me that this follows. For one thing, for China the whole point of saving is to not consume. As for me, I would need to set aside money for my retirement and child’s education even if I could not get any return. As for billionaire savers, what exactly has changed for them recently that would make them want to do a whole lot more spending than they used to?

    Steadily falling interest rates and progressively easier credit have brought us the dream of trickle-down economics — middle class wages stagnated, money flowed to the top, it got loaned back to the middle class, so their living standards improved anyway. Everybody wins. Until it doesn’t make sense for the middle class to go into more debt even with low interest rates. So now the savers are going to start spending their income as quickly as the middle class people they were loaning it to would have, simply because they can’t make much interest? They’ll do the spending they could have done but did not in good times, because it is no longer good times? I don’t see what law requires that this happen.

  20. yorksranter says:

    So if interest rates are too low and this is leading to unsustainable mal-investment, we should be able to observe this in the business investment data series. No investment boom is observable. I say stick with the data!

  21. Michael, I’ve cited your article and it is very useful, thank you.

    However, you leave out petroleum: a good whose price was too low for far, far to long … for enough time to build an entire world-wide waste-based economic system that is utterly dependent upon low-priced fuel. See US, China, Japan, EU and consuming nation wannabes.

    Now? Fuel prices have increased 10x since 1998 and 3x since 2005. The increase in price has not produced 10x or even 3x as much fuel. Instead, the price rationing kicks in and who is left out?

    The parties that have to repay legacy debts. The choice is to drive cars or pay the interest on trillions in cumulative debt. If you drive the cars you go broke on the fuel — that requires credit to buy. If you drive the cars you go bankrupt because you cannot afford to pay for fuel and pay your interest charges. If you pay the interest, you don’t drive and the car industry fails along with everything that accompanies it (as is underway in the EU right this second).

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