Monday, March 2, 2009

Short Story: The Economy

About two decades ago the expansion of credit in America began to accelerate. In the mid ‘90s consumers commenced what was to become a credit “binge” that would last 15 years. During this period consumer debt grew much faster than incomes. From 2003 to 2008 consumer credit tripled while the economy did not grow sufficiently to support that debt load. The consumer was not the only party that was binging on credit. The US Federal Government dramatically increased its borrowings during this period. In addition the government took on huge amounts of liabilities in the form of a growing Social Security and Medicare burden, neither of which shows up on its balance sheet.

The US society, during this period, embarked on a “borrow from tomorrow and spend today” way of conducting business. This caused the American economy to grow faster than the fundamental drivers (productivity and wage expansion) would justify. The result was that we leveraged up our economy.

At the same time, the excessive demand that resulted from credit expansion (and the excessive spending that accompanied it) caused asset values to grow faster than the underlying economic expansion could support in the long run. No place was this more evident than in housing.

Public policy was a major factor in the explosion of credit and unrealistic growth in housing prices. The US Congress and Presidential leaders promoted the concept of expansion of home ownership in America. They dramatically expanded the scope of mortgage financing in the nation. The extraordinary expansion of FreddieMac and FannieMae were central to this public policy adventure. Politicians believed that home ownership should be a right of all Americans, regardless of their economic status or creditworthiness. Consumers bought homes that they could not reasonably afford and refinanced them to higher levels, all of which fueled a spending boom. This metastasized through the economy as consumers spent at a high level on furniture, furnishings, house wares, boats, cars, recreational vehicles and much more.

The private sector contributed to the credit binge also in a big way. The securitization of mortgages added fuel to the fire. This mechanism facilitated the flow of investor funds into the mortgage markets in huge amounts. The creation and proliferation of new instruments also contributed to the credit binge. Credit default swaps provided a form of insurance against borrower defaults that allowed low quality credit to be upgraded and sold to the market. Collateralized Debt Obligations (CDOs) were another “creation” that fueled the flow of funds to the credit markets. Through these instruments portfolios of loans (mortgages, autos loans, credit card loans, etc.) could be bundled and divided into tranches that could be sold to the market. The symbiotic relationship between credit rating agencies and mortgage financing firms was also an unsightly mechanism that contributed to the growth of these debt securities.

For almost two decades this dramatic expansion of credit has fueled a growth in asset values, pumping money into the economy and creating a massive number of buyers (spenders). Home prices grew to levels that were well above the affordability level that could be supported by incomes. The low cost of mortgage debt mask the fact that homeowners simply could not afford the purchases that they made on a sustainable basis. Artificially low interest rates contributed to this problem.

The artificial stimulation of demand lead to an expansion of capacity in the economy that was not sustainable; too many stores, too much auto manufacturing, too many homes built; just too much “stuff”. We now find our economy oversupplied. It must shrink to the level that is required to supply the real demand.

So now comes 2008; the “day of reckoning”. The economy has begun to go through a deleveraging process. Unwinding leverage is a very painful process and can take time to reach a state of normalization. In this process asset values must fall. There are no buyers and all parties seek to sell at the same time. Banks, brokerage firms and consumers must follow this painful course. Fortunately most (non-financial) companies did not fall into this trap and have good balance sheets. Financial firms will make this journey fairly quickly, but it will take a long time for consumers to deleverage. This will curtail their spending and investing for a protracted period.

The backbone of the growth of the American economy in recent years has been the consumer. The consumer has been spending beyond his means for a protracted period of time and has now crawled into a fox hole and will stay there. In a strange way this is intelligent behavior. After partying all night and waking up with a hang over, the consumer must dry out; must live more conservatively; must moderate their spending behavior. Consumers have seen their household wealth disappear. Home equity has vanished, retirement savings and savings for the college education of their children have dropped precipitously in value, unemployment is running at very high levels…and the consumer is afraid. It will be a long time before they feel confident again.

So what about government intervention to “save the economy”? We have just witnessed the “loony tunes” in Washington pass a “stimulus” bill, the size of which is the largest in history. Presumably it will create millions of jobs. Politicians point to a large number of “shovel ready” projects that will be funded. This may help employment in the construction industry, but will not support employment in financial services, retail, manufacturing and virtually all other industries. Somehow I do not see a retail clerk, auto executive or bank executive getting a shovel and going to work.

More importantly, it was a “borrow from tomorrow and spend today” scheme that got us into this mess….and Washington’s solution to get us out is…to borrow from the future and spend it today. This is pure folly. The government, through the Federal Reserve has also attempted to manage the economy through monetary policy. Interest rates were lowered to unreasonable rates in the 2001/2002/2003 time-frame and fueled excessive, unsustainable, economic growth in the years that followed. Now it is happening again. Why can’t these economically illiterate political leaders keep their hands off the “steering wheel” and let the market do its thing.

This would mean that our economy would grow at a slower pace, but at a sustainable rate and perhaps might not go through the big cycles that are created by too much stimulus and too much government meddling in an effort to make things better today than the underlying economic drivers can support over the long haul.

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