The Real Problem? People Are Scared to Spend

It's interesting how short-sighted many so-called experts are when it comes to understanding the pace and path of forces swirling through the economy.

Even when it was apparent to everyone that the bubble had burst in housing, for example, some forecasters were predicting that municipal finances would not be seriously affected.

Aside from wishful thinking, one reason for the cognitive dissonance appeared to stem from the fact that people were not getting immediate reports from state and local officials that budgets were being wracked by falling revenues and rising costs.

Yet that should not have been a surprise to anyone. There are in-built delays, such as the time it takes to build a house or the grace period allowed for tax receipts to be remitted to authorities, that would postpone the moment of reckoning for months -- or longer.

The same holds true in terms of the state of the overall economy. The optimists seem to be saying that since today's data are not so bad, fears about a serious downturn are overblown.

As it happens, Charles Hugh Smith, publisher of the Of Two Minds blog, has taken the time to take such reassurances to task in "The Coming Great Depression: Leaving Fantasyland."

Wall Street Journal commentator Peggy Noonan is undoubtedly not alone is seeing no evidence of Depression in America--yet: Turbulence Ahead:

One of the weirdest, most perceptually jarring things about the economic crisis is that everything looks the same. We are told every day and in every news venue that we are in Great Depression II, that we are in a crisis, a cataclysm, a meltdown, the credit crunch from hell, that we will lose millions of jobs, and that the great abundance is over and may never return. Three great investment banks have fallen while a fourth totters, and the Dow Jones Industrial Average has fallen 31% in six months. And yet when you free yourself from media and go outside for a walk, everything looks . . . the same.

Everyone is dressed the same. Everyone looks as comfortable as they did three years ago, at the height of prosperity. The mall is still there, and people are still walking into the stores and daydreaming with half-full carts in aisle 3. Everyone's still overweight.

But the point is: Nothing looks different.

In the Depression people sold apples on the street. They sold pencils. Angels with dirty faces wore coats too thin and short and shivered in line at the government surplus warehouse.

Peg would be well-served by reading up a bit on the Depression's timeline. As noted here last week, (The Coming Great Depression: Scapegoats and Exploitation) the Dow Jones Industrial Average actually recovered in early 1930 to early-1929 levels. (Look for the same this time around, too--DJIA 12,600 is in the cards a few months out, despite all the structural damage to the market and economy.)

Breadlines didn't form in November 1929--the structural damage took years to play out then, and it will take years to play out now. So don't rush things, Peggy--we'll get to a visible Depression soon enough.

Great Depression: (Wikipedia)

The Great Depression was not a sudden, total collapse. The stock market turned upward in early 1930, returning to early 1929 levels by April, though still almost 30 percent below the peak of September 1929. Together, government and business actually spent more in the first half of 1930 than in the corresponding period of the previous year. But consumers, many of whom had suffered severe losses in the stock market the previous year, cut back their expenditures by ten percent, and a severe drought ravaged the agricultural heartland of the USA beginning in the summer of 1930.

In early 1930, credit was ample and available at low rates, but people were reluctant to add new debt by borrowing. By May 1930, auto sales had declined to below the levels of 1928. Prices in general began to decline, but wages held steady in 1930, then began to drop in 1931. We can already anticipate "ample credit at low rates" in 2009, just as we can also anticipate wages holding steady for awhile even as sales fall. The wheels will fall off later in 2009 and deteriorate further in 2010, 2011 and 2012.

Here are the structural realities which have yet to play out:

1. You can't force households or businesses to borrow more money and spend it. Japan's central bank has flooded that nation with liquidity and low interest money for 19 years to little effect.
2. U.S. consumers and corporations are already burdened with staggering debt. Not only can't you force people to borrow more, you also can't force lenders to loan more money to insolvent households and businesses.
3. Whatever money people get their hands on is going to paying down debt and savings. Studies of the first "stimulus package" checks which went out to taxpayers in 2008 revealed that 2/3 of the money was not spent but used to service debt or saved. Future "stimulus checks" will also fail to boost spending; people already have more stuff than they know what to do with.
4. The FIRE economy is dead. Finance, insurance and real estate [FIRE] all prospered for one reason: the velocity of transactions and debt instruments. With the volume of transactions off by 2/3 (real estate) or 99% (home equity loans), the FIRE economy is shrinking fast, with no barriers to further declines. With lending standards rising even as real estate values plummet, there is nothing to stop transaction and debt velocity from falling much further.
5. Governments and corporations alike are living with Fantasyland expectations of revenue. I recently pored over the 2009 fiscal year budget of my town of 120,000 people (general fund spending is $135 million, which doesn't include capital projects or bond-funded spending) and was dumbstruck by the insanely unrealistic revenue expectations.

The city expects to reap the same amount of easy money from real estate transfer taxes (1% of any real estate transaction goes to the city) in 2009 as it did in 2007 and 2008: about $11 million.

Huh? As transaction volumes decline by 2/3 and the sales prices plummet, then how can you possibly expect to rake in the same transfer tax revenues?

The downtown shopping district was eerily quiet on Black Friday; empty storefronts are everywhere, and sales are falling even at the town's sales-tax heavyweights, the Toyota (TM) and Honda (HMC) auto dealerships. Yet the city expects to haul in the same sales tax revenue as in 2008. Based on what?

The entire nation is in the grip of massive, total denial that revenues will drop in a recession. Companies are trimming travel costs, as are consumers; San Francisco International Airport was virtually empty on Wednesday, once one of the busiest travel days of the year. From Airports almost empty day before Thanksgiving:

The dreaded Day before Thanksgiving was not so dreadful after all. Bay Area airports were eerily empty for much of what traditionally has been among the busiest travel days of the year.
"There's nobody here," said Deborah Vainieri, who was waiting at San Francisco International Airport with her husband, Humberto, for a flight to Portland. In a plot to beat the crowds, the Vainieris had arrived at the airport four hours early. They walked right up to the check-in machine and were done in less than a minute.

6. If lenders make risky loans, they will go under--and most U.S. households and businesses are no longer creditworthy risks. So there you have it: This conflict cannot be resolved. Lenders who foolishly extend credit to over-indebted, risk-laden borrowers will be paid back with losses and insolvency, yet as lending standards tighten and assets plummet in value, the number of creditworthy borrowers in the U.S. has shrunk.

As noted here many times: many of those who qualify for loans are deadset against debt. That's why they're creditworthy--they've refused to take on huge debt for cultural or fiscal-prudence reasons. They have zero interest in taking on debt, even at zero interest.

You can't force people to borrow money, especially when they're already overloaded with debt, and you can't force prudent people to borrow when they have no need for more property, nor can you force people to buy real estate even as the values continue falling.

7. The U.S. already has too much of everything: too many hotels, malls, office towers, homes, condos, strip-malls, lamps, furniture, CDs, TVs, clothing, etc. As 50 million storage lockers filled to capacity with consumer crap are emptied in a desperate move to reduce expenses and raise cash, the value of literally everything ever manufactured will fall to near-zero.

As noted here many times before, the entire U.S. housing market was held aloft by two anomalies: speculators hoping to "flip" for huge profits, and a "one dwelling for every person" mentality that confused rising population with a rising number of households.

We are already seeing how population can continue rising slowly even as the number of households declines. It's called moving back home, doubling up, renting out a room, etc. There are at least 20 million surplus dwellings in the U.S. right now; there is no need for 700,000 more a year to be built, or even 70,000 more.

The FIRE economy based on transaction and debt volume/velocity: gone, over, toast. Housing market based on speculative flipping and one-person households: over, gone, toast. Loose lending by delusional lenders to risky, over-indebted borrowers: gone, over, toast. Borrowing based on rising real estate values: gone, over, toast.

The notion that we "need" more of anything: gone, over, toast. The idea that you can force lenders to lend to uncreditworthy borrowers: gone, over, toast. The idea you can force people drowning in debt to borrow more: gone, over, toast.

Comments

[Doug Poretz:]

Very intriguing but I have the following other observations:

1. Officially we are not even in a "Recession" yet -- we have not yet had two sequential quarters of negative growth, which is the defintion of a Recession, as you know. But if we aren't in a Recession, or a Depression, we are in a Something. I think that "Something" is new and should have a new name. For now, I call it "The XYZ Event." I think what we call this economic period is important -- if we use old terms to define and diagnose the event, we will use old remedies. I think this is different from either a "Recession" of the past or the Depression of the 1930s due to some vastly different fundamentals, among them a shft from a manufacturing to a knowledge economy, the emergence of a truly global and interlocked economy, and a radically different communications infrastructure.

2. I think there is a major consequence that you do not account for by virtue of the speed of information now as compared to the Depression and even previous Recessions -- we get information and put it to use much quicker, by an order of magnitude. We know much key fundamental economic data on a real-time basis, and that data we do not know as it happens, we do know very quickly, especially as compared to the 1930s. Improved IT networks and reporting systems allow manufacturers to control inventory much better, allow corporations to adapt budgets quicker, etc. This allows the rapid and almost total "shut down" of spending by both businesses and consumers, as we currently see, but that, in turn, should mitigate the ultimate damage.

3. Most significantly in my opinion, the current economic situation is not attributable to a single event or institution or enforcement or non-enforcement of any regulation, albeit all those contributed to what's happening. I think the innundation of "buy this" messages that have surrounded the American public since the post WW II boom, has led to a culture where "the American dream" is a consumer's dream: buy more, buy bigger, buy more expensive. All aspects of our society became ensnared in that culture -- those who created new debt instruments, those who encouraged their customers to stretch a little more for a bigger and more expensive house, and those who decided to buy a new flat screen TV even though they couldn't afford it because they didn't have to make any payments "until next year." Until we come to grips -- get out of denial -- about the cutlure that gave rise to this economic mess, we won't define the situation correctly -- and we won't be able to remedy the situation until it is correctly defined.

Despite my opinions, I am not optimistic about the economy for the near-term at least. I am, however, certain that the creative component of this destructive period will be very robust and ultimately the world will be better for it. For anyone interested, I express this type of thought and related issues about communicating messages at my blog, which is linked above.

2008 Dec 01 09:01 AM

[derryl:]

Although Mr. Panzner's observations of the state of the US economy are "depressing", they are all true. The only way to get out of debt is to reduce spending to payout debt, which leads to the kind of deflationary spiral Mr. Panzner describes.

Even if Obama's stimulus checks and infrastructure spending are huge they will maybe only replace the loss of private sector incomes from all those builders and manufacturers and stores who have to lay off staff because of bankruptcy or much lower sales volumes. The only way to get America spending again is to increase incomes so people can comfortably pay off their old debts while maintaining current spending levels. Barring some miracle (or a change in the way we operate our monetary system), national income gains are not going to happen anytime soon.

Deleveraging, paying off your debts, when you start from the extreme state of indebtedness of present day America, must almost certainly be depressionary. If mass bankruptcies eliminate most of the debt then all the goods like cars and houses that are collateral to the defaulted loans will flood a market with no buyers and prices will collapse. It could take years or decades before all this excess inventory is cleared from the system by way of people who want and can afford the stuff buying it at cheap prices.

Debt must be repaid. It cannot be repaid with new debt or with more debt. Debt is pre-income consuming that artificially grows market volumes and prices beyond sustainable levels. Now we are in the post-consumption paying stage that shrinks markets and volumes beneath sustainable levels, until existing surplus stocks are cleared. New consumption will plummet taking production, retail and financial services jobs down with it.

As Mr. Panzner notes, Americans already have too much stuff. Americans will be trying to sell existing stuff to get money to stay solvent. The prices of "stuff" have nowhere to go but down. Business inventories will not be salable at profitable prices. Wages and any other controllable input costs must shrink so necessary new stuff can be produced and sold.

If Obama borrows and spends trillions of dollars at today's cheap interest rates to prop up the existing economy, what happens 2 or 3 years from now when those rates rise to 8% and American taxpayers are stuck with annual interest payments of $800 billion on a $10 trillion national debt? That's $800 billion per year, every year forever, unless you increase taxes even more to start paying down the principal.

Unless Obama revokes the Federal Reserve Act and Treasury creates America's own debt free money like Lincoln did to pay for the Civil War, I don't see any pretty way out of this hole. New debt free money injected at an appropriate rate would provide money for Americans to maintain their incomes and payout their debts over the next several years.

New money that is used to payout old debt is not inflationary because in our fractional reserve banking system bank loans are the creation of new money and repayment simply eliminates that money from the system. Meanwhile that new debt free Treasury money was spent into the economy to keep the economy working, so it has a positive "economic" effect as it works its way toward its "financial" destruction when somebody uses it to paydown a bank loan. Self-eliminating money.

New debt money borrowed from offshore or the Fed merely postpones Depression 2.0 because in a system like ours where all new money is new debt, at some point you have to bite the bullet and suffer the Depression that happens when everyone tries to payout their debts.

2008 Dec 01 10:00 AM

[fran:]

WOW--

to the first two comments--

COGNITIVE DISSONANCE??

2008 Dec 01 01:25 PM

[John Lounsbury:]

Michael - - -
Good article. I am surprised you didn't say "the FIRE economy has gone up in smoke".

Doug Poretz - - -
According to the National Bureau of Economic Research, we are in a recession. The recession started in December, 2007, twelve months ago. The two consecutive quarters of declining GDP is a common result of recession, not the defining event.
That specific point aside, the rest of your comment is excellent. There are new societal, technological and economic paradigms, as you point out, and we have yet to appreciate how these will aggravate and mitigate the current crisis. For the intellectually curious, this is a great time to be alive. I just hope I am one of those who can afford the curiosity and hope that our society will survive and prosper.

Derryl - - -
I always enjoy the intellectual complexity of your comments. The problem you describe is real, but your solution is Draconian. How can the creation of some sort of "new money" not devalue the "old money" and be extremely inflationary? You argue to the contrary, but I am skeptical.
Why not repay the debt by evolving to a new national "business plan" that emphasizes production more than consumption and earn the repayments? I would much prefer such a solution to one that is simply more financial instrument manipulation. (I include paper money as a financial instrument.) Can our economy activity change in the following ways?
1. Produce more things that improve productivity (information technology, communications, machines using less (or cheaper) energy, new energy technologies, etc.)
2. Produce more things that reduce future costs (preventive health care, more effective education, environmentally cleaner processes, more efficient transportation, lower cost and more efficient energy distribution, etc.
3. Produce things that increase the circulation of dollars domestically (higher employment) and repatriate dollars held overseas via increased exports. These would include activities suggested in 1. and 2.

Can we replace Michael's burned out FIRE economy with a PERFECT economy? That would be Productivity and Employment Revival for Future Economic Cost Transformation.

2008 Dec 01 02:24 PM