What Happened to Demand?

Markets fell Monday by about 9% because we learned that we are in a recession. Well we already knew that, thank you. We are also told that this recession started in December 2007. If so, then what do you call what started in September 2008?

In September, a major financial crisis broke, accompanied by a sudden drop in demand for nearly all types of goods and services. In short demand fell off a cliff – if you look at the graphs for the markets, for commodity prices and for shipping they literally look like they fell off a cliff.

But people still want things. I know that I do. People in the US may be ‘maxed out’ on houses and cars, but they still want clothes, they still want to travel, and they certainly still want fuel to drive their cars and heat their homes. And we all still want to eat. So what happened?

We are in a cycle of reduced demand leading to job losses and falling asset prices, which reduce demand further. Once this kind of a cycle gets started, it grows on itself, and with the amount of layoffs being announced it is scary to think how much future demand will be lost and for how long this cycle will continue to feed on itself.

But that doesn’t explain what happened in September. The layoffs hadn’t happened yet and demand just disappeared. Usually a downturn starts slowly and builds up momentum, like a chemical reaction. This September we had a sudden bang like an explosion.

Let’s look at it starting from the very basics. How do you translate demand into economic activity? Well, at its most basic, one person wants something and has something else that others want in return. This is trade. The concept of money was introduced to facilitate trade, by deciding on a common something that everyone wants. This lets people sell what they have for money which they use to buy what they want – i.e. to satisfy their demand.

What we use for money is not central to my point here. The basic mechanism is the same – you produce something that people want, you sell it for money, and then you purchase what you want. We have manufacturers to transform basic commodities into goods that people want and merchants to move the goods to those that want them, but you still need to sell something first, before you get money to buy something else.

What banks do is change the order of this basic mechanism and by doing so fundamentally change the whole process. Banks lend you money that you don’t have so that you can purchase more than you sold. They do this in anticipation of future income from goods and services that you will produce in the future. This is credit.

What has happened in the past 40 years or so is that we have switched our medium of exchange from money to credit. The result is a system where one’s purchasing power is no longer based on how much money one has because of the goods and services he sold, but rather how much credit one can get in anticipation of goods and services he can produce in the future (and in some cases future income he will get without producing anything).

In the past decade, we have taken this to its ultimate conclusion: Since almost anyone has the possibility of getting income in the future, almost anyone is worthy of some amount of credit today. If everyone can get credit, and everyone has money, then everyone can buy what they want. This unleashed an enormous surge in demand that we call the “consumer economy”.

In this system economic activity is proportional to the amount of credit that the banks give out. Since banks will only extend someone the amount of credit they believe that he or she has a high probability of paying back, the consumer’s ability to borrow becomes the driving factor of economic activity. Managing the economy became a set of measures to increase the consumers’ ability to borrow and the banks’ ability to extend credit.

Reducing interest rates to low levels, making it easier to get a mortgage and extending additional credit based on rising “home equity” all increased the amount of available credit and helped fuel the consumer economy. A culture of consumption also encouraged people to borrow and spend.

The resulting nearly infinite surge in demand helped the growth of emerging economies, like China by selling manufactured goods, Russian resources, Indian services and so on. Since the US dollar is the primary unit of credit in the world, as long as the US or other western countries could generate credit in US dollars, they could buy whatever they wanted. The US naturally has the greatest ability to generate US dollar credit, so they could generate the most demand.

The world found economic nirvana. By convincing ourselves of our creditworthiness, we could buy whatever we want and the rest of the world was happy to sell it to us.

So what happened two months ago to bring this happy situation to an abrupt end?

A large portion of the credit in the US and some other countries was based on rising housing prices. When rising interest rates caused over-extended housing markets to fall, it became clear that some of the credit based on housing loans was at risk of default. Since these loans had been packaged, sold, re-packaged and re-sold throughout the world financial system and leveraged through all manner of swaps and derivatives, the effects threatened much more of the financial system than just the banks that made the loans in the first place.

Because no one knew where the bad credit was, all credit was suddenly suspect. This caused a sudden move to more trusted forms of credit such as cash and government securities. It also became very difficult to sell any other credit, so the banks no longer wanted to create more credit in a market suddenly saturated with questionable credit. This virtual freeze on new credit creation caused a sudden drop in economic activity.

Those who were overextended and over-leveraged started to panic, markets plunged, margins were called in, financial firms started to fail and demand fell off a cliff.

The world now has two options, going from a credit based economy back to a money based one, or trying to revive the credit based system.

Most people, including those in power, clearly prefer the second option. So we will try to fix the credit based financial system and bring back economic nirvana.

I will look at how governments are trying to do this in another article.

Comments

[Moon Kil Woong:]

3 things.

1) People want things. They recently figured out the one thing they really want is financial security. How more borrowing/credit grows out of this want makes me laugh. So far the Fed and Treasury have only been adding to the uncertainty due to a series of unfortunate bailouts that are far from uniform or with clear directives. It is more like offering everyone the "crisis du jour" with no real meal to sink your teeth into.

2) The credit system and money system are one and the same. Since 1913 there is no such thing as non credit currency in the US. Or money free and clear of counter-party liability. In fact there is more liability than dollars as people are starting to notice. But anyway, that's not here no there.

3) I agree with you that offering more credit isn't the answer. We need a concept of a safe level of credit/debt. This also solves the issue of topic #1. Until people have a clear hand on what's safe and who has a safe level of cash and debt there will be continuing crisis. So far the government has done nothing to force banks to show their CDS, CDO, or off book liability so we don't know who has safe credit. And sadly, banks have determined well most US households have too much debt so they aren't safe either. The housing issue is just a giant part of that equation. It is not the full problem.

There is no nirvana in the financial world. Like the weather there needs to be a balance of hot (credit) and cold (assets/cash) to make a temperate environment. There is too much credit from the past and not enough cash. So things are liable to get very cold. Prepare for winter.

2008 Dec 03 04:38 AM

[patio:]

I think "nirvana" would be a return to credit actually based on a person or company's ability to re-pay. We need those gruff old bankers in Jimmy Stewart movies to be back in charge.

2008 Dec 03 07:46 AM

[Thinker771:]

Excellent and accurate analysis.
Governments wants to get back to credit-based economies.
It may happen, but at the cost of a trillonary bill on bailouts, that will be paid by a huge devaluation of the dollar and other currencies.

2008 Dec 03 08:35 AM

[KSengineer:]

Excellent article that hits the nail on the head. It also implies the solution. Since credit created this problem, creating more credit is obviously (or should be obvious) not the solution. We must return to a lower, safer level of credit. Therefore, we must recede, regress (recess). I think we should focus on accepting this recession as a good thing that will return our economy to a stronger, healthier level which will bring a better future. Rather than trying to reverse it's effects, we should focus on programs to help us get through this without destroying the innocent.

2008 Dec 03 09:11 AM

[SlimLeeD:]

Agree that this is a great article and I look forward to the next one. But one thing was left our here, maybe it will be in the next. Namely that it is folly to attempt to insure debt, there is potentially too much in the world. Even governments that attempt this will fail. Equity and only equity can reliably secure debt.

2008 Dec 03 10:15 AM

[Jason Rines...:]

I can net out: Mr. Efficient Market Hyposis, I would like to reintroduce you to Mr. Save and Invest economy. Mr. Middleman, I would like to introduce you to the Mr. Producer who sees no real value in your services anymore. Mr. Politician, allow me to introduce you Mr. pissed off citizenship you stopped listening to decades ago.

2008 Dec 03 12:21 PM

[carey_jim:]

As the Buddha taught 2500 years ago, almost all demand (desire) is delusional.

If the Buddha could see (and hear) the relentless exhortation to buy just about anything and everything on the planet and the attendant greed, envy and unhappiness .... he would probably feel vindicated in his philosophy.

Where has all the demand gone? Where have all the flowers gone? All a long time passing ..... gone along with the rest of the environment. A long time passing.

Speaking of passing, I'll pass on the junk food, the vacation to Las Vegas and the new Hummer and settle for a cold beer in front of a warm fireplace instead.

It's cheaper and warms the spirit. All I demand is to be listened to occasionally but that's probably too much to demand already.

2008 Dec 03 04:40 PM

[axelrod608:]

Credit and debt are nothing more than pre-spent income. Americans, on average, have already spent most of their next year's income. We've been living large on incomes that haven't grown in 30 years. It was inevitable that an end would eventually be reached.

Also, the financial system we brought into the 21st century was and is unsustainable. The proper way to restructure is in bankruptcy. Based on the size of the losses, what Hank and Ben are doing is "fighting" a forest fire with a garden hose. They're just adding to the eventual losses.

Demand as we knew it in 2006 is dead, Time to bury it and restructure.

2008 Dec 03 06:14 PM