Economy in Crisis: Three Bears and a Missing Goldilocks

2006 and 2007 were framed by financial pundits as a time when we could truly have the Goldilocks economy. Growth wouldn’t be too fast or too slow, but just right. The Fed had both hands on the wheel and was goosing things just enough to keep the ship headed in the right direction. Of course all the while the same pundits chose to ignore raging inflation at the consumer level as energy and food prices headed for the stratosphere. While the fall of energy prices has been spectacular, however, the drop in food prices has been virtually nonexistent. As in the story of Goldilocks, there were some bears who weren’t too happy about Goldilocks and her plans for their porridge.

2008 was the year of the bear in many regards, but as we take a deeper look at the situation, it becomes very clear that there are several other angry bears out there that have yet to completely show themselves. The credit crisis, as many in financial circles affectionately call it, has been improperly blamed for the current economic malaise. In order to understand this concept, it is imperative that one be able to separate the financial economy from the real economy. The real (or producing) economy is the part that actually creates goods and services which are allocated by the markets, often with the use of credit from financial intermediaries. Those intermediaries make responsible loans based on a number of factors and intend to collect payments for the duration of the loan. Despite what we’ve been led to believe about securitization, a good deal of non-securitized lending was going on as well. This is the real economy. The financial economy is behemoth firms on Wall Street, which by and large produce almost nothing (except headaches recently).

This was not always the case. An economy does need financial intermediaries. Essentially what these intermediaries are supposed to accomplish is to bring savers and borrowers together in an efficient manner and take advantage of scale economies. For example, it is easier for a company to go to a bank for a million dollar loan rather than put ads in newspapers and solicit the loan a thousand dollars at a time. Likewise is it easier for someone who wants to save $1000 to head to their local bank than it is for them to seek out a borrower directly. In both these cases, the financial agent or intermediary provides a valuable service by adding efficiency to the process. For this service, the agent is paid a fee. That fee comes from the difference between the interest paid and the interest collected (the spread).

Unfortunately, what has happened is the financial intermediaries have been engaging in other activities such as underwriting, trading for their own accounts (Glass-Steagall) as in the case of broker dealers, and providing investment advisory services, often times recommending stocks which they themselves own or have provided underwriting services for. Lastly, and perhaps most dangerously, the use of leverage and super leverage became commonplace. The largest financial intermediaries dabbled too much in the conflict of interest and risk business rather than tending to their role in the system.

The Baby Bear has been the understanding that all of this would go well until the sea changed and the market moved against these intermediaries. This sea change, triggered by a strikingly small number of defaults on subprime mortgages and the avalanche of credit derivatives that followed has left a swath of destruction that has rendered our most venerable firms insolvent. What was Wall Street is now a giant zombie, requiring constant, ever-increasing, and ever-accelerating mountains of money just to keep it functioning. This is borne out in the news headlines as AIG, Citigroup (C), and Bank of America (BAC) in particular have required steady infusions of cash. Not to mention the GSEs Fannie Mae (FNM) and Freddie Mac (FRE).

The above scenario is a pure example of the downside of leverage. If someone takes $100 and borrows $900 to make a $1000 investment and that investment loses 11%, the capital is gone. What is left is an underwater investment and no way to make good AND remain solvent. In many cases we witnessed leverage rates of 20, 40, and even 100 to 1. In these cases, miniscule market moves led to instant insolvency hence the ability of a small number of bad loans to trigger the crisis. (See chart below for an idea of how credit in the financial system has been growing over the past half century.)

(Total Credit marked debt owed by the financial sector – an indirect indicator of leverage)

However, were the defaults on those subprime mortgages caused by the credit crisis? Absolutely not. They were caused by the Mother Bear: overleveraged consumers. The ridiculous notion put forth by the media and financial pundits that real estate prices could accelerate forever was prima facie evidence of a bubble. What these pundits failed to recognize is that in any debt structure, there is an absolute point where it is simply not possible to take on more debt because expectations for even the servicing of that debt are simply unreasonable. To put it simply, what were the prospects for the now famous California strawberry picker to make continually increasing payments on a $750,000 condo? Slim and none and Slim’s bags were packed before the ink was dry on the loan.

Unfortunately, it was not just housing; it was everything. A recession was avoided in 2001 by dropping interest rates to nothing, printing money, and blowing bubbles. We bought too many cars, too many computers, too much consumer electronics, too many swimming pools, too many granite countertops, and in general, too much of everything. Not until it was too late did we realize that we were saving nothing, spending well in excess of our means, and now the bill is coming due. Buying less was an obvious move on the part of consumers, and is in full swing. This pullback in spending is now rippling through both the manufacturing and service economies of the US and other OECD countries. The UK has officially entered a recession although I’d venture to guess that, like us, they’ve been there for quite some time. China’s output is falling as we (and others) consume fewer of their goods.

The Father Bear is time. Consider for a moment the trillions of dollars that have been thrown at just the banking system. These trillions have not fostered one iota of growth. They have barely unlocked the credit markets with regard to banks. The LIBOR Rate chart has more gaps on it than someone in dire need of an orthodontist, and the banking system requires unknown further trillions just to maintain a semblance of financial order.

(1-Month London Interbank Offer Rate (LIBOR) on a weekly basis)

All of this, and nothing has been done about the economy. And I’ve got news for the pundits – this will not go away by printing more money. This will not go away by lowering rates, which are already at zero in the US. This will not go away by handing out gift cards to consumers to force them to buy stuff (Suggested in 1/8’s MTC article as a possible ‘solution’ and mainstreamed by MarketWatch on 1/22). Creating more government jobs is not the answer. What has been lost in the analysis of the Great Depression is that despite FDR’s New Deal programs, the US remained in a depression for another 7 years at a minimum. The country was pulled out of that depression by the onset and eventual entrance of America into World War II, NOT by government spending programs alone. This does not bode well geopolitically.

The take-home message is don’t expect this to end quickly. It will not. The Depression of 2008 and beyond is here, no matter what we choose to call it. Every week over one half million freshly unemployed individuals are filing for unemployment insurance. Sure that insurance helps them to stay in houses and buy necessities. That’s about it though. I would not count on these people running up credit card debt to over-consume. So every week, one half million discretionary spenders are heading to the sidelines. This is a crisis of consumption, brought on by decades of overconsumption, facilitated first by sending a second wage earner to the workforce, and later by the introduction and rampant growth of consumer credit. These excesses were not created overnight, nor will they be purged overnight.

(New Unemployment Claims – weekly in gray, 4-week mean in brown)

(Total Consumer Credit in 2000 Dollars with y/y %change in red)

What is also going to become very obvious in the next 9-12 months is that inflation is a monetary, not an economic event. We have been riddled with talk from the financial press that prices cannot rise while the economy is weak so we should forget about inflation. They will be proven wrong. A growing economy actually causes prices to fall by creating efficiencies through scale and scope economies. Prices are much more a function of money supply than economic velocity or activity. Watch what happens to prices if the government starts handing out money or gift cards. Do you think flatscreen TV’s will sell for 50% off if those TV’s are flying off the shelves because you’ve got 300 million Americans armed with a Victory Card? I think not. Prices are a function of the supply of money and credit. The bad news here is that you can have inflation during a depression. Care for a recent example? Just go back to the 70’s stagflation. What we’ve got now is just a more extreme version of an already established event.

What do to? Believe it or not, there are sectors, industries and firms that will do exceedingly well in this type of an environment. They’re out there and we’ve been pointing them out to our subscribers and clients. Perhaps most importantly though, at a micro level, each person can clean up their own finances and temper their expectations of the future to whatever extent is possible. And if you happen to see Goldilocks, tell her to drop Ben a line; he’s been looking for her for quite some time and is rather worried.

Comments

[prudentinve...:]

It is fashionable amongst the punditry to blame the "credit crisis" as if it were the disease, whereas in reality it is the symptom.

The disease is lack of savings and overconsumption, fueled by artificially-low interest rates and easy credit. The fact that debtors cannot pay what they owe and the banks are collapsing is the symptom, not the disease.

All the talk we hear now is about how to alleviate the symptoms, with pain relievers, but there is almost no discussion of how to treat the underlying disease. This is more important than alleviating the symptoms.

Jan 25 03:02 PM

[patio:]

Geez, you were doing so well, until your brain cramped. We have a total melt-down in demand, from loss of wealth effect, loss of cash flow ( unemployment and under-employment ), the purchase forward effect ( we already have houses and garages full of stuff ), but now we face future inflation because of Victory cards?
Puh-leeze.
The whole article ends up being an advertisement for your firms "advice', for thriving in this not-to-exist future.

Jan 25 03:26 PM

[Hefaistos:]

"The disease is lack of savings and overconsumption" I don't agree that this was the real cause. If there were enough investments during normal years, there was no problem of a lack of savings in the aggregate.
I'd suggest that the real problem was the lax credit policies, lack of true risk management in banks. The problem was not the preferences of the consumer to consume, but entirely with sub-optimizing banks.

Jan 25 03:34 PM

[Hefaistos:]

sorry, forgot to say that the quote in the previous comment was from "prudentinvestor"

Jan 25 03:36 PM

[PeakOiler:]

"The bad news here is that you can have inflation during a depression. Care for a recent example? Just go back to the 70’s stagflation. What we’ve got now is just a more extreme version of an already established event."

Naw, I was there in the early 1970's. Inflation had exploded during the late 1960's because of the Vietnam war, and increasing oil prices. I took my first job in 1972 at $7200 a year. Two years later my salary was $12,600, and not because of merit. Everyone was getting wage increases of 10% or more a year to catch up with the inflation rate.

Today, we have no inflation on the wage front at all, in fact we have deflation of wages. Yes, the Fed is monetizing debt at present, a necessary attempt to fix to an economy in a deflationary spiral. When the time comes that the economy is expanding again I expect the Fed to try to sop up money supply by raising interest rates.

Increasing wage settlements will be the indicator I use to determine if inflation could become a problem. Right now we have the opposite problem, and it could be years until inflation shows up. Inflation would be a good sign that we are well on the road to recovery, but I doubt if it will ever become the problem it was in the 1970's.

Jan 25 03:57 PM

[dw57:]

nah i think the disease was the collapse of wages, with out that we wouldn't have needed as much credit.


On Jan 25 03:02 PM prudentinvestor wrote:

> It is fashionable amongst the punditry to blame the "credit crisis"
> as if it were the disease, whereas in reality it is the symptom.

>
>
> The disease is lack of savings and overconsumption, fueled by artificially-low
> interest rates and easy credit. The fact that debtors cannot pay
> what they owe and the banks are collapsing is the symptom, not the
> disease.
>
> All the talk we hear now is about how to alleviate the symptoms,
> with pain relievers, but there is almost no discussion of how to
> treat the underlying disease. This is more important than alleviating
> the symptoms.

Jan 25 04:37 PM

[bullwinkle:]

Actually if you have $100 of capital and $900 of debt funding $1000 of assets, all you need is a 10% decline to wipe out your capital, not an 11% decline. I don't think I'll subscribe because your math skills are so bad. Okay, just kidding, but this is the problem not only with banks, insurance companies, and other financial institutions, but also with private equity.

Jan 25 08:01 PM

[Andy Sutton1:]

A 10% loss makes you even, an 11% loss breaks your capital and the bank along with it. That was kind of the take-home message here - the damage leverage has done. you pointed out some of the other popular areas where leverage has wreaked havoc.


On Jan 25 08:01 PM bullwinkle wrote:

> Actually if you have $100 of capital and $900 of debt funding $1000
> of assets, all you need is a 10% decline to wipe out your capital,
> not an 11% decline. I don't think I'll subscribe because your math
> skills are so bad. Okay, just kidding, but this is the problem not
> only with banks, insurance companies, and other financial institutions,
> but also with private equity.

Jan 25 10:27 PM

[Andy Sutton1:]

All else being equal, prices cannot explode without money supply to support them. If the money supply during the time you mentioned remained flat then money paid for oil had to come from some other product(s).


On Jan 25 03:57 PM PeakOiler wrote:

> "The bad news here is that you can have inflation during a depression.
> Care for a recent example? Just go back to the 70’s stagflation.
> What we’ve got now is just a more extreme version of an already established
> event."
>
> Naw, I was there in the early 1970's. Inflation had exploded during
> the late 1960's because of the Vietnam war, and increasing oil prices.
> I took my first job in 1972 at $7200 a year. Two years later my
> salary was $12,600, and not because of merit. Everyone was getting
> wage increases of 10% or more a year to catch up with the inflation
> rate.
>
> Today, we have no inflation on the wage front at all, in fact we
> have deflation of wages. Yes, the Fed is monetizing debt at present,
> a necessary attempt to fix to an economy in a deflationary spiral.
> When the time comes that the economy is expanding again I expect
> the Fed to try to sop up money supply by raising interest rates.

>
>
> Increasing wage settlements will be the indicator I use to determine
> if inflation could become a problem. Right now we have the opposite
> problem, and it could be years until inflation shows up. Inflation
> would be a good sign that we are well on the road to recovery, but
> I doubt if it will ever become the problem it was in the 1970's.

>

Jan 25 10:30 PM

[Andy Sutton1:]

This is not post-facto wisdom, but a window into what happens next and needs to be read in the context of the rest of the articles make complete sense. I too have been yelling about this for quite a while now, so I think we've both earned the opportunity to do a little post mortem on what has gone on so far.

I would dispute unemployment being a lagging indicator. I feel it to be more of a leading indicator - especially announcements and initial claims. Companies simply don't lay off staff when they feel the bottom is in and think that a recovery (hiring) is not far off. More accurately, they lay off workers when the feel the bottom still lies ahead.


On Jan 25 02:53 PM gabe borenstein wrote:

> I am sick and tired of this post facto wisdom .The time to reflect
> analytical ability was two to three years ago.
> The warning signs of impending deceleration (Armageddon)were all
> over.
> I have issued the warning as late as September18,2007 in an interview
> (Bloomberg TV -FED time) .How much more explicit economic warning/analysis
> can be?
> What is the point of reflecting at this time of what transpired
> ?
> That part of the economic history is done with.
> It is the period ahead that matters .
> Most of the issues have been and are being addressed .The U.S economy
> is heading for a rebound in the period ahead unlike Europe and Asia
> (include Emerging markets as well), as these areas are lagging in
> properly addressing acceleratingt "economic cracks",
> Once the economic deceleration reaches the "implosion status",the
> affected area will not have the resources that theU.S has in addressing
> the issues.
> Inflation will not be an issue in the period ahead and I expect
> the food prices to decline substantially as demand pull is not an
> issue in the food prices inelasticity .The relevant companies are
> trying to increase the profit margin-they will fail just as the
> energy sector did.
> AsI have stated many times the unemployment while a shocking misery
> index ,is a lagging indicator.
> The necessary catalytic ingredients are in place for the noninflationary
> major recovery process but we may need a bit more time to achieve
> a convincing stability leading into a major economic/market rebound.

>
> In the meantime give the "economic remedies" a chance -impose moratorioum
> on short selling for at least a year.
>

Jan 25 10:36 PM

[Rakesh Saxena:]

Very good analysis Andy. We need more insights into the future based on facts as they present themselves today. - Rakesh

Jan 26 12:23 AM

[drbob66:]

Technically, an 11% loss would only "break the bank" if the bank had only $100 of capital to start with, right? If they have an extra ten bucks, they can just sell and swallow an 11% loss on their "investment."

I agree with the other comments about wage inflation/deflation...... we see real wages increasing, we won't see significant inflation.

I also agree that this article sounds like a pitch for the author's "investment advice." No disclosure with regards to stock positions makes me think that he's probably short the market now, and hoping to scare a few more stockholders. Either way, there's nothing new in this article that I haven't read dozens of times in the past few months. Just another waste of electrons...

Oh, and by the way... if you resent being "forced" by our government to buy stuff , feel free to send your Victory card my way...maybe I'll use it to buy a flatscreen tv (I hear there are some pretty good deals out there).


On Jan 25 10:27 PM Andy Sutton wrote:

> A 10% loss makes you even, an 11% loss breaks your capital and the
> bank along with it. That was kind of the take-home message here -
> the damage leverage has done. you pointed out some of the other popular
> areas where leverage has wreaked havoc.

Jan 26 01:24 AM

[Jake Berzon:]

All the talk about credit crisis and the Government solutions of the same make me sick to my stomach. The only thing that is worse is hearing the cries for the poor people who should be helped out, because they can not afford their mortgages.

Can somebody reasonably and calmly explain to me why I should pay my mortgage unabated now and agree to pay more in taxes later, so that somebody who bought something they obviously could never afford in the first place could keep it?!

Jan 26 02:13 AM

[Moon Kil Woong:]

Hopefully, we won't have to drop ben a line. Hopefully, he will be gone soon along with his helecopter full of money to support his friends with.

I also fully agree that monetary expansionism to help recessions does nothing until it does too much. As in it won't stop the recession until it creates too much inflation and even then it might not. Monetary expansion doesn't mean a lot if factories and services are still not expanding. It just means more money for the same fewer goods and services we all consume (inflation).

Jan 26 03:10 AM

[know nothing:]

Well, :the I want it all and I want it now ",entitlement generation, is in for alot of dissappointment! Thats all I can say.. It sucks when you have to finally pay the bill. What sucks even more is when the american tax payer has to pay the bill for all those who can't handle their own fianances!!

Jan 26 09:48 AM

[robert.b.fe...:]

Government intervention and coercion helped create this mess. Now the same people who were the architects of this desaster and the midwives for it's birth are trying to fix it. Give me a break they are playing the same game the Japanese did twenty years ago and are still paying for. Get government out of the market and let those who can't sirvive fail. The wreckage will be purchased by surviving institutions and the economy will recover albeit painfully for many. There is no magic bullet and this process will continue. Government intervention will only prolong the agony.

Jan 26 12:52 PM

[OldLimey:]

Mr. Borenstein, in your comment you wrote: "I am sick and tired of this post facto wisdom. The time to reflect analytical ability was two to three years ago."

Whatever you think of Mr. Sutton's analysis, I'm not sure it serves any purpose to be quite so 'direct'. Let me remind you of something you wrote on 11 September last year:

"The problerms in the financial sector have existed for years and are being addressed while their magnitude is distorted by the media and the market bears .
Why? take a look at the record short open interest in the equity market -that is why.
In the period ahead you will see Dow at 20,000 and the NASDAQ over 5000.
Hard to believe? So were my warnings about the current turmoil,issued over the period of more than two years."

Notwithstanding that your warnings may well have been prescient, neither your assessment of their cause and intensity nor your insights into the future appear to have been.

Jan 26 02:47 PM

[gabe borens...:]

I did not specify the duration of the period ahead.Certainly in the other comments i did specify the second half of 2009 as the time frame for the econonic and market rebound-so let's see what will transpire.
As to the past ,I challenge you to show me a one strategist to come even close to predicting the current turmoil.
In june 2005 I have predicted the current events and have stated that the yield on the 10 yr treasuries will decline to 2.5% .
In the same interview Bill Gross stated that at the end of the decade the 10 yr will decline to 3%-not even close.
In 1999 ,I have met with portfolio manager for the Vatican (and other managers as well)Dottorre Mengini.At the ime I have reflected to him the impending high tech implosion-that market collapsed two moths later.
My current analysis will be correct again but I am not a psychologist ,therefore I can not analyze market paranoia and psychosis.
As I have stated previously ,these emotional outbursts should have been expressed at least 2 years ago.
My track record speaks for itself.There are Central Banks that still play the video of my interview with Brian Sullivan.
Old Limey, ,just show me one individual that comes even close to my predictions/conclusion and then I will say Mea Culpa.


On Jan 26 02:47 PM OldLimey wrote:

> Mr. Borenstein, in your comment you wrote: "I am sick and tired of
> this post facto wisdom. The time to reflect analytical ability was
> two to three years ago."
>
> Whatever you think of Mr. Sutton's analysis, I'm not sure it serves
> any purpose to be quite so 'direct'. Let me remind you of something
> you wrote on 11 September last year:
>
> "The problerms in the financial sector have existed for years and
> are being addressed while their magnitude is distorted by the media
> and the market bears .
> Why? take a look at the record short open interest in the equity
> market -that is why.
> In the period ahead you will see Dow at 20,000 and the NASDAQ over
> 5000.
> Hard to believe? So were my warnings about the current turmoil,issued
> over the period of more than two years."
>
> Notwithstanding that your warnings may well have been prescient,
> neither your assessment of their cause and intensity nor your insights
> into the future appear to have been.

Jan 26 08:30 PM

[PROXIMO:]

Gabe---I've read thousands of posts on SA and I've yet to find anyone whose confidence exceeds their ability in economic/financial analysis like yours. Your postings on SA are hilarious they are so far off the mark. Regarding a name of someone who predicted this economic mess---A fellow by the name of John Mauldin (one of many who saw it coming).


On Jan 26 08:30 PM gabe borenstein wrote:

> I did not specify the duration of the period ahead.Certainly in the
> other comments i did specify the second half of 2009 as the time
> frame for the econonic and market rebound-so let's see what will
> transpire.
> As to the past ,I challenge you to show me a one strategist to come
> even close to predicting the current turmoil.
> In june 2005 I have predicted the current events and have stated
> that the yield on the 10 yr treasuries will decline to 2.5% .

>
> In the same interview Bill Gross stated that at the end of the decade
> the 10 yr will decline to 3%-not even close.
> In 1999 ,I have met with portfolio manager for the Vatican (and other
> managers as well)Dottorre Mengini.At the ime I have reflected to
> him the impending high tech implosion-that market collapsed two moths
> later.
> My current analysis will be correct again but I am not a psychologist
> ,therefore I can not analyze market paranoia and psychosis.
> As I have stated previously ,these emotional outbursts should have
> been expressed at least 2 years ago.
> My track record speaks for itself.There are Central Banks that still
> play the video of my interview with Brian Sullivan.
> Old Limey, ,just show me one individual that comes even close to
> my predictions/conclusion and then I will say Mea Culpa.
>
>
> On Jan 26 02:47 PM OldLimey wrote:

Jan 26 10:20 PM

[ozzy43:]

As usual, phenomenal article. But there is one non-factual (though commonly held) assertion:

"the country was pulled out of that depression by the onset and eventual entrance of America into World War II, NOT by government spending programs alone."

Robert Higgs' classic economic analysis "Wartime Prosperity? A Reassessment of the U.S. Economy in the 1940s" disproves that notion once and for all. Pity so few have read it. 'Tis here:

www.independent.org/ne...

Jan 28 07:47 AM