a fat panda's  Instablog

There a relatively new correlation between the stock market and employment, 401K contributions, that isn't receiving the attention that it deserves from the investment community. Over the last 20 years, the stock market has enjoyed a benefit from the inflow of cash from 401Ks and retirement plans.  Yet, no one seems to be asking what happens when that inflow becomes an outflow.

The deleveraging process going on in America is going to make this question surface soon.  It is very difficult to justify saving for the future when the present is insolvent.  People are going to realize that it is highly unlikely that the market will produce an after-tax return that will compensate you for holding consumer debt.  To illustrate the problem; If an employee puts away $1,000 with a $1,000 employer match, it will be worth almost $300,000 when the employee retires after 30 years (assuming an 8% return). After taxes, it will be worth something less. $1,000 of consumer debt at 14% will be almost 5 million dollars after 30 years. It isn't going to take a CFA to figure out that retirement savings simply makes no sense when they owe any consumer debt.  America is deleveraging, and retirement plans will play a large part of the process. 

Beyond, the people who reduce their commitments to retirement, there are people who are losing access to the system.  The number of people eligible to contribute to 401Ks will be reduced by millions this year alone.  Even when they get the ability to put money into a IRA, the allowances are much lower and there is no matching funds from the company.  Even when workers get their jobs back, many are going to defer saving for retirement to pay for the transition costs between jobs. 

The recession isn't just tough on employees.  Employers are looking for ways to cut costs. As part of this initiative, employee benefits are under constant scrutiny. This scrutiny may play out in 1 of 3 ways. Companies may eliminate the benefit outright. Even if they keep the benefit, they may reduce or alter the matching payments. Even if the companies keep the benefit with the same matching terms, the market will still feel the loss of inflows if the company changes the match from cash to restricted stock. Given the labor market, it is difficult to image many companies increasing the capital allocated to matching retirement savings for employees.

In the net, you have to consider how 401Ks are going to change over the couple of years.  Retirement plans have been one of the steadiest consumers of US equities.  It is about time someone starts asking what happens if one of the best customers of equity stops buying and starts selling.

The government’s efforts to save the economy have met to date with mixed results. On the positive side, the larger banks have shown profits, where even Citigroup has shown a profit of sorts. On the negative side, unemployment is increasing and underemployment is skyrocketing. The media has termed this the new normal.

Here is the problem with the New Normal. The economic equivalent of Boyle’s Law is that you cannot create or destroy economic demand without creating wealth. The government cannot create wealth. The government can shift demand from one business to another by changing the relative cost of goods. It can shift demand from the future to the present by lowering the cost of consumption, ie interest. The government cannot create demand by itself, nor can induce economic prosperity with fiscal stimulus.

Stimulus without innovation is nothing more than borrowing prosperity from the future. It is an unavoidable truth that when you create demand in one industry, say in autos with a cash-for-clunkers program, you are reducing demand somewhere else. When I spend $20,000 on a car, it is $20,000 that I am not spending elsewhere. In the case where I borrow the $20,000, it is $20,000 that I am not spending sometime else. The sum of the government’s effort is zero, where we are pushing demand from one business to another or from the future to the present.

I serve as an illustration of the problem. I am replacing perfectly workable air conditioners and heaters because the government is taking money from someone else to help me pay for it. The money that I am spending replacing the perfectly good air conditioners and heaters means that I am not doing the painting which actually needs to be done until next year. This is a zero sum game at best – and a negative sum-game should we find that good painters become bad air conditioner installers.

The government’s current approach to stimulus is far from a best case situation. We are heavily subsidizing the auto and lending industries. Both of these industries suffer from massive excess capacity. In the best case of the example above, a good painter becomes a good air conditioner installer because the increase in demand will lead to hiring. In the America in 2009, however, businesses aren’t hiring because the increase in demand serves only to soak-up excess inventory. So, the painters just become unemployed. This is why you see the GNP bottoming but unemployment increasing.

Price is the market mechanism for clearing inventory. Instead of allowing the price to clear excess inventory, the government is stealing demand from elsewhere to justify the existing price. The market works best when it is allowed to punish these people who cannot price products well. In this case, the market is punishing random people who had nothing to do with the poor decisions in the first place. The consequence is socializing of stupidity, in which the foolish benefit at the expense of everyone else.

This consequence is most clear in banking, where the government has decided to subsidize risk. We have lowered the cost of capital well below it true value. These subsidies have led many businesses to form a bank holding company. Subsidies in the case of health care and agriculture are of debatable merit, but they at least subsidize a public good. Comically enough, we are encouraging people to take risk during a credit crunch when capital should be treated with a premium. This is a level of stupidity that should be beyond even government bureaucrats.

The earnings report from Goldman Sachs is an unavoidable outcome of our folly. 80% of Goldman’s earnings came from proprietary trading. The report doesn’t indicate the amount of public assistance that Goldman received. But, as a bank holding company, it is entitled to borrow at the discount window. It can access the Treasury Auction Facility. It can issue debt backed by the FDIC. So while it may have paid back the TARP funds, Goldman Sachs has many lines of public assistance to subsidize its proprietary trading group. Is proprietary trading a public good?

Folks if you are wondering why we are seeing mixed messages in the economic results. It is because the government has one of the worst economic agendas since the Great Depression.  Even by government standards, this is simply stupid.

The Conservative mantra of the day blames the current financial crisis on the government’s over-regulation of an otherwise sound banking system. They want you to believe that the crisis stems from an intrusive government forcing lending standards lower by government fiat, namely the CRA. While the government is at fault here, the government's intervention in the banking system is only a component of a much larger problem - consumer debt.

Not all debt is the same. In economic terms, investment debt is unpredictable because the impact really depends upon the success of the underlying investment. Consumer debt on the other hand is very predictable. It pushes demand forward getting consumers to buy today what they would normally wait to buy. When we express future demand today, we pull revenue streams forward, thereby overstating present revenue.

In the microcosm of housing, the government and financial systems enabled people to borrow more and at a lower rate than ever before.  This pulled demand as well as revenue forward as people wanted more housing.  The builder, unfortunately, didn't think that his revenue was overstated, and neither did the banker who started lending on looser and looser terms. To them, the boom would never end. So the builder, in turn leveraged his wealth, buying things from people who found themselves suddenly richer. Those people in turn leveraged their wealth, and so on and so forth, until the economy was brimming with imaginary wealth entirely built upon imaginary revenue.

The problem is that at some point there isn’t enough future demand to pull forward. We hit that point in 2007. Housing demand for 2007, 2008, and 2009 had been depleted, having largely been filled in 2004, 2005, and 2006. There was no cheaper capital to pull into the game of low interest rates. In fact, we were experience the opposite as interest rates on variable notes reset higher, forcing the housing crisis. Higher rates forced people to sell at the exact same time that demand was falling. This was the housing crisis.

In the net, the problem wasn’t the marginal poor person buying a house that he couldn’t afford. The problem was the near-rich person who bought the swimming pool for the house that he couldn’t afford. It was people spending imaginary wealth, borrowed from bankers who imagined growing revenue streams. Having worked in banking for 20 years, I can assure you that the government didn’t force bankers to make bad loans any more than the zoo keepers force lions to eat red meat. The government simply lowered interest rates below the rate of inflation and stood back to watch economic gravity take hold.

The government is almost entirely responsible for this mess, but we as a nation need at least blame the right people, and learn the right lesson. Failing to assign the blame for economic bubbles is the reason that so many politicians try to create them.

LONG TBT, GLD

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