Thursday, March 5, 2009

How This Ends

The S&P fell 4% today and is now down almost 30% from the pre-inaugruation 2009 high, almost as much as it fell after the collapse of Lehman Brothers and of course this is only the most recent of a series of legs down from from the 1400s back in October 2007. It has been a long road and people have been asking for a long time "When and how does this end?"

I had a boss who, during the internet collapse used to say "if people are still asking if its the bottom, it's not the bottom. The bottom is when people stop asking and just start screaming sell." This is a good rule of thumb but it isn't nuanced enough for what I want to talk about today.

So the question lingers, "How does this end?"

I'm going to tell you.

First we have to decide what we mean by "this" when we talk about how "this" ends. There is a lot of talk in the press about what to call the current crisis. Technically it's a "Recession." Is it deep enough to be called a "Depression?" Should there be some middle term like "Repression?" I think this focus on terminology actually obscures the real issue, so I am going to begin by talking about what this is not.

  • It is not a housing crisis. Foreclosures are sweeping the country and millions are losing their homes. House prices are falling and will likely to continue to do so until house prices are more in line with historical norms for thier ratios to rents (the alternative to purchase) or incomes (the capacity to purchase.) When I say this is not a housing crisis what I mean is that solving the housing crisis is no longer enough.
  • It is not a banking crisis. The housing price deflation struck bank balance sheets hard and brought some firms down altogether. Today there are serious problems with the balance sheets of American banks and the constriction of bank lending has choked off the flow of capital to the general economy. But this is not a banking crisis in the sense that the real economy is declining so rapidly that simply solving the banking issues is not enough to turn things around.
  • It is not a budget crisis. On account of the stimuls package and extraordinary measures to protect the banking system the US deficit will be 12% of GDP, twice as much as it has been at any time since the World War II. This is a problem and will either lead to higher interest rates or higher inflation depending on how the government chooses to finance it. This is not a budget crisis because even closing the deficit as the administration is promising to do will not solve the problem.
  • It is not a trade balance crisis. America as a $700 billion trade deficit with the rest of the world. Decisions by our trading partners to invest thier surpluses in the US rather than convert them to local currency exacerbated our housing bubble and a persistent deficit will make it difficult for us to export our way back. But it is not a trade crisis in the sense that even narrowing the trade deficit will not be enough to stop the declines.
The real problem is that all four of these things are attacking the old order of the economy simultaneously. The government is trying mightily to defend the old order. The TARP, the TALF, multiple stimulus packages, promises to refrain from protectionism, promises to narrow the deficit. The government is doing everything that it can to try to preserve the old order but I think that the markets, and the economy is telling us that the government, funamentally, has already failed. Even if we succeed in reparing the housing market and the banking system and narrowing or closing the trade and budget deficits. The old order will never return for a very simple reason.

The simultaneous housing, banking, budget, and trade crises have made it clear to everyone who might consider lending money in the US that the levels of credit that have been extended over the past 30 years are no longer justified by the income being generated in the economy. This is regardless of whether those assets are investment banks, houses, the government or industry. It is not a micro issue, it is a macro issue. The US has $53 trillion in debt against a GDP of $14 trillion and it has been shown that under stressful conditions like those now occuring that debt cannot be bourne. So even once the micro crises are resolved it is unlikely that similar levels of credit will be extended in the future. I believe this will be true even once the banking system is repaired and functioning again. We may get the rifle working again, but we'll still have fewer bullets.


Anthony said...

This is very interesting point of view. You know that Canada has had very strict lending criteria for it's banking life time, as well as for the past 20 years in China. Growth in China and Canada for that matter have been significant. Even in this downturn the banks have held strong. You make a very good point though, i am not entirely sure this is the only problem.

Modestmerlin said...

For the last 10 years people simply had too much stuff afforded via too much credit. People need to understand that going forward we're all going to have less credit and therefore, less stuff.