Hair of the Dog

The quickest cure for a hangover is more drink - a little hair of the dog that bit you. Of course the quickest way is seldom the best way, and in this case does nothing to get at the root of the problem. It is at best a short-term patch, merely postponing and prolonging the inevitable. In the end, only rest and sufficient time for recuperation will repair the damage and return the body to normal.

Not Your Typical Recession

While the current economic mess we find ourselves in may not rival the Great Depression, it is also no ordinary recession, and the differences are important. Recessions are a normal part of the business cycle, typically the result of imbalances in the economy caused by business overexpansion, increasing interest rates, or external shock such as war or the ‘70s oil embargos. While a great deal of manufacturing capacity has been built in China and elsewhere, and the U.S. undoubtedly has more retail space than needed, these imbalances are mere symptoms of what we face today.

What makes today different is the woeful financial condition our past indulgence found us in when things began to unravel. The long-term increase in leverage over the past three decades helped prop up asset prices across the board. The sudden drop in these values has left the balance sheets of many Americans, our government, and financial institutions in tatters. We ran up the liability side with debt for a long time, and when this was supported by the appearance of rising values on the asset side (our homes, 401(k)’s and other investments) everything looked fine. Unfortunately much of the increase in asset value was illusory, a result of debt-fueled demand caused by an abundance of cheap and easy credit.

The entire system was pushed to an unsustainable extreme, which eventually imploded. Now we are seeing the beginnings of the repair and rebuild period, a period that will continue until the combination of asset building and debt reductions bring leverage and debt servicing to manageable levels. It will be painful, but continuing to put it off will only compound the problem.

It took a long time get to this point, and it will take a while to restore balance. Spending and savings patterns tend to be long-term and secular in nature, with a strong psychological component. They do not change overnight, and once set in motion, can usually be expected to continue for a very long time. I am talking about a generational shift, the kind that may have made you wonder, when listening to your father or grandfather talk about money, whether they were from a different planet.

The Consumer Will Not Bail Us Out

Consumer spending has for many years been the primary engine of growth for the U. S. economy, climbing from around 65% of GDP in the ‘80s to 72% in 2007. In fact, the American consumer has been the engine of growth for the world economy, and the world has built up an incredible amount of productive capacity to meet that demand.

As noted, much of this increased spending was fueled by debt. Mortgage equity withdrawals alone averaged over 3% of GDP annually from 2002-2007, most of which was spent. Needless to say, we will be without this boost for some time, and the implications are dramatic.

Banks and mortgage lenders are not the only ones that have cut back their activity, The non-bank lending infrastructure, the so-called shadow banking system that supports the securitization of credit card debt, auto loans, and the like, has been significantly impaired. This segment provided an ever-increasing percentage of funding over the last two decades.

However, there is evidence that much of the decrease in the supply of credit is not being missed much, as consumer demand for borrowing has also come down. The official savings rate has recently risen to around 5% after briefly turning negative a few years ago, and that trend is likely to continue. 

Unfortunately credit fuels the economy, and what is good for the individual consumer, and even good for the economy in the long run, is not good for economic growth today. Business investment, housing, durable goods sales, all depend on the willingness of lenders to provide credit on reasonable terms, and the willingness of borrowers to take on debt. The engine has stalled, and will likely be slow to recover.

Real Clunkers

The tax credit for first-time home owners and the cash-for-clunkers programs are simply substituting federal public debt for personal debt. They do nothing to promote real economic growth, merely pulling future sales forward.

The cash-for-clunkers program destroys serviceable if not ultra-efficient cars. A program to bulldoze and replace older, less-efficient homes and commercial buildings would likewise spur economic growth, but it would not increase our wealth. That these programs have been a “success” only shows the American consumer knows a bargain or, in many cases, simply can’t resist.

The programs are certainly good for those who were already in the market for a new car, and had a qualifying clunker ready to go. For others, going from a serviceable car owned free and clear, to a new car complete with new monthly payment, that will lose in value the $4500 clunker credit the moment it is driven from the dealer lot, maybe not so good. It is definitely not a good deal for taxpayers. The cash-for-clunkers program is also not very helpful to those in the market for a used car, particularly at the lower end of the price range, as the already tight supply of these vehicles has been further decreased.

That we are borrowing to promote such programs, adding to an already burgeoning federal deficit, casts a further shadow over already questionable policy. With all due respect to Keynes, the answer to a crisis caused at the most basic level by excessive debt can not be more debt. Substituting public for private debt does not change that.

Time to Put the Bottle Away

Our federal government and those across the globe have pumped tens of trillions of dollars into the world economy through a combination of direct injections, asset purchases, and guarantees of all shapes and sizes. Much of this liquidity has found its way into the financial markets, which have enjoyed quite a run since hitting decade lows in early March. Bernanke is a student of the Great Depression, and will continue to do everything in his power to avoid the deflationary threat.
All these trillions sloshing around the system will eventually begin working their way into the real economy, causing problems beyond the mere inflating of asset values. However, with unemployment nearing double digits and capacity utilization (the percentage of factories and plants producing) at 68%, deflation is probably the bigger threat for the moment.

While the consequences of deflation can be devastating, we need to find a balance. Easing our way through this transition may be acceptable, but at some point prices must be allowed to adjust. Unfortunately the Fed will almost certainly overshoot, remaining too accommodative for too long. Meanwhile the White House and Congress seem determined to fill the hole left by decreased consumer spending and credit with brand new, debt-financed government spending.

We need to accept that any recovery will likely be subdued, with growth tracking below average for some time. Any cut back in stimulus at this point will probably result in another recession, assuming the current one has indeed ended, but the chances of another recession in the near future are very high anyway.

We have left behind a decade of largely illusory economic growth, fueled not by increasing income levels but by increased borrowing and spending of savings. That well has run dry. Home equity is tapped out, and both the availability of and demand for consumer credit has been pared back significantly. Continuing the illusion with debt-financed government spending is not the answer.
It’s time to put the bottle away. Rest and recovery time are what we need, time to rebuild our savings, strengthen our balance sheets, and pave the way for a period of real, sustainable economic growth.