My Two Cents - "Anatomy of a Disaster - Part 1"

10/03/2008

For a minute, let’s forget about all that has happened in the past year. Forget about the signing of the bailout into law. Let’s forget about the failure of some of America’s most iconic Wall Street firms. Let’s forget about the insolvency of Fannie, Freddie, and FDIC (yes, they’re broke too). Let’s forget about Northern Rock, Countrywide, and AIG. They are all but casualties and symptoms. They are not the problem. Adjustable rate mortgages were not the problem, nor were 0% interest credit cards. No, there was one single source of all that ails not only the US economy, but the world, and that problem is greed. That greed has spread from sea to shining sea over the past thirty seven years as America decoupled totally from its monetary and spendthrift roots.

The amazing thing about the free markets though is that they are self-cleansing. Get too far out of line and the market zaps you. You’re punished and you learn your lesson and get back in line. Unfortunately, for much of recent history, we have sought as a society to mitigate or even eliminate the consequences of one’s actions. This is not purely a monetary phenomenon, but one that permeates every corner of our society. I’m sure you can all think of a myriad of examples of this mindset at work.
It was this very mindset that prompted me to warn readers about the coming barrage of bailouts in March of 2007:

“After the stock market collapse of 2000-2002, the economy faced a stiff headwind and the Federal Reserve reacted by creating the most credit-friendly monetary policy in American history with low interest rates and liquidity abound. However, the tragic flaw of easy money is that it leads to speculation, and ultimately, malinvestment. Low interest rates caused speculation in the residential real-estate market to a level that has been unprecedented. Double-digit home appreciation led lenders to make more and more risky loans based on the faulty assumption that appreciation was infinite and could always be relied on to make the payments when the borrowers were unable to do so. Developers took the cue and built a massive inventory of spec homes, creating a glut looking for a reason to happen. That reason came mostly in the form of 18 consecutive rate hikes by the Fed from 2004 - 2006. Mortgage gimmicks designed to allow fast-food workers to buy half million dollar homes began resetting at much higher rates and the defaults and foreclosures began. We are now seeing only the tip of the iceberg. While the media chooses to pretend this is a non-issue, the snowball gathers speed.

The fact that there will be a bailout is a foregone conclusion. We should be more interested in the timing and ultimately the cost of any such bailout and who is going to bear the cost. It is my guess that most of the people reading this column will not like the answer to the last question.”

Given all that has transpired over the past two decades, the fact that there would be a bailout could be mailed in. It was a slam dunk. I reference this prior posting not to gloat, but rather as a springboard into what will happen next because of the massive intervention in the free market system and particularly because of our failure to understand the true causes of the problem. There are certain irrefutable rules of economics, of markets, and of nature. While they can be altered for short periods of time, in the long run, they always reassert themselves. One would think that we’d have learned this lesson from the 1930’s and 1970's. Apparently, we have not. Because of this failure to grasp these simple realities, we are destined to relive what otherwise would have been memory lane.

The Great Depression – A market crash or something else?

Despite the position of the history books that the stock market collapse of 1929 caused the Great Depression, it must be noted that the US Economy had already dipped into a serious recession as early as August 1929. But what was at the root of that recession? It certainly wasn't the stock market crash. While the seeds of the 1929 recession were germinating, the stock market was headed for Mars, riding a bolt of lightning. Between May 1928 and September 1929, stock prices increased around 40%. This happened despite the Federal Reserve banning bank borrowing for margin purchases on February 2nd of 1929 in order to curb speculation. What a novel idea.
Despite the rapid climb in the stock market, by the middle of 1929, business inventories had grown to three times the prior year's levels. Production would quickly decline at an annualized rate of 20%, wholesale prices by 7.5%, and per capita income by 5%. While worker productivity had grown by an amazing 43% from 1921 to 1929, the wealth for the most part had been consolidated in the top 1% with the per capita income actually dropping 4% during the course of the decade.
The seeds of the 1929 recession had been sown by a decade of decadence. Unfortunately, the bulk of Americans were left out of that prosperity. Here are some 1920’s trivia that should help connect the dots and make some parallels.

• The number of people reporting a $500,000 income grew from 156 in 1920 to 1,446 in 1929 – a greater increase than any other decade, but still represented less than 1% of the wage earners.
• The top 1% owned 40% of the nation's wealth by the end of the decade.
• During the course of the decade, over 1,200 corporate mergers would gobble up more than 6,000 independent companies. By the end of the 1920's, 200 corporations would control approximately one half of American industry.
• In 1929, more than half of all Americans were living on below a minimum subsistence level. Per capita income was $750 per year.

New century – same problem?

Now let's take a look at the situation we have before us in 2008. When looking at statistics, it is very difficult to draw parallels between the actual numbers of that time and the numbers of today. Decades of manipulations (some justified, some not) have made it nearly impossible to do side-by-side comparisons.

• In 2007, approximately 37 million Americans or 12% of the population are living in poverty. Clearly this is much lower than the greater than 50% in 1929, but the devil is in the details. In 2008, the threshold income for poverty was listed as $10,787 for a single person under the age of 65, and %21,027 for a family of four with two children. I don't know what kind of standard of living this entails, but I found it extremely odd that when using BLS' inflation calculator, the $750 per capita income in 1929 is worth $9,094 in 2007 dollars. Given what we know about the relevance of the CPI, it is safe to say that the poverty rate is grossly understated. Even that aside, $21,027 is not much of a living for a single person let alone a family of four.
• A 2005 study conducted by the University of California at Berkeley, and the Paris School of Economics contended that income concentration in the top 1% of wage earners was equivalent to 1928 levels.
• According to the Census Bureau, the top 1% held nearly 46% of all wealth in the United States in 2007 with the top 10% holding over two-thirds of wealth. Compare to 1929 when the top 1% held around 40% of the nation's wealth.
• The average US household now owes nearly $10,000 on credit cards, and pays an average of $1,478 in interest each year.

The consumer's balance sheet is in shambles. Granted, a good deal of the responsibility for this lies at his own feet, but without the consumer, this economy is sunk and doomed for a serious contraction. As in the 1920’s, the average American is struggling. Where he barely made a subsistence level wage in the 1920's, today, he is burdened with debt. The result is the same, although the causes are different. Consumption now represents nearly 70% of GDP, with the bulk of that consumption coming from Main Street. Without it, the prospects for prosperity are slim to none. From a wage perspective, we are not faced with a 1920's style nominal wage decline, however, we are faced with real wage declines as the inflation rate continues to outpace expansion of earnings.

In the 1929 recession turned depression, there was greed in the usual places as power and wealth were consolidated. The rest of America was compromised by sub-poverty wages with the majority lacking the ability to participate in the boom. During the past 10 year runup, there was an almost universal greed. Those at the top consolidated more and more wealth as evidenced by massive bonuses and merger activity, however, much of the rest of America decided that this time they were going to try to follow suit. They were already half compromised by stagnant then falling real wages; credit cards and home equity loans took care of the rest.

One could certainly make the argument that there has always been a fairly high level of poverty and concentration of wealth. Hasn't there always been greed? What made 1929 different? What was the trigger? What makes 2008 different and what was (or will be) the trigger now? In 1929, the real economy began to contract because it had outgrown itself. Simply put, it came too far, too fast and there was no more fuel to sustain it. Exporting at that time was more difficult, so once the economy exhausted domestic consumption potential, it was game over. Due to the majority of Americans being unable to support continued rapid growth through consumption, the boom quickly ground to a halt. Simply put, there were too many products made, and no one to buy them.

In the case of the new century, we have had a lack of real growth. Much of the growth that has happened has been due to debt, and therefore, the debt must be figured in when considering the sustainability of growth. Point of fact if the credit cards, home equity loans, and deficit spending had been taken away we would have seen very little, if any, growth during the past decade. While credit is an accoutrement to any healthy economy, and is in fact necessary for growth, when an economy comes to rely on credit for its growth, that economy is doomed.

In our 21st century economy, we don’t rely on the consumption of our own products, but on vendor-financing from the producers in Asia and elsewhere. Our economy by and large ‘produces’ services, but if there are too many services, and no buyers, you end up with the same result: economic contraction. The biggest difference between 1929 and now is that we have the ability through our own contraction to affect the world economy since our consumption has created a demand for their products.

None of the above should be taken as an indictment of capitalism. Certainly ingenuity, industry, and hard work should be rewarded while the opposite discouraged. If anything, our problem is that we didn't stick to capitalism, but tried to intervene in the normal cleansing process of the free markets. We’ve tried to have Capitalism during the good times and Socialism in the bad times. Even in the best of capitalistic societies, the lesson has to be learned that if the consumer-worker base isn't included in the prosperity, the prosperity will soon come to an end. You simply cannot balance long-term healthy economic growth on the consumption of the top few percent of wage earners. There needs to be sustainable demand for the production of an economy, and the ability of the populace to participate in that demand by the sweat of their brow as opposed to VISA is absolutely essential.

Next week's issue will deal more specifically with the nature of the upcoming recession/depression. Will it be a 1930's style deflationary event, a 1970's style inflationary event, or a hybrid? What will it be like on Main Street when this event begins? (We've already gotten a good sneak preview). And most importantly, what can be done to lessen its effects at both an individual and national level?

Graham Mehl is a pseudonym. He is not an ‘insider’. He is required to use a pseudonym by the policies of his firm when releasing written work for public consumption. Although not an insider, he is astonishingly bright, having received an MBA with highest honors from the Wharton Business School at the University of Pennsylvania. He has also worked as an analyst for hedge funds and one G7 level central bank.

Andy Sutton is a research and freelance Economist. He received international honors for his work in economics at the graduate level and currently teaches high school business. Among his current research work is identifying the line in the sand where economies crumble due to extraneous debt through the use of economic modelling. His focus is also educating young people about the science of Economics using an evidence-based approach.