My Two Cents - "Commitments and Confusion"

4/3/2009

Talk about mixed signals. Confusion reigns supreme. On Thursday the economy was recovering because factory orders went up for February, breaking a multi-month downtrend. However, today, there is no end in sight as the employment report was released and another 663,000 Americans have lost their jobs. There is another storyline there, but we’ll save that for a different time. It would seem that commentators, economists, and policymakers alike are in a race to call the bottom. Fundamentals and economic analysis have all but disappeared under what is a seemingly never-ending wave of distortion caused by monetary creation. $1 Trillion to the IMF and World Bank. $787 Billion to ‘stimulus’, and a whopping total of $12.8 Trillion committed by the US alone with more to come. Let us take a sobering look at the commitments that have been created thus far (in Billions of Dollars) and eliminate some confusion:

Source: Bloomberg

Keep in mind that the above numbers do not represent the total cost of these programs. Just for example the second stimulus (HR1), which is counted as $787 Billion on the Treasury’s tab will actually cost $3.27 Trillion. This total is arrived at by considering the extension of current provisions, total impact of the legislation, and $744 Billion in debt service (interest) that will need to be paid on the borrowed funds. If that level of understatement is present in even a small portion of the programs listed above, it will result in a ballooning of the overall totals.

Just for illustrative purposes, we can get a very rough estimate of the total impact of these commitments by making a couple of rather weighty assumptions:

1) We’ll start making payment in 2020 since there is no possibility of a budget surplus until then. Unless of course the plan is to essentially take out a VISA to pay off a MasterCard, which is rather likely.

2) The interest rate paid on this debt will be an average of 3.70% (today’s 30-year bond yield). Granted, this is not an exact number, but it will allow us to ballpark the total.

3) We are assuming that 100% of the committed funds will be used to engineer the various rescues.

Given these rather basic assumptions, the value of the current commitments will have grown to around $18.5 Trillion by 2020 when we’ll make our first payment if everything goes well. Add on the 2020 value of our current national debt for a grand total of $34.5 Trillion. This is just for the current financial rescue and what we owe from past fiscal indiscretions. This accounts for none of the coming generational mess resulting from Social Security and Medicare. This accounts for none of whatever additional stopgap measures might be necessary to further ‘stimulate’ consumption. This assumes that we stop accumulating more debt today. In other words, the $34.5 Trillion estimate should be viewed as an absolute best-case scenario.

Perhaps even more telling in the numbers above is the portion that has been dedicated to helping the real economy as opposed to the financial system. While some of these programs indirectly help Main Street, they were clearly created to benefit Wall Street. By our count, approximately 4% of the funds above were created with the explicit intent of benefitting Main Street. So for every dollar committed, 4 cents were given to Main Street. We get 4 cents, but have to pay back the full amount - at interest. Sounds like a great deal doesn’t it? I’ll be the first to admit that the 4 cents figure is easily disputed and debated, but the spirit of the recent rescues is crystal clear.

Housing: Underpinning or Pinned Under?

All of the above notwithstanding, many ‘experts’ in the mainstream media have forecasted the recession to end by the end of 2009. How can this be so? It must be understood how many of these people view a recession. They are under the completely mistaken impression that the printing press is the solution to all economic maladies. Their biggest gripe with the Fed is that it didn’t print enough money fast enough. The concepts of savings, genuine capital formation, and the resultant investments elude them. They don’t understand that genuine capital comes from the foregoing of consumption, not the Greenspan/Bernanke printing press. It is also clear that these same people equate the housing and share markets with the overall economy. Ben Bernanke, true to his promise, has managed to lower mortgage rates by around a full percent since the Fed started buying mortgage bonds in late 2008. This has touched off a wave of refinancing, which will put a few bucks back in consumers’ pockets. Apparently that is enough to call an end to the recession. Never mind that job losses continue unabated and forget about the annoying fact that real estate prices are still falling. According to NAR, real estate prices have now fallen 28% from their highs back in 2006. That is quite a bit of equity that can no longer be borrowed against. Their own flawed model is broken and they still won’t admit it. However, the equating of housing with the overall economy doesn’t stop at the pages of your local newspaper. Cleveland Fed Governor Sandra Pianalto said recently that lower mortgage rates offer ‘encouraging signs’ for the economy. It is pretty obvious that policymakers are of the opinion that if the housing bubble can just be reinflated that we could rewind to 2005 and forget about this meddlesome little crisis we now find ourselves in.

The stock market does NOT equal the economy

This is an obvious point, but given the public reaction to the recent rally off multi-year lows, it is one that needs to be reinforced. Think about how many times you have heard lately that the stock market is doing well therefore the economy must be getting better? These comments are not just limited to parties either, but have become regular fare on the evening news, newspapers, and even dedicated financial publications. At the severe risk of being repetitive, I am going to trot out a chart of the Dow Jones Industrials Average from 1929 through 1933. We all know the backdrop and how the economy contracted throughout this entire period. What is more telling is what happened to the DOW along the way.

After the crash of 1929, the DOW rallied significantly, getting back nearly 40% of what had been lost from the top. While traders made some serious money on the moves over the next 3 years, long-term investors were decimated, losing nearly 90% of their wealth when all was said and done. The important thing to note is that the real damage was done after the crash. Here is an even less comforting thought. In real terms, investors NEVER got that wealth back. The value of their dollars eroded faster than any subsequent gains in the stock markets. That situation has played out to this very day. This reality has manifested itself over the past 30 years in particular as the family has come to rely first on extra work hours, and finally, on credit to maintain pace. The take-home message is that there are very clear examples in history that prove that sharemarkets do not equal the economy.

A more recent example is the 2007 DOW. In the fourth quarter of 2007, while America was entering a recession (which would not be admitted until nearly a year later), the DOW was peaking at an all-time high of over 14,000. Clearly, the economy had been slowing for a period of time prior, yet the DOW surged ahead. It is imperative to separate the two.

Perhaps the following definition will provide some guidance and eliminate a bit of the confusion that seems unfettered these days. The word ‘economy’ comes from the Greek words ‘oikos’ and ‘nomos’, which mean ‘house’ and ‘law’ respectively. Not much of a definition? Sure it is. I will take some linguistic license and say that it implies the order of one’s house. This applies whether you’re talking about individuals, businesses, states, or national governments. While we use fancy abbreviations, acronyms and statistics to describe the state of economic homeostasis, in the end what we’re really doing is assessing the extent to which we’ve kept our house in order. $34.5 Trillion in debt and commitments? Borrowing more than 100% of the world’s savings to finance it? Bailouts? The average person carrying over $16,000 in consumer debt - not including mortgages?

Let’s get our house in order - then we can talk recovery.

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Disclosures: None

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.