Wednesday, 8 October 2008

Show us the money

HT Ken for this one.

As I stated back here, the US $700 billion bail-out has to be funded with borrowed money. This is a country that is regularly borrowing billions to pay for its war in Iraq.

That's the thing about debt, eventually you have to pay it back. Steve Maich illustrates:

The world's biggest and most dynamic economy has been erected on a mountain of debt from the national government on down to the millions of ordinary families with hefty mortgages and wallets full of maxed-out plastic. America bought its vaunted standard of living on credit, and trading partners around the world profited wildly from its free-spending culture. Now the bill is coming due. Central banks around the world, led by the U.S. Federal Reserve, are pumping hundreds of billions into the system in hopes of keeping it moving. But that, even if it were combined with Paulson's massive transfer of tax dollars to Wall Street, only buys a temporary deferral, not a solution.

If only this were a simple problem. Everyone understands the concept of the borrower and the lender. Who owes whom and under what terms. But what happens when the lender uses the amount loaned as an asset and then sells it?

But in 2005-2006, it came time to pay the piper. Interest rates on the subprime mortgages shot up. Many new home owners were unable to pay or refinance. The crisis should have been confined to US homeowners. Unfortunately the banks and lenders making these loans had sold the debt to investors. The debt assets were diced up and sold to other investors and banks around the world, in complicated financial packages that few people seemed to fully understand.

During 2007, nearly 1.3 million US housing properties were subject to foreclosure activity, up 79% from 2006. Panic; nobody seemed to have any ideas who owned these ‘worthless’ debts, spread out throughout the whole worldwide financial system. Suddenly banks weren’t willing to lend to each other any longer, resulting in a ‘credit crunch,’ a period where there is little liquidity (or money) in the system because nobody is lending.

This is a highly advanced shell game similar to the concept of using your Visa to pay off your Mastercard and your Mastercard to pay off your Visa. In theory, as long as you use one credit card to make payments on the other, you're OK. Except the debt never goes away, or gets paid off. Which is where the theory falls apart.

Its a guess, but this is the part the US bailout package is supposed to solve. We now know who owns the debt. Except, the US has to borrow that money from somewhere and well, that's from the same system that passes debt around.

Back to Steve Maich:

The trouble with that, as dozens of economists were quick to point out this week, is that the U.S. economy isn't suffering from a single tumour that can be isolated and removed. The problems are systemic and more akin to a virus, rooted in the moribund housing sector but afflicting every corner of the economy, and rapidly spilling across borders to infect other nations as well.

"Eventually, somewhere along the way, the dollar is going to break, the foreigners will say enough, and we're going to have a much bigger crisis," Schiff says. "America won't be able to sell any of its debt, interest rates are going to skyrocket, the dollar will plunge, and prices for everything in the United States will go through the roof.

Granted, Us Government debt is mostly owned by China. Who apparently doesn't re-sell that debt in the financial markets. China gladly buys up US debt because US consumers buy Chinese made products. Anyone else see the problem with that? In effect you have Americans purchasing Chinese products with China's money. Its the Mastercard/Visa shell game. Where is China getting the money to finance US debt?

The problem is the same as it is for anyone running up a massive credit card debt with no clear plan of how to pay. At some point, and nobody knows exactly when, foreign investors like the Chinese will become concerned about America's ability to service its mounting debt payments and will look to protect themselves against a default — cutting back on the amount of debt they will finance.

All of this complexity can be boiled down to a simple point. To rephrase the famous "Its the economy, stupid" line, "The individual is the economy, stupid".

The economy runs because of you and me. The whole system is based on the individuals desire and ability to purchase goods. Its the raison d'ĂȘtre of everything.

And this at root is where the solution (if there is one) to this financial crises lies. Its all well and good to try to unfreeze the credit crunch and improve the banks ability to lend money again. BUT IF THE INDIVIDUAL CAN'T AFFORD TO BORROW, WE CAN'T AFFORD TO BUY.

I don't care how much money is available to be borrowed. If I lose my job or my home, my ability to purchase, never mind borrow, is seriously compromised. Likewise, with rising prices forecast for food and basic essentials, my flexibility to purchase luxuries is also compromised. This will impede economic growth.

When economists say, "we expect the market to start to recover next year" (funny enough that recovery date keeps getting pushed out, but never mind that) they ignore another reality for consumers. Everyone relies on the stock market, if not directly then indirectly through mutual funds, pensions, hell even the CPP. The one reason why we rely on the stock market is year over year growth. We put aside money today so it can grow in value in the intervening years, hopefully outpacing inflation so that there is enough money when we retire to live on. Other than cash based securities, almost all of our eggs are in one basket. (So much for diversification of your portfolio.) We all, but retirees especially, count on year-to-year growth of approx. 8% in our RRSP portfolios. Well the markets have just lost what 30% of their value? Say the markets recover all 30% in 2 years. Back to normal right? Wrong, you're still 16% behind in value because you counted on, NEEDED year to year growth of 8%. And that still assumes that inflation stays low. If inflation rises, that needed year to year growth is higher as well. The dire straights we are in can be calculated simply length of recovery X inflation = amount of consumer pain

To me this is why the market crashing is worse then the market crash of the great depression. Back then people's retirements weren't entirely funded by the stock market. It was more a get rich quick scheme (though the reckless borrowing has its parallels). Now it isn't just your current financial situation that is in jeopardy, your future is as well. With the higher percentage of retirees in the west this is a real problem.

The result goes back to my main point. We're going to have a large number of people that simply cannot afford to purchase goods. How will the economy recover and grow? Where will the money come from?

I don't know if it is really possible, but if governments truly want to stem this crises, they have to invest in the individual citizens. We may not directly be the cause of the crises, but at root we are the cure.


ADHR said...

Maybe. The issue right now, though, is that the banks are shit scared to lend any money to anyone. To the point where they're jacking up credit card rates and calling in debts. So, some money needs to be pumped into the system.

What's missing from the analysis you're talking about, though, is the fact that the bailout consists of buying investments. Which means that, unless the US government is incredibly incompetent (moreso than usual), they can be sold back to recoup the money spent in the first place.

Catelli said...

On your first point. I'm just advocating a different way that money gets pumped into the system. By helping (not paying outright though) the home owner with their mortgage the bank still gets their money.

This whole thing started when homeowners started defaulting. It wasn't the lack of credit that seized things up, it was when people stopped paying. Interesting aside, The Mound of Sound just posted that their stock broker told them that one reason why stocks are in steep decline is that people who bought stocks on credit are being forced to pay back that credit. So they have to sell out just to get cash.

So again, consumer debt is contributing to the problem.