Tuesday, August 31, 2010

The Economy: what happened, what's happening, and what will happen (Part 3)

I've been pretty vocal in my belief that the economy is going to double dip into another recession.  Or, to be more precise, continue the recession that hasn't really ended.  To me it seems not only obvious, but inevitable.  But most people don't agree.  Most economists today say that this recovery looks like it will slow down (is slowing down), but they feel that the chances of a double dip are slim.  I'll just take some time here to explain why I think the worst is still to come.

As I touched on in the previous two posts, the main thing that happened during the last decade or so is that people lived beyond their means.  Because credit was so cheap it was far too easy for people to go up to their eyeballs in debt.  It's just that they didn't care as long as the value of their house kept rising.  Or until they lost their job and couldn't make payments.  Once that bubble popped and things came crashing down, people's debt bit them in the ass.

Now, a few things needed to happen after the bubble popped.  First, housing prices needed to go down.  Obviously they did, that was the popped bubble after all.  But they didn't go down enough.  After a couple decades of a bubble housing market, there were a shitload of houses scattered across the country.  A lot of people owned investment property.  A lot of people has 2nd and 3rd houses, vacation houses, etc.  When they started defaulting on their mortgages the banks snatched them up.  A lot of people who were barely able to make payments lost their job and the bank snatched up their house.  Think about it, there were a lot of fucking houses out there and very few buyers.  Why so few buyers?  Because 70% of America already owned a home, or at least had a mortgage.  Once they started to get evicted and once their houses were repossessed, there weren't enough people with money to pay a considerable sum for the house.  There is a huge supply and very little demand.  They would have to be sold for pennies or torn down to build something else.  But the government didn't let that happen.  Bailing out the banks, mortgage companies, etc as well as paying people $8,000 to buy a house and guaranteeing the mortgages with government money caused prices to remain artificially high.  They weren't allowed to bottom out, but they will have to happen eventually.  I'll get to that in a second.

After the housing/financial bubble, a lot of companies found themselves in hard times.  Some were doomed to fail, others needed to get rid of jobs to stay solvent.  But again, the government intervened and didn't let it happen the way it needed to.  Don't get me wrong, if the government did nothing, then things would have been really bad.  Maybe 20+% unemployment.  Maybe 5,000 DOW.  We were drunk on credit for a long time, and the hangover was going to suck.  But if the government was able to let things play out and not get too involved, the companies and the economy in general would have emerged much stronger because of it.  GM would have been sold and/or a real restructuring would have taken place.  Banks would want 30% down payment and reasonable interest rates to protect their ass because they would have learned their lesson.  Housing prices would have gone low enough for the average person to save for a 20-30% down payment.  People would have paid down their debt and lowered their consumption to do so.  Again, things would have been really bad for a couple years, but it would be a good thing in the long run.

But because the government bailed out the banks and car companies, they didn't allow the systemic changes to happen that needed to happen.  The Fed is still keeping interest rates at 0%, encouraging people to take on more debt so they can continue to consume based on the promise of future earnings.  But what happens if those future earnings aren't there? Didn't our last President tell us to go shopping and buy shit after 9/11?  We did and it bit us in the ass because we lived beyond our means for far too long.  With the Fed issuing free money to people, they're essentially telling us to do the same thing.  People are trying to save and trying to pay down debt.  The savings rate has risen and debt has dropped.  But again, not enough.  And not as much as they would have if the government had not intervened.  With the Fed keeping interest rates low, it makes no sense for someone to put their money in the bank and lose the value of it to inflation when they could use that cash to pay down a loan for something and keep the purchasing power of their money.  This is the same terrible policy that led to the housing/financial collapse.

Speaking of housing, the main problem I see happening is that the problems with Fannie Mae and Freddie Mac have not been addressed, which is ridiculous because they were a major part of the problem.  The government has essentially guaranteed the mortgages and securities that these companies own, thereby forcing the taxpayer to assume all the risks of these high-risk loans.  It makes no sense that someone can be responsible with their money, and be forced to pay for someone who was irresponsible and defaulted on their mortgage.  Having the government guarantee the mortgage also keeps housing prices artificially high and lending standards too relaxed.  Fannie and Freddie already received a trillion dollar bailout.  They might need up to 5 trillion more before it's all over.  We have the worst of capitalism and the worst of socialism at the same time.  The taxpayer assumes all the risk and pays for all the losses while the few people who head these businesses get to keep whatever profit they make.  You couldn't design a more fucked up situation if you actually sat down and attempted to do so.

A year or so ago, the government bought a lot of troubled assets (securities, mortgages, treasury bonds, etc.) from Fannie and Freddie.  At the time, the discussion was over what the exit strategy would be for the Fed to offload these assets and shrink the balance sheets.  The thing is, the underlying problems with the housing market were not addressed, and the truth of the matter is that the Fed had no plan whatsoever in clearing their sheets.  Once they start to sell these assets back, it'll expose the fundamental problems again, collapse the financial firms that they bailed out, and take away the artificial legs that are propping up the housing market.  And now, just a couple weeks ago, the Fed officially admitted that they were going to maintain it's balance sheet, precisely for these reasons.

The truth is that the recession never really ended like some people want to suggest.  The recession was only interrupted by stimulus and bailouts.  All we did was postpone it while we accumulated a lot more debt in the process, so now we're facing a bigger problem than the one we had before.  And I'm not sure that the Fed is simply going to maintain their balance sheets.  Once the weak economic data starts to filter through, and once unemployment continues to rise and more people start to default on their mortgages because they lose their income, the Fed is going to increase their balance sheet and buy up more debt because that's all they know.  Printing money is the only weapon they have to try to fight this, so that's what they'll do. It's not like they can slash interest rates anymore because they're already at 0%.

Also, we recently saw the largest trade deficit ever, at something like $50 billion a month.  And that's during a weak economy.  Imagine what would have happened if the stimulus has worked and Americans were spending money.  That number might have been twice as high.  What we really need is to create more stuff.  But we can't use any of the stimulus money to invest in production, all we can do is buy stuff the Chinese or the Japanese make and increase the trade deficit.  And since the trade deficit takes away from the GDP it's only going to create a weaker economy and we will be seeing negative growth again in the near future.  Probably the 2nd quarter of next year at the very latest.  By that time we'll be seeing unemployment head above 10% and maybe even reach 11+% sometime in the year.  That will probably mean more stimulus from the government and low interest rates for a longer period of time which is all extremely bad for the economy in general and the dollar specifically.  And if all of this happens, we'll probably be seeing the value of the dollar start to fall faster than Tiger Woods' golf score has ever since he got busted banging every girl he met.  At some point down the road the value of the dollar has got to decline.  We can't just keep printing money indefinitely, keep interest at historically low rates, and borrowing money from overseas without eroding the value of the dollar.

We have become dependent on cheap credit and low interest rates.  The banking sector certainly is.  They borrow from the Fed nearly for free and they loan to the treasury and make the spread on interest.  That's about the only way banks can make money right now.  They're certainly not investing in business.  The housing market is being held up by the lowest mortgage rates ever, the artificial lending and the support of Fannie and Freddie.  Our national debt is only able to grow because it can be financed short term with low rates.  If rates go up then this whole house of cards comes crashing down and the Fed knows this.  At some point this is going to happen, interest rates cannot remain this low forever, and we'll all be saying goodbye to the value of our dollars.  If you think the latest housing/stock market bubble was bad, just wait until the bond bubble explodes and we stop finding people/countries that are willing to finance our debt and consumption.

Finally we are going to have a lot of tax increases next year.  Ever since this became apparent, it has been really interesting to watch all these companies report higher earning, which in turn has led to a boost in the value of their stocks.  But they know that they have lower tax rates this year than they will next year.  So what are they doing?  They're acting rationally and artificially boosting their earnings report this year, earnings that they would have otherwise claimed next year, so they pay taxes on it now.  Next year when those higher taxes hit they'll have less earnings to report, the stock prices will fall and another round of layoffs will start.  They could possibly even start laying off employees en masse at the end of 2010 because they know how 2011 will go.  Another round of layoffs means less people earning money, more people becoming unable to pay their bills, less consumer spending, and more government stimulus. It could be 2008 all over again, only much worse.

Simply put, the government is doing everything in its power to revive a broken and dead economy.  Instead of allowing it to turn to shit, getting out of the way, and allowing it to restructure into a much more viable economy (one where we actually produce, save and invest), we're trying to rebuild a phony economy that shouldn't have existed in the first place.  This will only serve to make the crash much more painful and devastating.  The recession that we have been trying to avoid for the past year or so is going to eventually catch up to us.  I just hope we don't have to find a new name for The Great Depression when it's all said and done.

I know this post is all over the map but I'm too lazy to change anything.  Maybe I'll go into more detail on some of the finer points later on, mostly the bond bubble that we're in.  Just keep this in mind for the next few years: A house chimney can easily be converted into a gun turret.

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