Reader of Wall Street Journal asks…
Posted by Jason Apollo Voss on Jan 22, 2009 in Blog | 4 commentsFor today’s post I wanted to copy for you a question asked by a Wall Street Journal reader in their “Journal Community” section. The questioner is named Hector Caaballo and he asks:
“I don’t get it. Day to day life has seemed to change little for the average American, but the financial markets are in an upheaval. I hear that ninety percent of homeowners pay their mortgage. And the crisis is due to falling real estate prices and loan defaults. huh? How can ten percent of homeowners spin the economy into such a dramatic tailspin? It just doesn’t add up. I wish someone could help a layman make sense of this mess. I have been reading the WSJ and watching CNBC trying to have a true understanding. It still doesn’t add up. Listening to Secretary Paulson’s testimony today to the Senate Banking Committee I was even more concerned. It seemed even the smartest guys in the room had a tough task of simplifying the information in a manner even Senators could understand. I have learned that a sign of mastery over information is the ability to explain it using simple concepts. Repeatedly stating that “its complex” is, in my mind, code for: I still haven’t figured this out myself. I feel like the American people are being asked to take a leap of faith. It would be better to understand and move from a base of comprehension rather than blind faith or fear. Am I alone here? Help me understand this better, please.”
As you can tell Mr. Caaballo’s question was posted some time ago as he references former Treasury Secretary Paulson. Anyway, the point of today’s post is to respond to Mr. Caaballo and say:
I don’t understand the tailspin of the financial markets either. No rational answer can be provided to explain the massive (seemingly) overreaction to the Crisis. The only explanation that seems to account for all of the facts is that all sorts of people, from businesspeople to the Average Jane, have overextended themselves financially for too long. These folks and financial institutions were living with very little room for error and as if the perfect conditions of a massive credit bubble were going to continue forever.
The problem with debt, which is the source of all of this mess, is that you have to make regular payments irregardless of your current financial situation. That, of course, requires cash to be on hand. If you have invested all of the debt monies you have accumulated in illiquid assets then you are in a pickle. This would not be a problem if only a small percentage of businesses and individuals in the economy had engaged in this type of behavior. The problem started because there was a massive structure of interlacing co-dependant relationships in place. As long as there was someone out there willing to put new liquidity into the system then a new house or building could be built in the hopes that a rent or capital could eventually be collected, damn whether or not there really was someone specific to fulfill that role. That made both the bank that lent the money originally, or the financial institution that eventually bought the loan, as well as the developer all dependent on cash coming from some source. If the cash dries up, say due to a massive financial market panic and everyone makes a run for the exits, then you have a problem. Does this make sense?
OK, but do you see the problem with this whole situation; and do you see why Mr. Caaballo and I are so confused? Logically, all of these problems should go away if cash returns to the financial markets. So why isn’t there more cash returning to the markets? Because we are dealing with human beings, not machines, and people are scared. The massive problem is that their fear is a self-fulfilling prophecy. They are afraid that they won’t get their money back if they invest it because things are scary and they might lose it, so they don’t invest it and it causes more financial institutions to fail which begets more fear. Etc. Ad nauseum. So what can be done to reverse this downward doom-laden spiral? As regular readers of this ‘ittle blog know, I have made numerous suggestions for how to restore trust. If you agree with this line of thinking then I would love to see some comments in the comments section as to how you feel confidence can be restored. [By the way, this is not a shameless plug for the comments section.] I know some of my regular readers and know that you are smart, smart people and I would looooooove to hear your thoughts.
Big smile to everyone!
Jason
PS – I am sure you have seen the ridiculous stock market gyrations, yes? Pay no attention to them. Instead pay attention to specific news about structural issues, like the bailout plan, changes being implemented at financial institutions, etc. Are those folks doing the right things?
I think that the Obama administration’s plan to digitize health care records, (as discussed in the blog), is an example of something that would help restore confidence. Another (larger) thing that I believe would help is if there were a significant federal investment in sustainable and green technologies. Both of these things would create skilled labor jobs and make for a more efficient use of resources, not to mention changing the environmental paradigm. Also, breakthrough environmental technologies could be exported. All of these things seem like they would help revive the economy. In response to the main question, these steps would restore the public mindset to a more confident one in that they represent tangible and positive change. This to me seems to be the most important thing in shifting people’s attitudes, because so far policy has been repetitive and largely ineffective. No wonder people are still hesitant, it’s hard to see what’s changed.
Hey Trav – Thanks for the comment. I agree with you almost entirely. There is big change afoot in the way that things are done. Many things that were previously considered sacred, such as regulating hedge funds and executive compensation, are on the docket for judgment. That’s a good thing. But, as I am sure you would agree, much still has to change for real change to have occured. Keep them comments coming!
Jason
I think you touched on why nothing is helping. The vast majority of Americans are over-extended. They have no more cash to sink into the system. Those that aren’t over-extended are not going to rush out to spend. Instead they will do it at their own pace.
We have been living under supply-side economics for so long now that we have forgotten that you still need a demand. Consumer’s credit is saturated. They can’t stand anymore. TARP wasn’t/isn’t going to work because people just don’t have the capacity to take on more debt. It doesn’t matter how much the banks free up and are willing to lend if there is noone there to borrow.
We have lived in America with the mindset that housing values and GDP will always increase. There was a perception that there would always be a demand for housing and never realized that eventually everyone (or nearly everyone) would own a home. It seems to me that our economy was built on the same premise as a Ponzi scheme. That being that there will always be either a new investor or someone willing to sink a little more of their personal wealth into the fund.(My guess is that we can equate Congress to Madoff)
I think this lack of confidence is the ultimate realization that we have truly, and completely, messed things up. People are finally realizing that they can’t be lazy any more and that they will now have to work to survive even a modest standard of living. The only way that confidence will be restored is by giving people time to de-leverage. This is ultimately what happened to bring us out of the Depression in the 30’s. Time simply had to pass. It’s time to learn to be patient.
Patrick,
I agree with you in spirit about the U.S. economy being a big Ponzi scheme. Somewhere here in the blog archives I did a posting about what the true underpinnings are of the economy, in general. Real growth is finding ways of using resources more efficiently. Unfortunately, our GDP figures are denominated in dollars and any increase in the dollar value of the economy is counted as economic growth. Yes, this figure is adjusted for inflation. However, inflation only counts if prices go up. Both of these figures overlook the fact that if money is cheap (i.e. interest rates are too low) that certain sectors that rely upon borrowed money for purchases (e.g. real estate) will develop bubbles. The growth in the “value” of houses looks like it has grown and gets counted as economic growth. But, the intrinsic value of the house is still the same as before the pricing bubble developed, right?
So why didn’t we see more inflation? Hard to say, but one very strong, anti-inflationary influence has been China. So much of the crap we buy is produced there and produced more cheaply than virtually anywhere else. Thus, prices in the aggregate (i.e. CPI, or inflation), have not risen. Also, CPI is adjusted by something called “hedonics.” As in, hedonism. This is a controversial adjustment that is made to compensate for increasing value of goods even if their prices stay flat. The classic example of this is the “hedonic” adjustment made for computers. Buy a laptop computer now, or 5 years ago, the price is pretty much between $800-$2,000. While the prices have remained flat, the quality that you can buy for that same amount of money has risen. So the Bureau of Labor Statistics – the folks behind the CPI – try and adjust for that increased value, flat price thang. However, that is more art than science. Not only that, but my problem with the “hedonic” adjustment for computers is that laptops 10 years ago provided you will basically the same computing experience: a word processor and access to the Internet. How many of users really use all of that extra juice?
Thanks for the comment!
Jason