Monkeys spend all their time picking bottoms, OK? And I refuse to pick bottoms because I don't live in trees
—Hugh Hendry taking questions on CNBC, April 28, 2009
A fish doesn't know about the water it swims around in
—variation on a old saying
I have talked about the FIRE economy (Finance, Insurance and Real Estate) on several occasions in this column (Harpers, February 2008). iTulip's Eric Janszen invented this apt metaphor. Today I will explain why such an economy is an aberration which must be dismantled if the United States is to have any chance of a sound recovery.
Last week I presented the Goldman Sachs/High Speed Rail scorecard, which showed that the capital funneled through AIG to its bank counter-parties far exceeds the capital that will be devoted to studying (not building) new high-speed rail systems.
I want those trains because I like trains and they would reduce our oil consumption. If we are to prevent such travesties in the future and build some actual trains, we need to understand the predicament we are in and why we need to extricate ourselves from this mess as quickly as possible. So this article is really about answering the question when am I going to get my trains?
I also want to squash this "glimmers of hope" notion making the rounds. Here is The Economist talking about hope and the dangers of optimism.
The rays are diffuse, but the specks of light are unmistakable. Share prices are up sharply. Even after slipping early this week, two-thirds of the 42 stock markets that The Economist tracks have risen in the past six weeks by more than 20%...
But, welcome as it is, optimism contains two traps, one obvious, the other more subtle. The obvious trap is that confidence proves misplaced—that the glimmers of hope are misinterpreted as the beginnings of a strong recovery when all they really show is that the rate of decline is slowing. The subtler trap, particularly for politicians, is that confidence and better news create ruinous complacency. Optimism is one thing, but hubris that the world economy is returning to normal could hinder recovery and block policies to protect against a further plunge into the depths.
Regarding the United States, even cautious talk of an economy returning to normal, let alone beginning a strong recovery, is utter nonsense. A return to previous "normal" conditions would recreate the same disaster that got us into this mess in the first place. Anticipating the BEA's preliminary GDP number for 2008:Q1, Marketplace raised the possibility of another jobless recovery like the one in the early 1990's or earlier this decade in 2002-2003.
Anemic but positive GDP growth could come in the third or fourth quarters, but most economists don't expect the unemployment rate to peak until sometime next year as the economy struggles with another "jobless recovery"...
[Note: Jobs are now said to be a "lagging indicator", meaning that the last thing that happens in a "recovery" is jobs creation. The U.S. will likely hemorrhage jobs throughout 2010. ]
The best aspect of the GDP report is likely to be consumer spending, which is expected to increase slowly after plummeting at a 4% annual rate for six months. Consumers got a huge boost in their after-tax incomes during the quarter amounting to about $200 billion from large tax refunds and cost-of-living adjustments, according to economists at Barclays Capital.
Heavy job losses are also weighing heavily on consumers, who are trying to pare their expenses, pay down their debts and build up their savings. Small increases in spending are the best we can hope for this year, economists say.
[Note: The BEA's advance estimate of 2008:Q1 real GDP is now in. Output "shrank at an inflation-adjusted 6.1% annual rate in the first quarter" according to the Wall Street Journal's Hopeful Signs Seen In GDP's Fall (April 29, 2009). The "hopeful signs" include a drawing down of inventories and a very slight (2.2%) rise in consumer spending compared to the 4.3% decrease in 2008:Q4. Tell the bank you want to make your mortgage payment with "hope."]
Do I really have to say that another "jobless recovery" is not a recovery? I guess I do. Ridiculing such ideas still doesn't get to the heart of the matter. No return to a sound economy occurred, jobless or not, after our well-deserved recession following the crash of the Dot-Con Bubble. There was merely a postponement of something approximating current economic conditions accomplished by means of the Housing Bubble, which has been far more destructive to wealth than monies lost from investing in dogfood.com. Janszen described it this way—
Nowadays we barely pause between such bouts of [bubble] insanity. The dot-com crash of the early 2000s should have been followed by decades of soul-searching; instead, even before the old bubble had fully deflated, a new mania began to take hold on the foundation of our long-standing American faith that the wide expansion of home ownership can produce social harmony and national economic well-being...
Only in an economy dominated by finance and real estate would signs like the recent stock market "rally" or 1st quarter bank "profits" be regarded as pointing to eventual "recovery" while ordinary Americans remain down for the count. And it will take many years for them to get off the floor. A $200 billion bribe in the form of "tax refunds and cost-of-living adjustments" does not even begin to address the huge debt and wage problems in the United States.
A FIRE economy creates, promotes and requires ever-growing debt to achieve "growth." Banks make money on transaction fees and interest on loans. Insurance companies take large, growing monthly payments, especially for soaring health care costs. Lots of self-interested parties get a healthy cut whenever a house changes hands and a new mortgage is underwritten. College tuition is also rising at over twice the inflation rate.
It's all about debt. I give you Exhibits A and B.
Figure 1 — Total U.S. debt as a percentage of GDP. The orange circles show specific data points. The graph is from John Mauldin's The Great Experiment. Debt levels in 1933 (at the height of the Great Depression) were surpassed in 2003.
Figure 2 — X marks the spot. The lines crossed in 1995. As savings declined in the period 1982-2007, household debt soared. Source.
The technocrat in charge of managing the "recovery" is Lawrence "Larry" Summers, who led efforts to oppose regulation of credit derivatives in the finance industry in the late 1990's. Summers outlined the administration's goals in a recent speech.
... and therefore the essence of the economic policy challenge is at the specific level to counteract the vicious [deflationary] cycles and turn them into virtuous circles. And at the broadest level to replace a spiral of growing fear with a more positive spiral of increasing confidence. If at the broadest level level the problem two years ago was that there was too much greed and opportunity seeking and too little fear, the problem today is that there is too much fear and too little seeking of opportunity. and so it is the very paradox of crisis, and especially of crises associated with de-leveraging, that the very behaviors that one most wanted to discourage to prevent the bubbles that led to to the crisis are the very behaviors — spending, borrowing, investing — that one needs to promote an expansion. It is this insight, this view, that in essence undergirds the policy program that has been undertaken in the United States, and while no doubt it would be expressed in different ways ... it is the need to stop vicious cycles associated with de-leveraging that is essential to a policy response to a crisis like this...
[Note: Virtuous circles? Of what? More debt? Also read Simon Johnson's commentary on the speech.]
It is remarkable, but not unexpected, that Summers can not understand or accept that Americans are now considerably over-leveraged as it is and are now sensibly trying to spend less, save more, and pay down their debt, a situation which promotes a deflationary trend that was reflected in the March, 2009 numbers. Apparently Summers (and by extension Obama) want Americans whose jobs are under threat to buy more stuff they don't need or can't afford by instilling in them some unwarranted confidence. This position—buy more stuff or we're all gonna' die—has been called the paradox of thrift.
How did we into a situation in which what is good for Americans (saving and paying down debt) is not deemed good for the American economy? How did it come to pass that the term "jobless recovery" entered the techno-jargon of our economic experts?
Let's talk about real wages over the last 30 years, the role of the FIRE economy and the steady erosion of the Middle Class.
The FIRE Economy Rides to the Rescue
Eric Janszen describes how the FIRE economy works in his Harpers' article The Next Bubble, so I will not review that material other than to note that the principle goal of such an economy is to blow and profit from asset bubbles.
FIRE is a credit-financed, asset-price-inflation machine organized around one tenet: that the value of one’s assets, which used to fluctuate in response to the business cycle and the financial markets, now goes in only one direction, up, with no more than occasional short-term reversals.
I want to tell the same story from the point of view of American workers. A simple, compelling narrative emerges from the next two graphs.
Figure 4 — Average weekly earnings since 1970 in 1982 dollars. From the BLS.
You can see that 1) the net worth of households regained its historical level of about 350% of GDP in the mid-90's but then soared twice during the bubble & crash cycle; and 2) average weekly earnings fell precipitously in the late 1970's/early 1980's and has floated around its 1982 level since the late-90's.
I hesitate—no, actually I am delighted!—to quote Rick Wolff, a Marxist professor of economics at UMass Amherst, to tell us what happened.
Real wages in the US rose during every decade from 1830 to 1970... No comparable steady rise in real wages has occurred since...
Stagnant or falling real wages undermine workers' basic expectations of rising levels of consumption. Those expectations had become key parts of what it meant to be "an American." Rising consumption has long functioned as the evidence of success in achieving the American Dream. When, after the mid-1970s, real wages no longer allowed for rising consumption, wage-earners turned, with growing urgency, toward other ways and means to maintain rising consumption...
In one "solution" to counteract the problem of shrinking real wages, many families sent more members out to work more hours... A second "solution" -- when longer work hours did not generate enough money to increase consumption -- was to borrow. Multiple credit cards per family and increasing mortgages added to vehicle financing to generate historically unprecedented levels of total consumer debt across the last 25 years -- and especially since 2000.
One need not be a fan of Das Kapital to understand these simple truths. In fact, all you need to be is an American worker of sufficient age to have lived through it all. I am not so much interested today in the many malignant causes of stagnant wages over a 25 year period as I am in relating this hardship to how Wall Street prospers when Main Street does not.
The allure of easy wealth glitters very brightly if your wages have not kept up with inflation for over two decades while two principal wage earners struggle to support the household where once—a long time ago in a galaxy far, far away—one would do. The bubbly asset inflation created by the FIRE economy (as reflected in Figure 3) gave Americans the illusion of increased wealth, which spurred unsustainable levels of consumption in the period 1995-present.
It is perfectly understandable why cash-strapped Americans, given the escalating value of residential properties, speculated in real estate, bought houses they could ill afford—and received the mortgage interest tax deduction in doing so—took on second mortgages or withdrew money from equity as you would draw on your checking account at an ATM machine.
FIRE interests also did their part for penurious wage earners still hoping to live the American Dream by extending easy credit in the form of credit cards, student loans, "liar loan" 1st mortgages, 2nd mortgages, home equity loans—you name it. Add to these the pointless loans for already over-built commercial real estate development. You can see where credit goes in Figure 5.
Figure 5 — FIRING UP the economy. From Calculated Risk's early report on government stress testing for banks. Note the relative size of residential mortgage + home equity + commercial real estate + credit cards (taken together) as opposed to commercial/industrial loans. The numbers cited are for potential losses, but the absolute sizes can be calculated by using the loss numbers and the percentages.
You can easily see in absolute terms that the lion's share of loans are forms of consumer credit (or financing for commercial real estate) as opposed to "productive works" that might support new manufacturing, urban re-development & mass transit, smart grids, wind farms or even those new high-speed rail systems that the Department of Transportation will think really hard about.
The FIRE economy "rode to the rescue" of poorly compensated American workers by filling up the 25-year income gap with easy credit and after 1995, inflated asset values in stocks and housing. Such an economy is parasitic in the sense that it fuels and feeds off of much greater borrowing & spending than would be warranted by traditional—antiquated?—measures like real wages, debt and savings. It did not matter whether Americans were credit-worthy—FIRE doesn't care. But in the end, it always matters.
I'll sum up with an example of the FIRE in action. As usual, the Federal Government is conniving in the farce. The newspaper blog Opinion LA is all over it.
The original Making Home Affordable program, which the Treasury Department announced earlier this year, enabled more troubled borrowers to refinance their Freddie Mac- or Fannie Mae-backed mortgages. It also provided subsidies to encourage lenders, loan servicing companies and borrowers to agree to temporary loan modifications that reduced monthly payments to 31% of the borrower's income. But the program didn't do anything about second mortgages, nor did it address many troubled borrowers with loans that were deeply underwater (that is, their homes were worth 95% or less of the amount they owed).
[Note: This last condition is called negative equity.]
One of the new features announced today would enable borrowers with second mortgages -- a situation that describes about 50% of those in danger of foreclosure -- to get a temporary cut in interest rates on both their loans... This initiative addresses two problems with the loan modification program: the need to pay off a second loan made it impossible for some borrowers to afford their homes, even with a steep reduction in the primary mortgage, and the refusal by some lenders holding onto first mortgages to accept lower monthly payments as long as the second mortgage holder kept collecting the full amount.
Wait, there's more. Bloomberg reports that—
Fannie Mae and Freddie Mac mortgage delinquencies among the most creditworthy homeowners rose 50 percent in a month as borrowers said drops in income or too much debt caused them to fall behind, according to data from federal regulators.
The number of so-called prime borrowers at least 60 days behind on mortgages owned or guaranteed by the companies rose to 743,686 in January, from 497,131 in December, and is almost double the total for October, the Federal Housing Finance Agency said in a report to Congress today.
Of all borrowers who ended up in default, 34 percent told Fannie and Freddie they were earning less money, about 20 percent cited excessive debt as a reason for missing mortgage payments, and 8.1 percent blamed unemployment, FHFA said.
Here are some details on subsidies for lenders from the Washington Post's Foreclosure Prevention Plan Expanded to 2nd Mortgages—
Under the new plan, lenders would receive $500 for modifying the second mortgage [or home equity line], plus $250 a year for three years if the loan remains current. The borrower would be eligible for $250 a year for five years to lower their principal balance. The borrower could have the interest rate lowered to 1 percent, depending on the type of loan, with the government sharing the cost of the rate reduction.
Bribe lenders to refinance second mortgages? People are underwater, they're drowning. There's a pretty serious underlying issue here that Larry Summers won't acknowledge. Larry, do you think there might be a catastrophic wage & debt problem in the United States? Ya' think?
Let It Burn
When will I see those high-speed rail lines? And the answer is: not for a long, long time. When assets deflate, debt remains. I discussed this in my article The Kiss of Death referenced in Figure 3. And there's no new bubble on the horizon to FIRE up.
In an interview back in September, Bill Moyers asked Kevin Phillips what he thought we should do about our predicament.
KEVIN PHILLIPS: ...So I think what we're looking at here is an attempt really like a drunk will feel better and get over his hangover better sometimes just by having more liquor. And I think what we're seeing with the actions of the Federal Reserve Board is the people who are the arsonists, the people who pumped it all up, who blew up the bubble are now racing to show up in firemen's hats and say, "We're gonna solve it. We're gonna take care of all this. Oh, and by the way, we're gonna keep pumping in the gasoline that we pumped in before that made a good flame." But, you know, nobody knows that.
BILL MOYERS: Are you suggesting that the best thing to do is let the house burn down and build it over again?
KEVIN PHILLIPS: I would say, first of all, you never should have blown the bubble this way. If we could invent a time machine and go back and cure it that would be the best economics of all. Having blown it up, I think the case is that they should have accepted more of the tough medicine beginning last year and not tried to rescue every stray tentacle of the financial octopus...
Janszen's FIRE metaphor brings so much to mind—a conflagration, something burning out of control, too much smoke (and mirrors). The politicians and the technocrats have the hoses out, and they're showering vast amounts of water (money) on the FIRE in a futile effort to put it out. This country needs good paying jobs in manufacturing again. So-called "consumers" should be encouraged to pay down debt and save. The Middle Class desperately needs a revival. Health care costs must be extended and brought under control. A college education must be affordable again. Accomplishing all of this will take at least a decade. As for the FIRE economy, I say Let It Burn.
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