A Vicious Downward Spiral, or How This Economy Is Going To Play Out: Revisited
Back in November, I wrote a brief article describing how I expected the financial meltdown underway to continue, and how I expected it to impact the real economy. In March, I updated the article, looked at how many had come true and added 5 more predictions. It’s been 5 months since our last update and 10 months since the original set of predictions, let’s see how we’re doing. Below I’m reprinting the 15 predictions I made and I’ve put in bold those which have already occurred and added commentary when useful. I have also added 5 new predictions for the coming months.
1) Housing prices and sales will continue to decline. Expect 3 years before the bottom, as a very optimistic best case scenario.
Note: updating this slightly, I expect an average of at least 50% declines in the key markets where the run-ups were largest. Three years is best case, five years worst case.
2) Commercial real-estate will suffer a steep decline as well.
3) Consumer demand will drop. Unemployment will rise.
4) The US will go into a recession at best, a depression at worst. Expect first stagflation (high inflation and high unemployment), both because of the increased price of imports and deliberate pump priming by the Fed, then deflation, as asset prices collapse so hard they take everything else with them. The other likely scenario is stagflation followed by hyperinflation. Formal inflation numbers put out will become not just a joke amongst market-watchers, but amongst the actual population. Same thing with unemployment numbers.
Notes: NBER hasn’t declared a recesssion, but I’m going to go ahead and say that since by every definition except the formal "two quarters of GDP loss" one, the US is in recession, that it is. Especially since official US inflation figures tend to underestimate inflation and thus overstate GDP. Stagflation is more questionable, but certainly we have rising inflation and unemployment, even if it hasn’t reached early 80’s levels yet.
More After the Jump
5) The Asian economies are not going to "decouple", they are going to have their own financial crises and recessions. Yes, this includes China.
6) China’s stock market will collapse some time next year. China will go into a recession. There will be huge amounts of violence and the Chinese government will redirect anger towards the US and Japan.
Note: The Shanghai composite has lost over 50%.
7) Multiple banks will probably go insolvent. They are simply holding too much crap paper. There will be an extreme tightening of consumer debt of all kinds, including consumer loans, credit cards and mortgages. Even people with good credit will start having difficulty getting loans.
8) Protectionism is going to get stronger. Even if Clinton, a free trader, is put in power, by the time the 2010 Congressional elections are over no "free trade" bill will be able to pass Congress and in fact actual tariffs are likely to be put in place.
Note: Haven’t seen that much of this yet, 2010 is where I expect the real sea-change. However the WTO talks failed due to agricultural protectionism.
9) I wouldn’t be surprised, at some point, to see capital controls put in place to stop money-flight from the US.
10) When the full extent of how bad things are hits Joe Public, expect a move for reregulation of Wall Street and to reinstitute something similiar to Glass-Steagall.
Note: Nothing yet. So far the reaction to the crisis has been "socialize the losses, privatize the profits." However, again by 2010 I’m expected this to be much more real. The size of the bailout is going to be much larger than people expect.
11) The government will have to bail out Fannie Mae and Freddie Mac because they are insolvent. Minimum 500 billion dollars. Possibly much more.
Note: Already begun, but the estimate of how much it will cost is stupidly small. It is not going to cost only 25 million, or even 100 billion.
12) Large waves of government layoffs at the municipal and state levels as the inability to raise money cheaply and the reduced property taxes cascade through the system. (Yes, this is already starting to happen, so it’s kind of a safe prediction. But it’s going to get magnitudes worse. Many many municipalities are going to go bankrupt, and many states will be unable to maintain any but the barest of services.)
13) The price of oil will actually drop as there is an actual demand reduction for oil. Don’t expect this to necessarily be reflected in pump prices, which are constrained by refinery capacity.
Note: this hasn’t happened, obviously, although there was a drop recently from a higher level. I’m going to stick with this prediction, however. US demand has dropped, the question now is whether demand drops in emerging markets – both China and India subsidize oil heavily, so those are the key markets. China will cut back after the Olympics, so I’d watch that time in particular.
14) The federal government will become the largest holder of mortgages, and in effect, owner of houses, in the country. By far. The Fed, which has been accepting sub-prime paper already, is going to wind up stuck with a lot of it, because some of the banks using it as "collateral" are not going to survive absent huge government bailouts.
Note: with the bailout of Fannie and Freddie and the Fed’s lending facility accepting CDOs at near face this is well on its way to reality. Arguably could have bolded this, but we’ll wait a bit longer and see if reality sinks in about what the Fed and Treasury are actually doing.
15) A serious collapse of the US stock market, probably by September at the latest. Maybe within a couple months.
16) One of the Big 3 car companies goes under. Then it’ll probably get bailed out.
17) So many countries selling oil in Euros that the dollar is no longer the world’s sovereign currency
18) By the end of 2009, actual reported starvation/malnutrition deaths unless Congress and the new president step in with significant aid. The food banks aren’t keeping up and neither are food stamps.
19) Continued drops in illegal immigration, whether or not the new president continues having them rounded up in large numbers. The jobs just aren’t there for them anymore, especially with the crashing real-estate industry. Many of them made their living as casual construction labor.
20) A huge push to gut entitlements in 2009, no matter who is president. Even if the US quickly pulls out of Iraq, the deficit will be totally out of control, and hundreds of billions will be needed for bailouts. A rapid consensus will form that rather than increasing taxes significantly on the rich, or slashing expenses like the military R&D and equipment appropriations budget, that the real problem is people retiring at 65, poor people getting Medicaid and old folks who aren’t destitute receiving Medicare.
Commentary: Recessions and depressions get bad when vicious spirals really begin. A new vicious spiral for this economic mess is sputtering to life as we speak. New York recently announced that an emergency session would be needed as revenues have guttered while expenses are increasing. New York is one of the early warning signs on this, because of its exposure to the financial industry. In particular notice this delightful bit (h/t Mish):
“Revenues are dropping dramatically,” the governor added. At the start of May, the state budget office projected a cumulative deficit of $21.5 billion over the next three years. Now, just two months later, that estimate has risen to $26.2 billion — “a staggering 22 percent increase in less than 90 days.”
Mr. Paterson offered another example of the rapid deterioration in the state’s finances. In June 2007, he said, the 16 banks that pay the most on their business profits remitted $173 million to the state treasury. “This June, just a month ago, they sent us $5 million — a 97 percent decrease,” he said.
Patterson, as seems to be the habit (Schwarzenegger is threatening the same thing) is declaring that he will try and "fix" this by slashing costs.
Now the way this plays out is this—real estate prices drop. They cause a drop in home evaluations which cause a drop in tax income. Because housing values dropping puts a lot of people underwater on their mortgages, it also causes a lot of folks to default on their mortgages. Increased default rates make many tranches of the collateralized debt obligations (CDOs) which mortgages were based on go belly up. That causes banks and financial firms to either go belly up themselves or to extremely restrict lending at the very least. Reducing lending means businesses can’t get credit to hire new people or do expansions or even to service existing debt. At best that means no new jobs, in some cases it will mean businesses going under and throwing people out of work. Reduced lending also means less credit card debt, fewer consumer loans and so on (Chrysler recently decided to stop doing any car leasing). Meanwhile many people were "taking money out of their homes" and now that their homes are losing value, those lines of credit have become anchors. Many will lose their houses because of them, those who don’t certainly won’t be buying consumer goods on housing credit anymore.
Reduced employment, reduced business investment, reduced consumer credit in all its forms.
These things have a cascading effect—they all reduce spending, whether business or individual spending. Each time spending is reduced, another business reaches the red line and goes out of business, or it has to lay off unproductive staff, or it orders less goods from its suppliers who do one of the two. As all those people are laid off they cause a reduction in tax revenues (payroll, property, income) and they start spending a lot less. That leads to businesses being under even more pressure and the logical thing for them to do is to… cut more staff. I’m sure you see where this is going.
It’s a self-reinforcing vicious spiral. It is, actually, a huge part of what made the Great Depression as bad as it was. Now, the correct response to this is twofold—you clear the private books, and you maintain demand. As Keynes noted over 70 years ago, what that means is that when private actors can’t spend, the government should.
This doesn’t mean boondoggles, the Roosevelt administration had almost no fraud, literally magnitudes less than that which takes place routinely these days. It doesn’t mean not slashing programs—in fact slashing programs which don’t either provide relief or significant demand is very important so that money can be freed up to do other things. And it doesn’t necessarily mean running huge deficits, in fact, at least at the Federal level, it is entirely possible to balance the budget with a series of cuts and tax raises on corporations and the rich (it certainly makes little sense to allow oil companies to reap all the benefits of oil prices increases, since they are not caused by management—unless of course, oil executives want to argue that they were responsible in front of Congress? Hmmmm?)
If instead governments start slashing services and employment they contribute to the vicious spiral, and they do so in an even more pernicious fashion than private enterprises, because many government services tend to be countercyclical. In a downturn more people need social assistance, more people need Medicaid, and more people need police assistance too, as far as that goes. Pulling services when they are needed most makes a lot of things much, much worse.
But, while the Federal government has a fair bit of room to move, state and municipal governments are a lot more limited. That means that in some cases federal aid to states and municipalities, always temporary and tied to specific economic conditions (i.e. ending automatically when tax receipts recover) will almost certainly be necessary. Aid should, of course, be tied to a specific state’s conditions. If California, for example, refuses to get rid of propositions which forbid its state government from taxing effectively, it is not the Federal government’s job to tax the rest of the country to bail out Californians who voted not to help themselves or their neighbours.
And in every state and the country overall it is going to be necessary to increase progressive taxation. The rich have received the vast majority of the gains of the last economic expansion, and indeed of every expansion since the 70’s. The middle class, on the other hand, is literally broke. They can’t afford to be taxed anymore. And taxing the poor is pretty pointless, as well as cruel. The Reaganomics deal, that if the rich got richer, they’d make it good for everyone else, was broken—by the rich themselves. Everyone else hasn’t gotten richer.
Calls for government to slash their way out of this, such as Mish’s incredibly cruel California budget proposal with its suggestion that poor people with liver and heart problems should just up and die, are misguided as well as harsh. They will make the situation worse, not better, and they will do it quickly. Again, this doesn’t mean that no slashing of expenses is necessary. At the federal level I’d personally slash the military budget very heavily, for example, end the Iraq war and end large numbers of other programs, while providing savings by bringing most outsourced jobs back into the government (because yes, private contractors do usually cost more.)
Finally, the idea that government failed and that’s why there’s this disaster needs to dealt with. Government failed because regulatory agencies were gutted and anti-regulatory zealots were put in charge of them. It is laughable to suggest that a company like Fannie is innately flawed and will inevitably fail when it operated since 1938 with minimal problems. Fannie became a problem not because it was a public institution but once its executives started rewarding themselves with huge bonuses and spending tens of millions of dollars lobbying to stop the House from providing any oversight.
Government doesn’t work if you don’t want it to work. Period. For most of the last 30 years the US has been run by people who figured government couldn’t work. Even when a Democrat was sort of in charge, this basic ideology reigned. Glass-Steagall, for example, was repealed under Clinton.
So now the response to companies doing things they shouldn’t isn’t to stop them before they kill again, it’s to wait till the pile of corpses is so large it threatens to suffocate everyone, then remove the bodies at government expense, bailing out the responsible parties (socialize the losses) so that they can kill again (privatize the profits.)
How Bad’s This Going to Get?
Much, much worse. The bottom line is this, most estimates are severely underestimating how bad the situation is. The underlying real-estate market is likely to move as much as 50% down in the key bubble markets. That’s more than is being built into most assumptions. And the structured debt, based not just on real-estate but on interest rate swaps, credit defaults and much more besides, is likely worth even less than that. Because it was leveraged, it will fail at higher rates than the underlying assets. We got two glimpses of this—first when Merrill sold a bunch of CDOs for 22 cents on the dollar (5.5 cents if you count the fact that they loaned much of the necessary money for the purchase)—second when the National Australia Bank wrote off 90% of the value of its conduit loans (h/t Agonist).
Add to this the fact that most profits were booked the year of the sale, but the liabilities can still come back to haunt you if the income stream doesn’t perform, and while executives may have gotten their bonuses booking year, investors and taxpayers are about to find out that when there’s an income stream it really does matter if that stream keeps delivering.
These things interact in a vicious spiral as discussed above, because each time something drops in price it makes further price drops more likely. The end result is that the inverse pyramid of structured debt obligations and other structured securities will keep resting on a narrower and narrower base. It’s not just de-leveraging that is occuring, actual destruction of real wealth at the base is occuring. Each time it does, the leverage ratio increases again, and de-leveraging has much further to go. And, yes, you guessed it, that too is a self-reinforcing cycle.
So take most estimates of the cost of the bailout (usually around 1 trillion) and double them (to two trillion), at least. Expect job loss figures to keep getting worse, and expect years to go of a deflationary/inflationary riptide where the cost of your assets is going down, the value of your wages is going down, but the cost of things you must have and can’t avoid, like food, energy and healthcare are going up. There’ll be ups and down (in particular I expect oil prices to drop, then rise again) but the overall trend will be clear – your fixed expenses in real terms will be going up and your real income will either be going down or not going up as fast as your expenses.
Meanwile, since the monetary base of the US is its housing stock, eventually stagflation will probably turn into generalized deflation. But my guess is that we’ve got till at least 2010 for that fun.
It’s bad. It’s going to get worse. Governments are going to slash at the wrong time and instead of demanding that private actors clean up their books and take their losses, Treasury and the Fed are doing everything they can to aid and abet Banks and Wall Street in covering up how bad the losses are. This will mean years and years of zombie-banks, fictionally solvent, who actually have very little lending capacity. If they are completely bailed out, it will be done at the expense of taxpayers, and probably on the basis of largely regressive taxes, and cutbacks in Social Security, Medicare and Medicaid (this is the current Washington (village) consensus, that "entitlement" programs are the problem—not the debt, tax cuts for the rich, the Iraq war and a bloated military budget.)
What Can You Do?
First of all, remember the iron law: TANSTAAFL. There ain’t no such thing as a free lunch. Every time the Treasury, or Congress, or the Fed bails out some bank or Wall Street or a GSE or someone else remember that it’s your money they’re using. Every cent they spend making sure that no financial executive who made millions isn’t left behind, is a cent they won’t be spending on anything else you care about, and since it’s a cent paid for with deficit money, it’s a cent (or, oh, a trillion or two trillion dollars) that you’re going to have to pay for. And fundamentally, it’s being used to bail out executives who awarded themselves multi-million dollar bonuses for years while running their companies into bankruptcy.
Second, on a personal level—get debt free. Make sure you are on good terms with your spouse, your family and your neighbors. Make sure your friendship circle is healthy. Consider trying to make your home as energy independent as possible or even putting in some energy production (brownouts are going to be more common going forward). Reduce expenses. If you’re in a position to make money right now, do so, because pretty soon you may not be able to. Create a garden if you can (even apartments can have small gardens.) I prefer not to give financial advice, but I will say this: if you live in the US, work in the US, get paid in US dollars, you have more than enough financial exposure to the US. That said, in a real general global downturn there are no obvious safe places to put your money, which is why I recommend the non-financial steps above (especially making sure your marriage is happy. Really. Nothing is worse for your finances than breaking up.)
Third—on a political and social level. Get involved. Get your voice heard at the local level. Be active. There are going to be a lot of people who want to balance the budget squarely on the shoulders of the poor and middle class, who are going to, like Mish, decide that if you need a heart transplant and you can’t afford one, you should die. Outside of die-hard libertarians everyone knows that tax rates are going to go up significantly to pay for the drunken spending and shooting spree of the last eight years, and to bail out all the executives who made themselves rich by driving the economy and their companies into the gutter. The rule here is the same as in poker—if you don’t know who the sucker is, it’s you. And since you, yes you, have been the sucker for the last thirty years, in which time ordinary wage earners haven’t had a single pay increase in real terms, while the rich have increased their income and wealth to gilded age levels, odds are you are the sucker. The rich took the money, but they don’t intend to get stuck with the bill.
So, TANSTAAFL. Every free lunch some executive gets is a lunch they took from you and your children. This is no longer a theoretical argument, this is fact. Because the bailouts are with your money. And I don’t think most of you got rich in the last eight years, did you? But the people who made all the decisions at the firms being bailed out, they did.
So get involved and stay involved. Eternal vigilance isn’t just the price of eternal liberty, it’s also the price of prosperity. Everyone can be prosperous but not everyone can be rich. And the economic collapse happening right now is happening because Americans felt that government was something they didn’t have to watch closely, that it was the problem, not the solution, and that private business didn’t need to be watched like a hawk. They felt that Wall Street making itself sickeningly rich was like some guy striking it rich in the casino "nothing to do with me, Jack". But it wasn’t, and it isn’t, and neither government nor business operated with concern for the public good. Let’s learn the lesson, because we’re paying the price and will keep paying it for years to come.