The “Black Hole” Economy

In many an economic downturn, the media is blamed for dispensing too much doom and gloom, crushing consumer confidence and needlessly delaying recovery time. Now, the opposite is happening. People and media alike want very badly to believe that the old “bubble” economy is just around the corner. But, just like the economy spun out of control due in part to mass financial hysteria, there exists today a collective failure to confront reality. Hey, don’t get me wrong, I would love to return to the days when my phone was ringing off the wall with new business, and people were put on waiting lists.

But I have decided that at this point, the only hope of arriving on a solid footing in some blissful future starts with confronting reality, as bad as that might be, and making the necessary adjustments to the system. In fact, I’m convinced that failure to do so is far more scary than the worst that reality can hold.

The dictionary defines a black hole as “a gravitational field so intense that its escape velocity is equal to or exceeds the speed of light.” That mind-bending explanation aptly describes the Sisyphean task of trying to push the limp economy to recovery by printing money, against the backward pull of everything being devalued or “repriced.” Or, as economist Gary North describes this recovery, “pushing on a string.”

Much of the confusion as to which tool to use for the fix revolves around one key conundrum: will inflation or deflation rule the next decade? Inflation is normally too much money and credit chasing too few goods, while deflation is the opposite. Right now, it seems that the inflationary effect of the Fed printing almost unlimited amounts of money is offset by the deflationary effect of the falling value of just about everything. No one knows how this will play out, although some pretend to.

The big unknowable variable, the one which makes any vigorously-held prognostication an exercise in arrogance, is the proliferation of economic “black holes.” Stability and predictability are the first casualties as these things move through the economy. Here are a few:

Black Hole #1: Debt as Money - The easy money supply which fueled the bubble was driven in part by an ever-broadening definition of “money.” John Rubino points out in a 2007 article entitled Nope, That’s Not Money: “more and more instruments came to be used as a store of value or medium of exchange or even a standard against which to value other things—in other words, as money. Thus, mortgage-backed bonds and even more exotic things came to be seen as nearly risk-free and infinitely liquid... credit gained ‘moneyness,’ which sent the effective global money supply through the roof. This in turn allowed the U.S. and its trading partners to keep adding jobs and appearing to grow, despite debt levels that were rising into the stratosphere. For a while there, borrowing actually made the world richer, because both the cash received and the debt created functioned as money.”

Rubino goes on to state the obvious: debt as money turns out not to be one of humanity’s better ideas. “Hedge-fund traders found out that an asset-backed bond was not the same as a stack of hundred dollar bills.” This huge pool of debt/money is far from being fully wrung out. So pervasive was it, with its tendrils reaching far into the most hidden recesses of the economy, it will be years until we even are aware of how much wealth is “real.”

Black Hole #2: The Job Swap – Between 1998 and 2003 alone, three million manufacturing jobs were lost. At the same time, the trade deficit in manufactured goods rose by $230 billion. It’s not hard to notice this trend, just go to WalMart, China’s sixth largest trading partner. Clearly, globalization has re-arranged a huge sector of America’s economy. We are addicted to cheap goods from Third World countries. I’m not knocking globalization, I think that’s futile. The question is how we address this re-shuffling, and what hand we think we will draw after the cards are cut.

So far, most of the manufacturing jobs have been replaced with jobs in the service industry at about half the pay rate. Whereas Dad was able to support a family working at “the factory” while Mom raised the kids, almost every family with an income over $75,000 now has at least two wage-earners.

There is a big reason why this huge restructuring was not felt in the overall economy in the boom-boom 2000s. The answer lies in an innocuous-looking statistic I pulled up while researching economic trends. In 1990, the “financials” (investment banks) represented 16 % of corporate profits. In 2006, they were 42%. In the 16 years of shipping factories overseas and buying cheap stuff from China, we conjured up a whole new monetary behemoth that fueled corporate profits and the GDP.

That trend probably represented one of the largest re-arrangements of wealth in history – from the middle class to the very wealthy. The resulting income inequality has yet to be addressed, and will be a huge drag on any recovery – there won’t be one until the middle class is comfortable again.

That same statistic highlights another even bigger problem: A substantial portion of the rise in the financials turned out to be just smoke and mirrors. The net effect of taking that manufacturing and replacing it with financial gimmickry is a very large black hole that will be moving through our economy for some time to come.

Black Hole #3 – The Savings Deficit – Just like the proverbial frog in a pot of water that is not yet boiling, we eased into the debt a little at a time, because it felt good. And just like the frog, we didn’t notice the temperature until it was too damn hot.

Debt overload is crippling many companies and many families. As reported in “the Motley Fool,” the economy reaches a tipping point called a “Minsky moment.” That is when everyone tries to de-lever debt at the same time, after the economy has gorged on more debt than its cash flow can bear. It’s named after economist Herman Minsky. Obviously, we need to get past our “Minsky moment”, to reach a point where debt is sustainable.

The consumer debt orgy did not start just recently. It has been rising from the mid 70s, more than doubling since then, to 130% of household debt compared to disposable income. The task of retiring those staggering levels of debt is daunting. The last five quarters, after consumers shut off the faucets, sending the consumer-based segments of the economy into a tailspin, have only dented the debt by a few percentage points.

Getting back to 70s debt levels of 63% is not even attainable. We are finally saving now, rising from negative numbers in 2005 to 4% this year. But it will take 10 years of dedicated saving to get back to the 35-year average of 88%. That means extracting something like $5 trillion from consumer spending during that period. Ouch, that’s going to hurt! (All these figures come from “the Motley Fool”).

These are just a few of the black holes. I’m sure there are more. They are not going away. The easiest thing to do is re-heat the economy and deal with them another day.

To use the admittedly simplistic analogy of a sinking ship, in the long run we’d be far better off by mending the holes than furiously bailing incoming water. True, we have to bail enough water to buy enough time to mend the holes (especially black ones). Right now, we are not even discussing the holes or the mending. Given our three-decade history of entitlement thinking, we will probably just keep bailing and hope for the best. But I’m hoping we deal with the black holes, so that the economy we pass on to our children is not just another train wreck in the making.

Doug Friesen July 20, 2009

We Won’t Get Fooled Again

President Obama’s new regulatory reforms are weak and ineffective, and they will do almost nothing to rein in the worst excesses of Wall Street. That’s the charge being leveled by a wide variety of business commentators, and even by legislators in Obama’s own party. The only constituency that likes the reforms are the bankers. They should, they may as well have penned them. Is this “change we can believe in?”

The plan is still sketchy, but the details revealed so far paint a picture of a President no less in the pocket of big banking than any others have been. This is not why my wife was out on so many early mornings holding Obama signs on highway overpasses. In announcing the new regulatory scheme, Obama starts off by chiding “a culture of irresponsibility (that) took hold from Wall Street to Washington to Wall Street.” But right away he gets all wishy-washy and talks about how the regulatory system was “overwhelmed by the speed and sophistication of a 21st century global economy.” The implication is that no one was really to blame.

As award-winning writer and author William Geider puts it: “That is not what happened, to put it charitably… The regulatory system was not overwhelmed by historic forces. It was systematically gutted and dismantled by the government in Washington at the behest of the banking interests. If Obama wants details, he can consult his economic advisors--Summers-Geithner--who participated directly as accomplices in unwinding the prudential rules and regulations. Cheers were led by the Federal Reserve with heavy lifting by both political parties.”

In his June 19th piece in The Nation, Geider goes on to say how similar this is to stumbling into Iraq with false CIA telemetry and then claiming “hey, we were all fooled.” Just like Iraq was premeditated ideological adventurism, with facts on the ground ignored and/or distorted to fit that ideology, this meltdown, and the official response to it, is robber barons plundering the nation under State protection.

The biggest problem with the new regulations lies in giving much of the power to the Fed. At a time when more and more people are questioning the murky and secretive nature of the Fed, and its outsize role in manipulating money for the benefit of the wealthy elite, it hardly seems a good idea to make them the watchdog of Wall Street. As Geider says, “give the mess to the Wizard of Oz, the guy behind the curtain.” 230 House members have endorsed a measure to audit the Fed (this has never been done). Even Nancy Pelosi has said “The American people want to know more about The Secrets of the Temple,” which was a good plug for Geider’s book of the same name, about the Fed. Chris Dodd (D-Conn.) likens trusting the Fed with more regulatory power after their complete failure to stop out-of-control greed, to “a parent giving his son a fast new car after he just crashed the family station wagon.”

This “irresponsibility” President Obama keeps talking about, as if someone was naughty and needs a good talking to, is fraud and corporate crime, pure and simple. The cure for that irresponsibility is to crack a few heads and send some of the worst offenders to prison. It is not as if it’s a mystery who they are.

This notion of responsibility is at the heart of what’s wrong with most everything. Responsibility has to start with a detailed, in depth understanding of everything that led to the breakdown, something that has been scrupulously avoided. At the risk of being repetitive, building a new stable economy without really understanding what happened to the old one is nonsense, and dangerous nonsense at that. Steven Pearlstein at the Washington Post mocks the new regulations as “not being grounded in a thorough and independent analysis of how the crisis was allowed to develop and what regulators did and didn’t do to prevent it.”

Securitized mortgages were at the heart of the meltdown. Wall Street was able to bundle junk, collect a huge fee, and pass the mess on to unsuspecting investors. New regs would require the originator to retain a 5% stake. That will not make them responsible. 50% would.
Glaringly missing are any new controls of hedge funds, private equity funds, structured investment vehicles, derivatives, or credit default swaps. Some of this stuff is only dimly understood, even by the people that trade them, and still represent a potential cloud of doom hanging over the economy.

The only bright light is the new consumer protection agency to control Wall Street’s predatory behavior. Ironically, some House member, I can’t remember which one, but a Republican, got up during the debate and decried that cracking down on the credit card companies would raise the cost of credit to consumers. Elizabeth Warren, Harvard Law Professor, head of the Congressional Oversight Committee on the bailout, and the one brave and brilliant high-profile critic of Wall Street out there today, laughs about that. “So the only way these companies can survive is to con and trick their customers?”

Wall Street warns against new excessive regulations stifling the fragile recovery. But what has really changed that would cause us to think a recovery is around the corner? As John Carney writes in the Business Insider, “the financial sector faces almost all the same challenges it did last autumn—uncertainty about profits, outdated business models, heavily leveraged balance sheets, self-dealing, short-term thinking by bonus-hungry executives, ineffective regulation and—perhaps most of all—a huge amount of credit assets of extremely questionable value.”

In as much as I was cheering the downfall of the Bush Jr. administration, what most presidential historians are now calling the “worst presidency in US history,” I didn’t think it would involve such a complete evisceration of the Republican party. Now I’m lamenting the lack of an opposition with any gravitas. And as Frank Rich, New York Times columnist writes, “That’s a double-edged sword for Obama.”

The fact is, nothing much has changed on Wall Street. The SEC has charged Angolo Mozilo, (Countrywide CEO) with insider trading, but that was a no-brainer. The revolving door between the SEC, Washington, and the boardrooms of Wall Street is as greased as ever. The rating agencies are still being paid for ratings by the companies they rate. Eric Dash writes in The Times “It is as if Hollywood studios paid critics to review their would-be blockbusters.” The CEOs are not in retreat, they are re-grouping and re-branding (AIG is now AIU).

To paraphrase Frank Rich writing in the New York Times, the “hope” phase of Obama’s presidency is now evolving into the “change” phase, and we won’t be fooled again. Even if these new porous regulations permit another meltdown a decade hence, Obama might still look pretty good. But if, in the shorter term, the economic quality of life for most Americans remains unchanged as the financial sector resumes living large, he’ll face anger from voters of all political persuasions.

Doug Friesen
July 5 2009