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