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    Posted November 1, 2008 by
    hrtschudi

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    economic stimulus (1): the disabled consumer

     
    Panic is a terrible advisor. America's leaders need to think clearly and take note that their "expert" advisors are divided, unsure, and shocked about the unprecedented changes that are taking place in our economy. A high profile example of that helplessness is the Nobel Laureate Paul Krugman's article in the nytimes, Oct. 31, "When consumers capitulate". He argues that the consumers are changing their behaviour and tightening their belts because of their newly found "sobriety". He thinks that individual virtue leads to public vice. Further, he outlines that the Fed's cut in interest rates has become irrelevant. I have a hard time believing that the consumers have "smartened up". They love spending. We all do. If we are in a position to spend, unless there are some important incentives in place, we spend rather than save. Alright, granted, America has been living beyond its means for a couple of decades now. Consumers, businesses, and governments have been spending on credit bringing about market bubbles in homes, stocks, derivatives, and other assets. More importantly, it has created a debt trap that threatens to close as soon as growth halts. Including mortgages, the average American household owes around $120'000 spurred by low interest rates. The overall consumer debt is about $2,5 trillion. That's a LOT of credit. Or is it? Let's argue that the average interest rate on $120'000 is 7%, which would translate into a monthly interest of $700. Never mind the principal for the moment. A consumer has possibly been able to afford that with an average income of $3600 per month. That's just under 20% of income, and does not sound all that bad. So, in average, Americans should actually be financially sound and they could possibly increase their monthly interest load by $380 and still be sound. At 7%, that would finance up to $185'000 until the consumer would be "maxed out". If we reverse the argument and increase the interest rate to 10%, then the monthly load is $1000 and the average consumer is almost maxed out. If we factor in the reality that the real wage of our sample consumer has actually fallen by about $250 per month, everyone can quickly understand what the situation is that many are in. The consumer is over-extended and has nowhere to go to put out the fire. In 2004, the Fed started pushing up interest rates in the erratic assumption that it had to fight inflation. What it did, however, was maxing out a large portion of consumers very quickly. About $500 billion fixed rate mortgages turn into the more expensive floating rate mortgages each year and those that were already floating and/or financially tight, stumbled fast. Delinquencies rose sharply, home foreclosures skyrocketed and the financial system (through its derivative credit default swap casino) faced a serious liquidity crisis that is far from over. As long as real incomes rose and interest fell, the house of cards could be built ever higher, as soon as income fell and interest rose, it started to collapse. The various bubbles and the economy were unprepared and unprotected from the fallout of a substantial interest rate increase. Wage inflation would have been what was needed instead. As a newly found "virtue", as Krugman would term it, banks have stopped the "no-money-down" approach to mortgages. Homeowners can't finance more than 65-80% of the home value, and other loans are under prudent scrutiny before being approved. This new approach is a "healthy" approach to credit. However, the changed credit assessment translates into first time homebuyers being locked out of the market until they are able to afford 20% to 35% of equity. For debt-free Americans, that translates to more than half a year's salary of equity building before even thinking of financing a $120.000 home. Let's assume that the average American, during the next 4 years will either build that equity or drive down debt at a rate of $500 a month in order to either build the equity needed or drive down debt to below $100,000. That translates to 14 % of less economic consumer activity from that group. Trouble is that the average American added about $500 a month onto the principal owed. Thus, that part of spending on credit will disappear altogether, which translates into a whopping 27% loss in total economic activity. In other words, the consumers have not capitulated from spending, they never will. Instead they have been DISABLED from spending, and that is what's fundamentally different from any recession or downturn that we have seen in the last decades. In the past, consumers kept on spending through bad times. The banks (and investors) have fundamentally shifted how credit and assets are valued to a healthier, more prudent way, from an irrational "free credit for all" attitude. Instead of spending, consumers will now have to shift their focus on SAVING. The catch is that consumers need to drive down debt and negative home equity first before accumulating new wealth. Alan Greenspan calls it "replenishing depleted assets" into form of 401s and homes. The 401s create an economic tsunami on their own. Retirees will probably be forced to cut down half or more of their expected lifestyles. That is 1 out of 4 economic contributors. Thus, we look at dire numbers, probably more than 10% economic fallout from this group alone. Combined with the above numbers of the average consumer, the next 4 years will see a persistent contraction of at least double digit numbers. That is not factoring in the massive income contraction to be expected in the wealthier segments. Without measures that are addressing the income/cost gap swiftly, we can expect an economic downturn that will show a sharp rise in unemployment within just a few months, even lower home prices and more foreclosures, significantly lower stocks, a rapid contraction of retirement funds, and a collapsing derivative market. No matter what actions will be taken, we will also see the Federal Government's deficit ballooning to over $1 trillion in 2009 and practically all state governments in need for large scale bailouts (compared to the Federal Governments budget for 2009, individual income taxes will fall short by at least 20%, corporate income taxes by 50%, Social Security/Insurance income and the rest by 20%). This crisis requires fundamental rethinking of how to address the economic downturn, which I expect to be excessive for 2009 through 2011. The Fed says that a stimulus needs to include measures "to help improve access to credit by consumers, home buyers, businesses and other borrowers." The prescription reads like giving the addict another shot. I don't think that expanding credit is the answer (if the banks would turn another blind eye, it might work for a while, though, they won't). Stabilizing credit and addressing the income/expense gap is the smart approach. However, Tax cuts here and there are insignificant and insufficient to address a change from credit spending to equity building. In particular, cutting business taxes, for what they even matter, is doing nothing to address the root cause. The consumers are disabled. They need to be enabled to spend without increasing credit - and I am certain that they will come back and spend. How to get the consumer back to spending is addressed in my next article "focus on income and equity". This article is part of a series of articles focussing on what local, state and federal governments need to do now in order to address the upcoming economic Depression. economic stimulus (1): the disabled consumer at http://www.ireport.com/docs/DOC-132064 economic stimulus (2): focus on income and equity at http://www.ireport.com/docs/DOC-132067 economic stimulus (3): quarantine risk at http://www.ireport.com/docs/DOC-132200 economic stimulus (4): sweep up the unemployed at http://www.ireport.com/docs/DOC-132202 economic stimulus (5): bailout state governments at http://www.ireport.com/docs/DOC-132205 economic stimulus (6): protect food and energy supply at http://www.ireport.com/docs/DOC-132795 economic stimulus (7): invest into the future at http://www.ireport.com/docs/DOC-132856 economic stimulus (8): be globally the most competitive at http://www.ireport.com/docs/DOC-133022 economic stimulus (9): change politics at http://www.ireport.com/docs/DOC-133026 economic stimulus (10): prepare for budget cuts at http://www.ireport.com/docs/DOC-133113 Please comment. I will try to address questions, if I can. H.R. Tschudi, economist and entrepreneur, Vancouver

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