Feedback Loops of Doom III:

Retail, Downtowns and Cash-Strapped Cities


How many of you have looked at a book, CD, camera, etc. in a "bricks and mortar" store and then gone home and ordered the item online? Everyone with a computer and Internet access must have had this experience. There are plenty of reasons: the store didn't have the model or color, the price online was much lower, or the fun of browsing on eBay exceeded the fun of driving to the mall.

The problem, as we all know, is the revenue model of cities and local government is still based on "bricks and mortar" retail. It's wonderful that an entire eBay economy has sprung up, but most eBay transactions do not include sales taxes; nobody wanders "next door" for a cup of coffee after transacting the purchase, either.

I have addressed the overbuilding of Mall-USA here before, and readers have sent in reports on the empty retail spaces which remain empty in downtown/urban-core districts. Readers are also aware of the Pareto Principle, which suggests that the "the vital few" (20%) influence effects more than the "trivial many" (80%). This introduces the notion that when 20% of a downtown area or retail mall becomes vacant, a downward spiral of lower traffic and sales might begin.

There are several inter-related factors at work here. One is the death of the "downtown" deprtment store, which has been replaced by a Wal-Mart, Target or mall in the suburban periphery.

Another is specialization: where you once went to a department store to buy bath towels, now entire vast stores are centered around the premise that there can never be too many choices for towels, bathmats and other bathroom gewgaws.

We might also add the consumer's embrace of poor quality. Why spend more for a BBQ grill which might last a few seasons, when a cheap. poorly made one is half the price? Never mind that on a strict cost-analysis basis the cheap shoddy grill is a waste of money and much more expensive than the Weber when you factor in the cheap one must be replaced annually, and the rusted old one transported to the landfill; Americans live more or less in the present, and they have no demonstrable desire to calculate anything but their current credit car balance and checking account balance. (For proof, please consult the U.S.'s negative savings rate.)

Perhaps most troubling, people are abandoning entire "real world" retail activities which once anchored vibrant retail areas. Top of the list of course is independent bookstores; not only do Americans not read much anymore, they also seem to have lost the ability to enjoy browsing for physical books--especially those under the age of 40.

Cody's Bookstore in Berkeley to embrace Internet after former owner steps down

"The company is considering a range of changes aimed at adapting to today's era of Internet and chain store competition.

"The new Cody's will have to adapt to the online market and attract new people because our current market is graying," said Galoob, 30, who joined Cody's as its controller in autumn and was recently promoted.

"My vision was of how Cody's on Telegraph was in the 1980s - a great intellectual bookstore," Ross said. "Anything that was intelligent, we could sell. It really worked in the '80s but it doesn't work now. Young people aren't coming in. They aren't reading the way they were. People don't have the patience to sit down with a 300-page novel or a 500-page work of history when they are used to getting information from Wikipedia.

"Cody's needs to reinvent itself, and I can't seem to get out from under this beautiful vision that isn't working right," Ross said. "It needs a new way of looking at things."

Will wi-fi and online ordering lure young Americans back to bookstores? Will they ever actually buy a book at the store, or will they just buy a coffee and spend two hours IM'ing their friends? It's an open question.

Even for people who read a lot, it is not an easy issue. I like browsing in used bookstores, but the fact remains you can more easily locate the used title you seek online. If you want a new book, it is always cheaper online, and you needn't stir from your house to order and obtain the book.

This phenomenon is not limited to bookstores or the U.S. The last time I was in Paris (2004) visiting my brother, as we went about his business he pointed out empty corners which had until recently been cafes or bistros. He commented that people didn't go to cafes as much now, but went home to log on and "interact" online.

Rising taxes and steep rents don't help much, either.

But rather than focus only on these negatives, let's ask: what retail stores can thrive in an era of extreme Internet competition and mall-based specialty chain stores?

Here is an incomplete and not-at-all-comprehensive list based on my own observations:

1. Bicycle shops (new and used both). Large, heavy bulky items like bicycles cost a lot to ship, and most people would still prefer to ride the machine a bit before deciding to plunk down hundreds of dollars for a bike which depreciates 25% the second they buy it. Riders without tools and/or skill still need someone to fix flat tires and rehab bikes, so a thriving repair business is also possible (winter reduces this in northern climes, of course.)

2. Stationary/paper goods. It isn't worth the shipping costs to buy stationary online, and most people still prefer to select wrapping/gift paper, cards, etc. in person.

3. Ethnic groceries and restaurants. Any survey of vibrant urban business districts will soon reveal that in many cases, the busiest areas are those with halals, Hispanic ("Mexican") grocery markets, tacquerias, Asian, Indian, Pakistani and Mideast restaurants, etc. If I were to choose what would anchor a decaying downtown district, I would choose multi-ethnic groceries and restaurants, hands down.

4. A decent bakery. You can't order croissants over the Internet (any worth eating) amd bread is so abysmal in the U.S. that a real bakery will always have a market and be a draw.

5. Farmers markets/outdoor food stalls. Any traveler to Asia who strays from the 5-star hotel will notice streets bustling with vendors and sidewalk food stalls--and lots of customers. (Bangkok is especially instructive, but many other cities around the globe contain the same street-based energy.)

But for these businesses to knit together into a vibrant urban district, policy and regulations have to change. If cities try to increase tax revenue by leeching more off the existing real-world retailers, they will only exacerbate the trend to empty storefronts and closed businesses.

What's needed are these policy changes:

1. Small-business friendly city agencies that aren't out to strip off all profits via taxes and fees. Permits should be dirt-cheap, not skyhigh; renovations should be approved in a day and expedited by courteous staffers at every stage.

One of our friends owns a restaurant here in Northern California (tax, fee and regulation capital of the world, until proven otherwise). Moving one wall and adding a walk-in cooler required permits which cost thousands of dollars--more than the renovations! And the permit process was absurdly arduous, painful and slow, requiring multiple plan-checks (each one costing hundreds of dollars, of course) and weeks of wasted time.

Note to cities: if you want to destroy all taxpaying businesses and go bankrupt as a result, by all means keep on this path.

2. Enable and encourage street vendors. There is a restrictive health and bans outdoor food service, etc. Yes, all of this might have made sense in 1911 when disease was rampant, but you're now just as likely to pick up a disease from factory-packaged meat as from a street vendor selling tacos. Yes, care must be taken when preparing food; but not all Americans are so squeamish as to fear anything which isn't triple-wrapped in plastic.

3. A tax/revenue system which has adapted to the realities of the Internet, malls and eBay. If cities want any retail to survive, they need to stop burdening the survivors with ever-more taxes and regulations, and seek revenue streams from the competition, i.e. eBay and Amazon et. al. This may entail Federal/state regulation, which of course the online retailers will fight; but online retailers have to recognize the reality that they owe the same cut to local government as every brick-and-mortar store located within city limits.

No city can prosper by leaning ever more heavily on the remaining "real world" retailers, especially when the recession kicks in and reduces sales across the board. Taking small business for granted is a surefire way for cities to guarantee their own bankruptcy.

Public unions would be very well served by a campaign which encouraged and supported an increasing tax base for their municipality, and a municipal code of conduct for staffers which treats small business taxpayers as the boss and city staff as the helpful employees, not the other way around.

As noted here yesterday: cities, counties and government agencies can and will go bankrupt; The courts will strip off "guaranteed" pensions and other "ironclad" benefits from their employees because the money's simply not there. As small businesses go under and property prices continue their long slide back down to 2000-era valuations, the remaining taxpayers will rise up in rebellion at steep tax increases; and when the money runs out, so do the guarantees.


Thank you, James A., ($20), for your generous contribution to this humble site. I am greatly honored by your readership and support. All contributors are listed below in acknowledgement of my gratitude.

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Feedback Loops of Doom II:

Financial Worry, Health, and the Reverse Wealth Effect As Housing Pops


It's been said that the difference between childhood and adulthood is financial worry. Children are of course troubled by family insecurity, but the gnawing weight of financial distress really eats away at the responsible adult(s).

As you have probably surmised, I know because I've been under extreme financial duress all too many times. (That goes with being self-employed in cyclical industries.) But financial worry can also arise from "death by a thousand cuts"-- small reductions in income and small cumulative increases in expenses which slowly work to bring household balance sheets into worrisomely negative territory.

The greatest source of stress is the loss of a loved one, followed closely by combat, divorce, the loss of one's job/livelihood/home/business, serious injury/illness and moving, i.e. "pulling up stakes and starting over." Unfortunately, the last three are intertwined with financial losses and worry.

We all know financial distress is highly stressful, and that chronic stress is a killer. Though this is hardly news, it is also largely ignored; thus The San Francisco Chronicle's recent feature on the topic was most welcome: Stress makes us depressed, fat, sick - and we do it to ourselves.

It may be difficult for younger people who have only known prosperity and shallow, brief recessions like 1991 to know just how wrenching a "real recession" like those of 1973-74 and 1981-82 can be. I vividly recall the headline in 1973 announcing that General Motors was laying off 100,000 workers that weekend.

In 1982, unemployment was officially over 10%, and unofficially about 15%. In recent years, most of the unemployed soon find some kind of paying work; in a "real recession" jobs dry up almost completely and so the unemployed stay unemployed. Since there is about 130 million jobholders in the U.S., a 10+% unemployment rate would mean 13 million people were out of work. Most of those laid off will experience financial worry--as will their dependents.

Let's consider all the feedback loops which are starting to reinforce each other.

1. Housing and the Reverse Wealth Effect. Since a house is the largest asset in most American households, any rise or decline in the home's value has a profound effect on our deepest sense of financial well-being. When our house appreciates, it makes us feel wealthier, hence the name for this phenomenon, "The Wealth Effect." When people feel confident in their financial future, they tend to spend freely.

But the Wealth Effect has a flip side, called "The Reverse Wealth Effect". When housing declines in value, people feel poorer, even when the decline has no measurable effect on their actual income or bank balances.

But in this era of "debt-based prosperity," the house was not just a reservoir of psychological well-being but a source for cash, extracted via refinancing or HELOCs (home equity lines of credit). Now, the drop in housing valuations has a very direct and measurable impact on household bank balances and spending because, as the cliche goes, "the home equity ATM is closed." Here are two charts which depict the vast equity extraction of the past seven years:





2. As housing and equity extraction decline, so will consumer spending, leading to recession. As this chart shows, wages have been essentially flat, so where will the money come from to replace equity extraction? The stock market? Most households have little exposure to the markets, except in their pension funds, 401K and IRAs.



3. As the stock market succumbs to lower profits and a recessionary economy, then pension and retirement funds will take a hit. Public and private workers alike have enjoyed outsized returns in their pension/retirement funds for 25 years. All the pension plans are now predicated on outsized returns continuing indefinitely. Yet history suggests Bull Markets don't last forever, and there is virtually no awareness that pension plans may actually suffer losses rather than 7%-15% annual appreciation.

The net result is a decline in income, for workers will be required to begin contributing, or contributing more, to pension plans as pay-outs exceed investment income.

4. Government "junk fees" and taxes are rising, reducing consumer income. Have you noticed that the parking ticket which used to be $10 a few years ago is now $30? This may sound too trivial to mention, but then add in the 1%-of-gross-receipts "city business license," the $300/year "rebuild our libraries" bond tacked on your property tax bill, the "fire extinguisher inspection fee" and dozens of other "junk fees" for things which government used to pay for out of property, sales and income taxes, and it starts adding up.

I pay thousands of dollars a year in these "junk fees"--licenses, fees and property tax surcharges which were once paid for by the regular assessed property taxes and sales and income taxes. Cities have increased the costs of parking tickets, vehicle fees, business licenses and the like to harvest more revenue without "raising taxes." If you're paying more for "fees," the net result is the same: your disposable income goes down, tax revenues go up. Is a "fee" not a "tax"? It's orwellian to say "no" when the citizenry is captive; either pay the absurd $30 parking ticket or we impound your vehicle. Next thing you know, there will be a $10 "processing fee" for your library card.

5. Mortgage re-sets will reduce the incomes of millions of households. The plan to "save" 500,000 subprime borrowers from onerous re-sets is all in the news, but millions of non-subprime mortgages will be re-setting for households which can afford the higher mortgage payments--but it will certainly reduce their disposable income.

6. As consumer spending declines, millions of jobs will have to be cut to preserve profitability. No CEO earns a $100 million stock option "compensation package" if the corporation's stock tanks and profits turn into losses. Labor is the highest cost for all American businesses, large and small, and just about the only way to slash expenses significantly is reduce headcount, i.e. lay off the highest paid, least productive employees.

Bullish apologists claim "business investment" will save the day, but the world is awash in excess capacity for virtually everything except oil and commodities like platinum. The global ramp-up to industrialize China is much farther along than the Bulls are willing to concede. China has been industrializing for 25 years already, and some leveling off would be natural. To claim that the U.S. economy can put 10 million people laid off in a consumer recession to work making stuff to sell to China, India and Europe is quite a stretch, given that exports are less than 10% of the U.S. economy while consumer spending is 70%.

7. The costs of borrowing and servicing existing debt is rising. As "risk" is re-set in the global financial system, the costs of borrowing and servicing existing loans is rising, regardless of what the Fed does with the Fed Funds Rate. This is true not just for housing but for business as well. In just one example, consider this Wall Street Journal story: Mortgage Pain Hits Prudent Borrowers:

Some of the costs of cleaning up the mortgage crisis are beginning to affect people who pay bills on time and avoid excessive debt. A new fee from Fannie Mae comes as interest rates are heading up and increases in insurance costs.

The new charge from Fannie Mae adds to the general gloom over the housing market. It comes as mortgage interest rates are heading up again after a recent dip -- as well as increases in mortgage-insurance costs, tougher requirements on down payments and other moves by lenders to ration credit. And last month, Fannie and Freddie imposed surcharges for mortgage borrowers with lower credit scores."

8. As lay-offs increase, more households lose medical insurance. Since there are already 40 million uninsured citizens in the U.S., what's another 10-20 million? Perhaps one difference is these households were middle-class, at least they were until one of the primary wage-earners lost his/her job.

If you're a civilian worker in the U.S., you know the drill: your spouse's medical benefits may be either poor ("fake" coverage) or non-existent. He or she might be a contract employee, or self-employed, or working at a non-profit or small business which provides no coverage. If the wage earner with the "good" health plan gets laid off, the family loses coverage.

If you're self-employed, you know how expensive healthcare insurance is: any family policy under $1,000/month is considered reasonable. Sure, if you're 23 and single you can buy a cheap plan, but if you're middle-aged with kids, it's hard to get coverage for less than $800/month.

If a small business falters in a recession, the proprietors may have to choose between keeping the house and feeding the kids or maintaining health insurance. You know what goes--the coverage.

9. As recession takes its toll on the nations' households, stress increases and health declines. Nobody thought the economy could decline in early 1929, or in 1969, either. people who have grown accustomed to their house rising in value and their stock or pension stake rising like clockwork every year will encounter financial stress they are unprepared for if a family wage earner is laid off.

Though I cannot list any statistics to back this up, an informal survey suggests that an extraordinary number of middle-class households are already experiencing severe financial worry--that is, they're barely keeping their heads above water as it is. Any shock--an unexpected medical bill, an elderly parent requiring financial aid, job loss or mortgage re-set--can push the household over the edge into insolvency and bankruptcy.

It wasn't always this way. Wages rose faster than expenses, and people were more prudent with their finances, saving more and choosing modest vehicles and houses. It seems incredible that so many people are stretched to the limit in "good times," and so unprepared for "seven lean years" or indeed, any financial reversal.

This is how a reversal of the wealth effect, financial worry and health are intertwined and feeding back into each other. It is worrisome on many levels, for people without medical insurance often don't receive any care except emergency room treatment, which is typically too late to address the underlying causes or chronic conditions. It's possible that some people will become disabled by financially-induced stress-related diseases, further impoverishing the family. Without healthcare, the condition will go untreated.

As people fall out of the job market, the family loses its middle-class perks like medical coverage. As expenses like mortgage re-sets rise, income falls, and any lay-off could trigger the loss of the home. On top of the high-stress loss of livelihood/job/business, the family may also be forced to "pull up stakes and start over again"--sometimes a welcome escape but stressful nonetheless.

When the economy's cheerleaders wave their pom-poms, they never consider the reinforcing nature of the negative forces listed above. Yet in the real world, they are tightly linked: being laid off triggers loss of health coverage which then impacts the family's health and even the breadwinners' ability to work. Financial strain, if it lasts long enough, can cause once-stable households to break up or lose the family home--even a home with equity and a fixed-rate mortgage.

Those of you who lost your jobs or businesses in 1981-82 and had to relocate to start over know what I'm talking about; and with medical coverage many times more expensive now that it was then (in real inflation-adjusted terms), starting over and reclaiming a middle-class lifestyle after the decimation of a lengthy recession will be that much harder.


Thank you, Louis M., ($25), for your generous contribution to this humble site. I am greatly honored by your readership and support. All contributors are listed below in acknowledgement of my gratitude.

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The Unintended Consequences of the Housing Bubble Bursting

Readers Journal Updated!


As the housing bubble pops with a reverberating shockwave heard round the world, we can be sure the players who inflated it did not intend or anticipate the ramifications now unfolding.

Just as the teenagers racing down the cliffside highway with bellies full of alcoholic beverages did not intend to lose control of their vehicle and plunge off the cliff to their deaths, the mortgage brokers, investment bankers and their partners-in-fraud, the rating agencies, did not really intend to bring down the entire economy.

Yet this is indeed the "unintended consequence" of the housing bust. Let's consider two "unintended consequences" which are emerging as the housing and mortgage-derivative markets break through the safety barrier and descend in a slow-motion cliff-dive.

1. As risk is "re-priced" higher, the cost of borrowing will rise. Frequent contributor Albert T. explains:


The problem with the bailout is that it devalues money by diluting the weighted average of money outstanding through bailing out people/firms whom shouldn't have got it. Ergo, stupid banks who took stupid risks and stupid borrowers. While we won't notice it right away, when the rate freeze is in effect in actuality it will reprice all new risk with a higher implied rate to compensate for the future freeze possibility, hence we will all pay higher rates to subsidize the current "crack addicts". (emphasis added-CHS)

Once this happens two things will occur: five years from now instead of losing 30% on the loan, the bank will lose 70% except that 70% will be insured by the gov't as a thank you for the freeze. Hence we will have the doubling of our money supply on loans that weren't supposed to create it. In effect the gov't will allow banks to print money in the future to make up for the loss today."

Albert sent in this link Homeowner bailout is a lousy idea(John Markman, MSM Money) and called attention to the following excerpt as evidence of another kind of risk repricing is already underway:


"Indeed, everywhere you look now is evidence that the subprime-debt crisis is morphing and expanding like a creature in a horror movie. Just this week, we learned from hearings in Congress that strapped credit card companies such as Capital One Financial (COF) and Bank of America (BAC) had begun to soak customers by jacking up interest rates on balances for the slightest changes in their credit profiles."

"If you so much as apply for a new credit card, according to testimony gathered at the hearing, your current card provider can boost your rates as high as 30% per year."
In other words: since lenders now know the government may "freeze" the rates they've charged customers, they'll be re-pricing those rates higher to compensate for that possibility. If the government might step in and freeze the rates I am charging my customers, then it behooves me to raise rates on all customers now, not just the riskiest ones because, well, it's not longer a "risk-free world." The government might freeze all interest rates, or "low-risk customers" might soon become "poor-risk."

How does this re-pricing hurt the economy? Since borrowing is the grease which lubricates the entire economy, re-pricing risk means higher borrowing costs for everyone-- regardless of Fed-Speak or the Fed dropping the Fed Funds Rate.

This chart reveals how the ratio of mortgage debt to disposable income has risen far above the last housing bubble top in 1990. Simply put: people are spending more on debt service and this has reduced their remaining disposable income. The rubber band of debt service has already been stretched to extremes unseen in 30 years; so the question becomes, how much more can the rubber band be stretched before it snaps?

Just to refresh our awareness of how critical debt/borrowing is to our current "prosperity," take a look at this chart:

Please go to www.oftwominds.com/blog.html to view charts.

2. As non-U.S. investors realize they have been handed hundreds of billions in losses, they will be wary of buying more U.S. debt.

We are already hearing that the market for SIVs, CDOs and MBS (mortgage backes securities) is dead, over, gone, dried up, history. And just to refresh our awareness of how debt-based derivatives like CDOs and credit swaps have grown, look at this chart:



How dependent is the U.S. on foreign/non-U.S. buyers of debt? Very. The standard number tossed around is the U.S. needs to offload $2 billion a day onto non-U.S. investors just to keep the U.S. debt/borrowing/spending machine humming.

But now, as this article from the San Francisco Chronicle details, we have ripped off our non-U.S. investor friends and are busily shredding all evidence of fraud --even though we all know every step of the housing bubble, from appraisals to mortgage funding to securitizing of the mortgages to the rating agencies' "AAA stanp of approval" on those securitized loans was riddled with "wink-wink-nudge-nudge" fraud:

MORTGAGE MELTDOWN Interest rate 'freeze' - the real story is fraud


But unfortunately, the "freeze" is just another fraud - and like the other bailout proposals, it has nothing to do with U.S. house prices, with "working families," keeping people in their homes or any of that nonsense.

The sole goal of the freeze is to prevent owners of mortgage-backed securities, many of them foreigners, from suing U.S. banks and forcing them to buy back worthless mortgage securities at face value - right now almost 10 times their market worth.

The ticking time bomb in the U.S. banking system is not resetting subprime mortgage rates. The real problem is the contractual ability of investors in mortgage bonds to require banks to buy back the loans at face value if there was fraud in the origination process.

And, to be sure, fraud is everywhere. It's in the loan application documents, and it's in the appraisals. There are e-mails and memos floating around showing that many people in banks, investment banks and appraisal companies - all the way up to senior management - knew about it.

I can hear the hum of shredders working overtime, and maybe that is the new "hot" industry to invest in. There are lots of people who would like to muzzle subpoena-happy New York Attorney General Andrew Cuomo to buy time and make this all go away. Cuomo is just inches from getting what he needs to start putting a lot of people in prison. I bet some people are trying right now to make him an offer "he can't refuse."

I can hear it all now--as no doubt you can, too. The non-U.S. pension or township or sovereign fund, realizing its supposedly "safe" U.S.-based investments are now worth 50% or 20% or perhaps 0% of the purchase price, now go to New York and hire a razor-sharp law firm to force the investment bank which sold them the garbage to buy it back, based on the fraud which permeates the entire pool of mortgages and debt.

But oh my gosh, we didn't know it was fraudulent. Proving fraud, after all the emails have been deleted and the hard-drives crushed and the paper trails shredded will be very difficult, indeed. The "innocent" bankers will point to the rating agencies like Moodys, who will point to the mortgage underwriters and brokers, who will point to the originators and the appraisers, who will promptly declare bankruptcy or point to the realtors who forced them to support inflated valuations.

And after all the attorneys' fees have been deducted from the paltry settlements reached years from now, there will be pennies left for the non-U.S. investors. We all know how this works because we've seen the play before in the aftermath of the dot-com debacle: investors lose $200 million due to fraud, the company settles for $11 million, the attorneys take $5 million for their work and the investors get a whopping 3% compensation.

So how does this massive, seamless, trillion-dollar fraud hurt the U.S. economy? Just ask what happens when non-U.S. players tire of getting ripped off or become wary of "AAA low-risk" U.S.-based debt. What happens is this: when non-U.S. buyers of new debt vanish, then the great debt-churn-spending machine that is the U.S. economy grinds to a halt--or at least loses $700 billion a year in non-U.S. funding.

Anyone who is an investor (as opposed to a "pusher" who needs to "fund the junkie's habit" so he can afford to buy more "product", i.e. the central banks of China and Japan) will turn away from U.S. debt (other than Treasuries) in complete disgust.

Ask yourself this: if a national government might arbitrarily "freeze" or lower the interest rate being paid on a security, thereby lessening its value, how anxious are you to buy more of that nation's debt? If you do, you'll want a hefty risk-premium to compensate you for the unknown risks that the government will gerrymander your return in order to placate their banker buddies and restive domestic voters.

Bottom line: as risk rises, so do borrowing costs. As non-U.S. investors shun new U.S. commercial and mortgage debt, those markets dry up. Since debt can no longer be sold to unwary non-U.S. "marks" (suckers), then who's left to fund $5 trillion in new mortgages? Essentially bankrupt U.S. banks? Negative-equity U.S. households? Negative savings rates Americans? If this sounds bleak, please consider this chart:


Reader's Journal has been updated. Enjoy Jed H.'s Financial Haiku and diverse comments on the housing bubble, subprime meltdown, gov't bailout, stock manipulation and more. Here are three new excellent essays which you're sure to enjoy, and new poems from one of our two contributing poets (Verona and Protagoras):

Inflation and Deflation -- A Reader's Perspective (Gary G, 12/10/07)

In Praise of Awk (Protagoras, 12/10/07)

Suburbia, Jobs and Housing (Lloyd L., 12/10/07)

Two Poems: Guilt and Hurt (Verona U., 12/10/07)

Thank you, Eugenio M., ($10), for your generous contribution to this humble site. I am greatly honored by your readership and support. All contributors are listed below in acknowledgement of my gratitude.

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Muddling Through Malaise


Astute reader Jeff neatly summarized the important "inflation/deflation" question we are all pondering: do we get hyperinflation as the Powers That Be labor to reinflate speculative bubbles, or are we facing Japan-style deflation?

"I was wondering if you could write about what you think the government will do to make it seem like everything is just fine to the masses. I have read they will create hyperinflation by printing and devaluing the dollar down to 40. I find it hard to believe that Paulson and the Fed would go to that extreme as they would be looked upon in history as the guys who destroyed the dollar. I have also read that deflation is what is going to happen no matter what they try to do. I can see the housing deflation already which I think needs to happen. I just hope they don't make things so much worse that it is already. Its so hard to figure how what to do with any saving. Thank you very much for your time and great blog."

The only way I know to address such enormously complex topics is to start with what we know or can readily surmise.

1. Politicians are bound to try to "fix" or "resolve" any financial crisis. Though politicians are required to praise "the market economy" in front of microphones, as soon as their contributors and/or constituents are screaming they drop that pretext and rally round a mandated or government-funded "fix."

To do nothing simply isn't acceptable in "Can Do" America, even when the last thing the "patient" (the U.S. financial system) needs is more meds and operations. Just as in our dysfuntional medical system, the "caregivers" (politicians) are under extreme pressure to "do something."

Will you ever hear a doctor in America say, "Folks, I am sorry to say that your family member is dying, basically of old age, though we call it 'multiple organ failure.' We're going to keep him/her comfortable but beyond that, anything we do will only waste time and money and very likely increase the suffering of your loved one."

In a similar way, you will never hear a politician say, "Folks, lending and speculation got completely out of hand, and several million irresponsible borrowers and a large number of speculative investors and lenders will have to go bankrupt and start over. Any attempt to make the problem go away with phony fixes will only make it worse."

This is why I anticipate a decade or more of Malaise with a capital M: a long, fruitless period in which the nation muddles through. "Fixes" are proposed and enacted, but since they aren't acting on the root causes, they will do nothing but spackle over the rot to make things look presentable for the next election cycle.

2. Non-U.S. players have the same game plan as U.S. politicos: keep the ailing giant healthy enough to use his credit card to import oil, goods, etc. As I have written here recently (Self-Interest in an Interconnected World 11/29/07), central banks and other non-U.S. players know their own prosperity is dependent to some degree on healthy U.S. demand for their goods and commodities.

I know, I know--China and India are the New Big Players and they can now "decouple" from the U.S. Perhaps--but please take a look at this chart of global oil consumption by nation. Petroleum use is as good a proxy for economic and financial activity as any, and as you will note, the U.S. market (as a consumer of other nations' exportable goods) is significantly larger by this (or any other) measure than China and India put together:

oil consumption by nation
U.S. 20.5 million barrels a day (MBD)
China: 6.7 MBD + India 5.5 MBD = 12.2 MBD

As a footnote, the U.S. military uses as much oil as an entire country (Greece). (Note that capital U.S. Navy ships like submarines and aircraft carriers are nuclear-powered and don't burn oil.) US military oil consumption

In other words, non-U.S. governments such as the Gulf oil states and Asian exporters know full well they need the U.S. as a robust market for their own goals of robust prosperity to be met. They will weigh in as needed--but mostly without blaring PR--to pursue their own self-interest, which may require actions like propping up the dollar, etc.

3. The foundation of the inflation/deflation question is supply and demand. In terms of the dollar, or any currency, if there's no demand for the buck the price drops. If there is more demand than supply, the value rises.

The basic argument runs thusly: the U.S. Treasury, Fed and U.S. money-center banks can create stupendous sums of new dollars which then overwhelm demand. This is what has caused the dollar's decline against other currencies and against gold--a massive imbalance between supply of dollars (ever-growing) and demand (weakening as holders get tired of declining value).

But there are other forces potentially at work in currencies, forces touched upon here in The Economist Cover Dollar Indicator (12/3/07). If economic conditions deteriorate in Europe or Asia, for whatever reasons, then the dollar might actually gain favor as a relative "safe haven."

Just as "hot money" has flowed to China to reap the gains of the yuan strengthening, a nasty outbreak of Avian Flu in China (for instance) might reverse that trend as traders lock in their gains and exit to "safe haven" currencies.

In other words, for reasons beyond the Fed or Treasury's control, demand for dollars could conceivably exceed supply and the "price" would rise. This possibility is currently discounted to near-zero, but we should recall the old adage that when the U.S. sneezes, the rest of the world catches cold.

Currencies are relative to each other, but all currencies have declined against gold in the past seven years. In a world flooded with new paper money, paper money buys less "real world" goods. One way to see this is to look the U.S. stock market priced relative to gold (DJI/gold ratio, courtesy of Harun I.):

Please go to www.oftwominds.com/blog,html to view all the charts.

Here is the dollar/oil ratio, again courtesy of Harun I.:



Bottom line: priced in gold or oil, all major currencies have declined in value. Thus the question might be: what might retain its value against all currencies? For many people, the obvious answer is gold or other precious metals.

As for currency valuations, we should note that some $3 trillion trade on the forex (foreign exchange markets) every day. No government agency can control the global currency market for long, and so we have to be alert to forces beyond the U.S. Treasury and the Fed. For context, here is a chart of the trade-weighted dollar 1970-2007:



4. How much of U.S. demand for housing, goods and even oil is based on low-cost/easy borrowing? How much demand is there for more debt? As lenders tighten standards and shun risk, we have to question how much the Fed dropping the Fed Funds Rate will do to boost borrowing and consumption. We also have to ask how much demand there is for more debt.

Asking about the supply and demand illuminates all questions. If the supply of money available for lending shrinks (due to fear/risk avoidance), then the cost of borrowing will rise regardless of the Fed Funds Rate. If demand for new debt drops as people decide to start saving and reduce debt, then "new money" will go begging no matter how low the "teaser rate" may be.

If demand and supply both contract, then there will certainly be less spending/consumption. If the supply of goods exceeds demand, the price of the goods will fall.

We all tend to want a global answer to big questions, but in such an interconnected world, the anwers are necessarily tentative and contingent. What essentials are in short supply, and can not be increased or replaced with substitutes? You might answer oil, and you wouldbe largely correct--it's increasingly difficult to increase oil supply, and substitutes are still a small part of global energy.

But my answer would be: fertile soil and fresh water. What if the demand for fresh water and agricultural goods exceeds the supply? Then the price could rise dramatically, even as the oversupply of houses, computers, iPods, BBQ grills, etc. cause prices ofthose goods to plummet. Courtesy of frequent contributor Harun I., here is a chart of wheat:



What might retain its value against all currencies? perhaps we should include soil and fresh water along with gold and precious metals. How much can any government do to increase supply of arable soil and fresh water? How much is beyond any government control?

Governments must attempt to "fix" supply and demand imbalances, but the levers in their control are few in number. They can certainly effect markets, but only for short periods of time and only at the edges. Or so these charts suggest. That is why I anticipate the best that any government will manage in the coming years is "muddling through malaise."


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Exhaustion, Jobs and Housing


Longtime contributor Cheryl A. proposed an important topic:

"I hope you'll post on Paulson's five year plan and the effect on the economy. Do you think this will delay the recession projected for 2008-2010?"

As you know, the "five year plan" (which smacks most weirdly of old Soviet and current Communist Chinese Central Planning at its best/worst) "solves" the "subprime crisis" by having lenders freeze the interest rates and payments for "some" subprime lenders for the next five years--until 2012.

All of the obvious objections are contained in the quotation marks above:

1. It is not a "solution to keep homeowners from losing their homes," it's a blatant attempt to keep the lenders/investors solvent by chaining underwater/negative equity owners to the debt-serf machine, i.e. mortgage payments on houses which keep declining in value.

2. The crisis is not limited to subprime borrowers, but to virtually everyone who accepted an exotic, ALT-A, HELOC, adjustable or even fixed-rate mortgage on a property which has declined into negative-equity territory.

3. How the triage works--i.e., Who gets offered the "5-year freeze" and who gets dumped in the "hopeless" ward--is unclear. In all likelihood the triage will work like this: if you're six months behind, you're toast; if you're current, you're golden.

But missing from such superficial analyses are two larger factors which will eventually come into play: exhaustion and job losses. Let's start with a chart of how bubbles tend to deflate--symmetrically:



The question posed by this chart (or any chart of a bubble retracing to the mean) is: how long will the "saved" homeowners keep shouldering their mortgages when every year their house is worth less?

Humans are selected for basic optimism, and the real estate industry's PR machine will be wedged in high gear for the next five years, proclaiming every Spring that "the market has turned the corner." If you think this cynical, then I invite you to go to any major newspaper's archives and read the real estate industry's eternally positive "market is turning" hype for the years 1991-1997--a stretch of years in which housing declined in real terms every year.

So how long will you pay $2,000 a month to "keep your piece of the American Dream" when you can rent the same house for $1,200/month? How many years will that $10,000/year difference be "worth it" if the property value erodes like a half-toppled sand castle buffeted by a rising tide? How about when the gutters need replacing in Year Three of the freeze, and when the water heater blows out in Year Four, and the roof starts leaking in Year Five? How motivated will the beseiged homeowner be to scrape up the money for repairs?

The human spirit has limits of endurance, and five years will be plenty long enough to find out just how few people will still believe the "market is turning up" after five years of declines and false hopes dashed/betrayed.

There is nothing new about the current real estate bubble deflation except its size; which brings us to the second type of exhaustion: the physical kind. Back in the early 90s (yes, during the last housing deflation period 1990-1997), there were stories of distant exurbs outside Los Angeles slowly being abandoned by newly-minted homeowners who could no longer maintain the grinding 3-4 hour commutes and the destruction of their family life.

Parents no longer saw their kids except late at night or yawning at 5 a.m. in the morning; the Potemkin Village of hastily constructed McMansions had no town center and nothing to do, so the kids did drugs and defaced the abandoned houses around them. As property values declined, people gave up and left, preferring to rent somewhere closer to their jobs and to "get their life back."

Lastly, consider what happens in the (inevitable) recession just ahead: people lose their jobs. Where will the jobs be lost? Where will they not be lost? Retail: yes. Restaurants: yes. Finance: yes. Manufacturing: yes. Government (as tax receipts plummet): yes. And so on.

Even healthcare will not be immune to job losses. As large employers like government and finance/lenders shed workers, those organizations will not be paying health insurance premiums for ex-employees; not only will those unemployed workers no longer be covered, but all the healthcare businesses which were feeding off those well-insured workers will suddenly find themselves on a starvation diet.

And if the energy scenario plays out according to supply and demand, as I expect, then global recession will cut demand for petroleum and oil prices will drop from $80-$90/barrel to $40/barrel or even less. If that occurs, even the energy sector may find layoff notices are necessary to protect profits.

As those of us who lived through the last "real recession" in 1980-82 (12% unemployment, etc.) recall, job losses quickly spin into a voracious positive feedback loop as layoffs in primary industries trigger layoffs in hospitality, restaurants, entertainment and retail which then trigger declines in tax receipts which then cause horrendous government deficits and "hiring freezes" (a.k.a. layoffs).

Unfortunately, as this chart shows, job statistics are so phony it will be hard to tell when job losses are actually gaining momentum until the statisticians are no longer able to mask the carnage.



So what happens to the mortgage in two-income households when one wage-earner loses his/her job? The family hangs on for awhile, doing everything in their power to maintain the huge mortgage payments, but recessions don't end in a month or two; they deepen over time as the positive feedback loop of job losses works its way through the entire economy.

Recessions last longer than most people's savings, and so we can anticipate, with much anguish, much more extensive foreclosures, regardless of "Five Year Plans" to freeze payments. Once you're lost your job, a $2,000/month mortgage payments suddenly looms like the summit of Mount Everest right as your oxygen runs out.

Thank you, knowledgeable reader Jeff for correcting my error regarding positive and negative feedback loops. Jeff passed on this link as background: Positive Feedback (Wikipedia)


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