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Saturday, March 7, 2009

Wash, Rinse, Repeat...

We seem to be caught in a vicious cycle.

Here is my take on the cycle and endless loop we are currently seeing and how it may inevitably feed more vicious cycles…

Let’s start with my attempt to summarize the current state of the economy…

1) Toxic Debt, and defaults are killing the banking, insurance and real estate investment world. This causes businesses to loose money, people to loose both jobs and investment savings.
2) High unemployment, and loss of savings are not only stopping people from spending, but preventing business from generating revenue which
3) Prevents them from making payments to creditors, (banks, real estate investments, and insurance agencies) which causes them to go into default and creating more toxic waste…

I think you can see the cycle I am alluding to…

OK, so bear with me for just a moment longer while I summarize a couple more ideas…

Traditional economic thinking has some basic goals and tenants.
1) A reasonable amount of debt (good debt – debt you can and do pay off on a regular basis) is OK and often necessary especially in business.
2) Don’t spend more than you earn.
3) And save for a rainy day.

The current administration, and for that matter – the previous one too, passed various bail-out bills, and economic stimulus plans and even based the latest revision of the budget on some of these basic traditional economic goals.

In other words, they are attempting to do the following…
1) Get rid of the bad debt.
2) Rebuild the foundations of the economy (infrastructure) and encourage people and banks to spend - get the flow of money going again in the economy.
3) This will help the financial markets and restore people’s ability to save through investing.
4) And… Most important of all - This all will intern help restore the economy and generate revenue for taxes necessary to make the current proposed budget and plan work.

There is only one problem with this.

Everyone; people, banks and business; currently feel the pain and hardship that the current vicious cycle has generated. It is to a point that this cycle has yet another component added to it.

Fear.

This fear was evident when the banking mess first started. Banks did not want to lend because they wanted to make sure that they had as much cash as possible on hand to cover all their toxic debt. They hoarded their cash and attempted to save as much as possible.

Now we have people; people who still have jobs and earning good money; afraid to spend unnecessarily and risk loosing what they have. They are hoarding their cash and attempted to save as much as possible.

Notice that this, “saving”, is one of the good basic ideas behind traditional economic thinking.

Which is why I found this following article so compelling and interesting…

How savers could doom the economy
The mainstream theories that are guiding efforts to fix the broken US economy assume people will react rationally. Uh-oh.
By Jon Markman
MSN Money

Pramod Kadambi wakes up every morning fearing the world has come to an end. He and his wife don't spend money on anything but essentials. Friends who have lost their jobs visit and cry. He sees war or revolution coming. Gold coins and guns are new additions to the household.

An unshaven, out-of-work survivalist in the backwoods of Georgia? Not at all. He's a young medical professional in California earning more than a million dollars a year -- and the new face of the wealthy in America. That makes him the Obama administration's worst nightmare: someone who could help revive the nation's economy but instead has shut down his wallet in stark dread.

Over the next few months, a searing debate over paying for the nation's trillion-dollar deficit with new tax increases on the rich will divide the country by class and political ideology. Yet it's becoming increasingly clear that the dispute will be moot as the economy is poised to sink more deeply into a recession and bear market that will provide shockingly less income for authorities to tax.

How much less? Maybe as little as half, and fretful savers like Kadambi are part of the reason. Most analysis of the $787 billion fiscal stimulus package and President Barack Obama's spending priorities so far have assumed all the economic theories embedded in the plans by Harvard and Princeton economists in the White House are accurate and unassailable, and will direct federal money to work like magic to restore order if only recalcitrant Republicans and naysayers would get out the way.

What's hasn't really been challenged is whether the assumptions underlying the plans' model fit any sort of reality that exists outside the hallways of Ivy League economics departments and whether emotional individuals acting in their own self-interest to save money -- rather than as robotic consumption machines that spend like crazy -- can mess them up.

Saving for (and creating) a rainy day

Fresh evaluation from Wall Street analysts steeped in economic traditions outside Boston and the Beltway is focusing on the idea that the government's recovery efforts depend too much on people acting rationally in a way that fits historical patterns of calmer times. If people instead ramp up their savings rates to a degree not anticipated by the economists' models, then consumer spending will decline at a rate that that will crush corporate earnings and, in turn, push stocks a lot lower. The resulting loss of confidence will then reflexively cause people to save more, leading to a vicious downward spiral.

To understand this scary effect, an obscure but well-regarded model of economic behavior called the Levy-Kalecki formula has begun to gain favor in some circles in part because, since its creation 70 years ago, it has done an unusually good job of forecasting how high levels of saving and a decline in borrowing can lead to the devastation of profits.

Plugging current U.S. output figures into a classic version of the Levy-Kalecki formula shows that if households save as little as 7% of their incomes over the next year, the S&P 500 Index ($INX) could plunge as low as 550, which would amount to a 21% decline in value from the current level. The equivalent for the Dow Jones industrials ($INDU) would be about 5,300.

If the wealthy are taxed at higher rates, as currently contemplated by the Obama administration, and savings rates go to 10% per annum, the formula suggests corporate profits will be cut in half from their peak two years ago. Because earnings at the companies that make up the S&P 500 totaled $84.70 a share in 2007, that would mean forecasts of the stock market need to start with the assumption that earnings will sink to about $42 per share.

If investors are confident that a decline to that level is just a temporary aberration, they will apply a price-earnings multiple similar to what we see today, around 18, and then you get a forecast of 755 for the S&P 500, which is a little higher than where we are now. But if investors fear earnings will continue to slip, then they'll cut the multiple to as little as 9 or 10, as they did in the 1970s, and if you do the math you get a projection of 420 for the S&P 500, or around Dow 4,000.
Yow. Talk like this used to be strictly in the realm of grumpy old men and cuckoo birds, but it's occurring now in smart circles because mainstream economic theories are not adequately explaining consumer and government behavior in this cycle. Wall Street practitioners are thus turning to alternative theories, and the Levy-Kalecki formula -- independently developed by New York physicist-entrepreneur Jerome Levy in 1914 and Polish economist Michal Kalecki in 1935 and then unified by American economist Hyman Minsky in the 1960s -- is helping to better elucidate the relationship among debt, savings and profits.

Le freak, c'est chic

A key difference between the theories animating the work of Obama's economists and the theories behind the Levy-Kalecki formula are that the former assume people will act rationally in accordance with government prodding and the latter consider the possibility that people will freak out. Contrary to mainstream economics beliefs that people operate with perfect knowledge, Levy-Kalecki assumes that economic participants -- families, officials, workers, investors and executives -- grope about their lives in an atmosphere of uncertainty, develop false beliefs and make mistakes, especially when surprised.

While mainstream economics argues that markets and people tend toward a harmonious equilibrium that can be guided by didactic government action, Levy-Kalecki suggests behavior instead tends toward disequilibrium. The difference in policy that must be developed in each case is profound, for the former tends to rely on inflexible formulas while the latter would seek to constantly adjust.

The rubber meets the road now in two views of how individuals will react to incentives embedded in the stimulus package. The Obama team apparently believes enough dollars are being applied via government credits, direct spending and state grants to overcome the deep erosion of individual Americans' consumption. Yet Wall Street practitioners who follow Levy-Kalecki tell me that the package falls short by a whopping $1 trillion.

Without directly creating private jobs via public-works projects to give laid-off workers new income streams -- and thus help people stop obsessing about a bleak future -- the Levy-Kalecki model forecasts the next year will feature a steep climb in saving, plunge in spending, wipe out in corporate earnings and disintegration of the stock market.

Anticipating a collapse

One Levy-Kalecki adherent who runs a credit portfolio at a New York investment bank told me he believes that complacent policymakers don't seem to realize the nation faces a grave financial crisis on par with war. If people react to weakening job prospects by stiffing their credit card and mortgage lenders in order to save at a level that will let them survive a financial meltdown, he sees the potential for $6 trillion in lost spending over the next two years.

"This is what commodity, bond and stock markets are trying to price in right now," said the manager, who asked not to be identified. "Investors gave up waiting for the government to act effectively and are taking down the value of everything in anticipation of collapse."

If we were dealing with only a global banking crisis, current policy might have been effective. But the credit drought has sparked what economists call a Fisher debt-deflation spiral, in which companies' long-term cost of funds is too high to provide a reasonable rate of return, so they cut both their borrowing and their investments. The less big companies borrow, the worse banks perform, the less they can lend to smaller companies and the less can be invested in expansion. Rinse and repeat until total implosion in a cycle already beset with individuals similarly disinclined to borrow and spend, as happened in the Great Depression.

Levy-Kalecki followers believe the answer to this is massive direct government public-works spending totaling up to 30% of gross domestic product, even if the national debt rises to greater than 100% of GDP from 60% today -- something along the lines that British economist John Maynard Keynes recommended in the Depression.

Since the Obama team has shunned that path, the fear now is that only an event similar to the one that bailed out the United States from the Great Depression will vanquish the six-headed beast of rising unemployment and savings rates, falling spending and earnings, debt deflation and corporate dis-investment. That was the intense manufacturing demands of World War II.

Hopefully a saner alternative will emerge.

Fine print

To learn about other families that are cutting back on their spending, click here. . . .
To find out more about the Levy-Kalecki formula, check out the Jerome Levy Forecasting Center at this site, especially this page. Also check out the Levy Economics Institute of Bard College. To learn more about the views of Minsky, check out this article in The New Yorker.

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