Recession and Deflation

What is, I believe, a little known fact is that during a recession, the money supply begins to deflate. As you should know from reading Tying it All Together, the amount of money in the land increases when people take out a loan, and shrinks as they pay it back until the true, non-deficit supply of money is achieved. Year-to-year growth in inflation happens because people are continuously taking out more money in loans than they are paying back to the banks. In a recession, however, people stop taking on new debts, and subsequently the only direction of money flow is back into paying off debt, shrinking the total money supply.

What this means in practical terms is that each remaining dollar is worth more. That probably sounds like a good thing to you. The problem, as John Maynard Keynes pointed out is that this means that value of things like labor and products should shrink — for instance, if the money supply has halved, if you were making $40k a year, you should now be making $20k a year — but people are too stupid to realize this and instead of lowering the price of their products or giving their workers a wage decrease, they lay off workers so that they can continue to afford their best workers at the same (but now overvalued) wage. They continue to charge the same price for products, figuring that the market will come back. In a recession, everything freezes as the money supply shrinks, instead of shrinking along with the money supply, which only exacerbates the situation.

A simple solution to this problem is to inflate the money supply directly.

Let’s classify there as being too types of money, fundamental and loaned. In the example given in Tying it All Together, I gave each of our farmers $1.20 to start with, for a total money supply of $120 in the whole land. That sum is our fundamental money supply. All other money is loaned, i.e it exists only as a fiction where we accept money made out of debt as having value.

At any point in time, the amount of money that each individual had could be doubled by simply physically going around and handing them new bills to that extent. If Billy had $10, he now has $20, and if Megan had $50, she now has $100. This can be done without anyone, not the government nor the banks, taking on debt, because the fundamental supply of cash to begin with was entirely arbitrary. The only issue is in maintaining the balance of wealth between entities, as upsetting that could wreak havoc.

Now, presuming that money will naturally flow the same way as it has previous, so that those who are good at amassing money will do so at the same rate as they have before, and those who lose money will similarly do likewise, periodic, small checks mailed around to the general populace will in effect raise the supply of fundamental cash, and wreak havoc because the amount (per person) is so small that it doesn’t unbalance anything to a noticeable extent, and of course it will soon find its way to its ultimate destination via the natural flow of money. By periodically doing this — giving enough time for money to settle — one can maintain or continue to inflate the economy (and devaluing the currency) to maintain a status quo.

There is essentially, no economic downside to this. Prices and wages are able to stay where people expect them to be so that they don’t have to feel like they have to take a pay decrease to get back into the system. The only end result is that if all debts were to be paid off throughout the land, the amount of money that remained after all debts were cleared would be higher.

And of course there is the secondary, potential benefit of sending about checks that the receipt of free money will spur people into getting back into the market and kick-start everything up again sooner.

On the Other Hand

It is worth noting, however, that all of this is predicated on the idea that people don’t and can’t understand deflation. That they don’t is certainly true, but it’s entirely in the province of the President and the Mass Media to inform them. It would be perfectly easy to tell businesses that the dollar is worth more and that, rather than laying off 10% of their work force, that they decrease salaries by 10%. Such a thing would likely also cause businesses to lower prices to match. In return, the amount of money that people had in savings would increase in value and give them motive to get out spending. This is the way the market is supposed to act to recover from a market crash naturally. Making it happen as it is intended may just be a matter of making people aware of what is happening and how it all works.

Failure in the Information Age

In my previous post, I hinted at two topics which I didn’t have time to properly cover and so left hanging. Specifically, I pointed out the relative timelines of the presidential election and the housing market crisis without specifying how this was relevant, and I pointed out how small, monetarily, the crisis actually was without showing how this became the lead-in to “the greatest economic recession since the 1930s”.

The problem is one of real, rational information, and I’m going to deal with this topic before approaching the other two.

People can’t be expected to research information themselves beyond reading the newspaper or watching the news. It’s infeasible for us to wander across the country interviewing important people and questioning those who are qualified to comment. And even with the introduction of the internet, for most of us it’s not practical to spend several hours a day searching for information, let alone having the talent to recognize decent information from hokum.

So, we need journalists and reporters. But, journalism is reliant on three things to be of much practical use:

1) They must remain objective and bi-partisan.
2) They must investigate thoroughly and report everything without self-censorship.
3) They must have access to key sources and of course not be censored by external sources.

On the other hand there are the following issues which inhibit this:

1) Partisanship is hard to avoid, and once you have gained the slightest bit of it, you attract both readers and journalists who endorse that stance.
2) Partisanship sells news in the same way that a store which sells plain baseball caps must charge less than a store which sells New York Yankees branded baseball caps. People generally treat politics like sports and want to feel a part of the team.
3) Uncensored and realistic news is boring, tedious, depressing, and/or gruesome. Sensational and/or pleasant and amusing news sells.
4) Sources don’t want to give you information if they can’t trust that you’re on their side.
5) Policing journalistic standards is nigh impossible without government intervention, which is impossible since we do not want the government or any group imposing “reality” on journalists.

Now, somewhere between Watergate, Vietnam, and Edward Murrow fighting McCarthy there was a fairly strong standard of journalism established in the latter half of the 20th century lasting through, perhaps, the 80s. Through the 90s, and especially with the introduction of the internet and the great collapse of the paper news market and the rediscovery that shallow and entirely partisan journalism costs less and makes much much more money, we’ve got a problem.

Getting back to our original topics, let’s consider first the question of how the housing crisis became a trillion dollar deficit where the whole thing should only have cost $39 billion.

The best, simple example is given in a discussion between Ben Kingsley and Robert Redford in the film Sneakers:

Cosmo: Posit: People think a bank might be financially shaky.
Bishop: Consequence: People start to withdraw their money.
Cosmo: Result: Pretty soon it is financially shaky.
Bishop: Conclusion: You can make banks fail.
Cosmo: Bzzt. I’ve already done that. Maybe you’ve heard about a few? Think bigger.
Bishop: Stock market?
Cosmo: Yes.
Bishop: Currency market?
Cosmo: Yes.
Bishop: Commodities market?
Cosmo: Yes.
Bishop: Small countries?

The thing about the economy is that, by and large, the health of the economy is (nearly) entirely at the whim of what people think about the economy, regardless of what any macro-economist’s formulas might say. Oh certainly there is such a thing as bubbles or bankruptcy or other things which are quite solid and undeniable. But at heart, the economy is good when people buy stuff and people buy stuff when the economy is good, meaning that it’s people’s perception of the state of the economy that gets them to buy.

But as I’ve pointed out, people are reliant on the news for their perception of the economy.

If the news is sensationalist and hammering on the point that “millions” of Americans are going to be unemployed and homeless and that economists think that the government’s solutions to the problem are ill-advised, then everyone pulls all of their money from the market and causes banks to begin to topple. This means that instead of having to cover the mortgage expenses of a few million people, you had to prop up the sudden shrinkage of the entire world market.

If, on the other hand, newspapers had said (in August of 2007) that it was a fully containable problem, that people wouldn’t be homeless or unemployed for another 6 months–plenty of time to solve the crisis–and stated what sorts of solutions would actually work, then we would have had a much different future.

Of course either of these points to the need for a realistic solution to come out of the government. This leads to the other topic I had raised for discussion, the presidential election.

Two years before President Bush was the leave office, the campaign for the Presidency had already begun, and it wasn’t some small event happening in the background. It was widely reported upon and considered to be of utmost importance because President Bush was felt to be effectively gone from the office already. The American public, as I perceive it, felt like their country was being lead by no one and any actual problem which afflicted us could not be resolved until the new President came in. In the face of this a $300 billion bailout was fully ineffective.

But more importantly was that the bailout was the product of the nominees. The news presented it as being thanks to either Barack Obama or John McCain that it passed at all. But the news did not present the fact that it guaranteed enough money to purchase all the houses held under mortgage plus some. Everyone knew that things could not properly be resolved until the new President was elected, and everyone knew that $300 billion was simply a band-aid to tide us over until January 2009.

Why? Because that was the common perception, and the common perception is what dictates the economy. The July 2008 bailout was fully sufficient to achieve everything needed by any measure that was actually wrong with the US market.

But it was not to the advantage of the politicians who were running for office to make this known. It wasn’t to the advantage of the news to make this known. Though in both of these cases, moreso the problem is a complete lack of understanding of the actual issue at hand. Neither side really took the 10 minutes it would take to figure out what was wrong, how bad it was, nor how it could be fixed. I generally distrust the idea that people will really screw over a whole bunch of other people as some sort of conspiracy, but I do think that people will gladly stay ignorant of pertinent information where that information could only ever hurt their position.

It was the duty of our representatives to acquaint themselves with the realities of the issues at hand and make reasonable responses to it. But it was also the duty of the media to make sure that they were actually doing so. And it was the duty of both of these groups to make sure that the electorate understood the issue well enough that we wouldn’t pull all of our money from the market.

In the Information Age, a botch-up like this should have been nigh impossible. That it wasn’t is where I feel that the need for this blog comes into play. Reality and rationality have to be re-introduced. There is no way to know when the mass media will return to a reliable state of being, but one could hope that at least one or two voices can become the new generation of Edward Murrows and be, again, trustworthy.

I am frightened by the imbalance, the constant striving to reach the largest possible audience for everything; by the absence of a sustained study of the state of the nation. – Edward R. Murrow

The Law of Toos

A thing you will see as this blog continues is a review of some basics of economics. Today’s post will demonstrate why I should suspect that almost no one has an understanding of this topic, regardless that I am no wizard at it myself.

As you may recall from last two years that we had a presidential election. In the background of this, the Subprime Mortgage Crisis was unfolding and the race became one to decide who was the better of the two candidates to handle this crisis or, as it ended up, the after-effects thereof.

Timeline
Let’s review the timeline of these two events (largely lifted from Wikipedia):

January-February 2007: Presidential hopefuls announce their intention to campaign for the office
February 2007: The first subprime lending companies begin to go bankrupt.
April 2007: The largest subprime lender, New Century Financial, files chapter 11
August 2007: Subprime loans are discovered to be contained in the portfolios and investment packages of regular banks. (Presumably after having been purchased from the failed lenders.)
August 2007: Presidential hopeful Hillary Clinton proposes a $1 billion bailout fund to help homeowners at risk for foreclosure.
August 2007: President Bush announces a limited bailout of U.S. homeowners unable to pay the rising costs of their debts.
September 2007: Federal Reserve Chairman, Alan Greenspan, announces the “housing bubble” and its scope. The Fed begins to lower interest rates.
October 2007: A consortium of banks and the US government decide to spend $100 billion to purchase up mortgage-backed securities and consolidate them into a single package held by stable banks called the Super SIV.
November 2007: The Fed allocates $41 billion for cheap loans to banks to help them stay afloat when things crunch.
December 2007: President Bush announced a plan to voluntarily freeze the mortgages of a limited number of mortgage debtors holding adjustable-rate mortgages.
December 2007: Banks start trying to back out of Super SIV.
January-March 2008: The US stock market begins to decline.
March 2008: Bear Stearns, a large holder of mortgage securities, is forced to sell itself to JP Morgan Chase.
March-June 2008: John McCain wins the Republican primary, becoming the official Republican Nominee for President
June 2008: Barack Obama wins the Democratic primary, becoming the official Democratic nominee for President
July 2008: The Housing and Economic Recovery Act of 2008 is passed, setting aside $300 billion to aid subprime borrowers.
August 2008: 9.2% of all US mortgages outstanding were either delinquent or in foreclosure.
September-October 2008: Presidential debates between the two candidates unfold, giving “final” overviews of their intentions as President to Americans.
September-October 2008: Several major institutions either failed, were acquired under duress, or were subject to government takeover. These included Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac, and AIG.
November 2008: Barack Obama is elected as President.
January 2009: Barack Obama assumes the Presidency.
February 2009: The American Recovery and Reinvestment Act of 2009 is passed, devoting $787 billion to the economic recovery of the US.

Looking through this, especially if you note the transformation of $1 billion into $787 billion, you might think that the point of this exercise was to demonstrate what they mean when they say “throwing good money after bad”. But of course, you can only throw good money after bad if you want to have any hope of turning that money good, rather than losing it all.

Some might say, well, the homeowners who signed up for sub-prime loans deserved what they got and so you are better to simply let them lose. Others might say that the banks and the financial corporations which perpetrated this deserved to be allowed to fall.

On the other hand there is the phrase “too big to fall”.

Impacts
As best I can tell, as of May 2007, approximately 7.5 million people had a subprime mortgage. About 2/3rds of these were adjustable rate mortgages (ARMs), or roughly 5 million people. The rate of deliquency on these was about 11%, almost double that of the previous low. But the question is, how much money is this?

For a $200,000 loan at 8.5% interest for a 23 year term (assuming half of everyone goes for a 15 year loan and half go for a 30 year), the average monthly payment would be about $1,944 according to mortgagecalculator.com. At 11%, it would be $2,286. 8.5% is the average starting rate of subprime ARMs (lasting about two years), and 11% is the rate these loans would have been starting in 2008 after they left the starting rate. A difference of $342 per month is a significant difference by anyone’s measure, and of course subprime ARMs were largely targeted at people with poor credit scores to begin with.

But so, if all of these people had simply defaulted on their loan, we’re looking at this much money lost:

(5,000,000 people X $1,944 X 2 years) + (5,000,000 people X $2,286 X 21 years) = $259,470,000,000

Or roughly, $260 billion.

Again, this is the value to outright pay off the full loans, plus interest, of all subprime ARM loan holders. The Housing and Economic Recovery Act of 2008 set aside $300 billion to help these people.

However, it can be assumed that the borrowers felt they could cover their loan at the starting rate (8.5%), so if they had been able to continue at that rate, they would have been able to continue on without excessive default rates. This gives us two numbers, the amount that the borrowers would pay at this rate, and the amount that banks had expected to earn:

5,000,000 people X $1,944 X 23 years = $223,560,000,000 paid
5,000,000 people X $342 X 23 years = $39,330,000,000 more expected

If, in August of 2007, President Bush had simply said that all sub-prime ARMs will be covered by the United States government, with legislation to this effect presumably passing in December 2007, the taxpayers would be liable for $39 billion.

Let us consider how much this is in practical terms.

The average salary in the US is about $25,000. There are about 145 million Americans employed. The average tax burden is perhaps around 40%. This is a total value, per year, of $1.5 trillion. To cover a further $39 billion in one year, the tax rate would need to be raised 1.08% or about $22.50 per month to the average tax payer. Since the creditors were not expecting to receive this value in a single year, but rather over 15-30 years, we actually only need to raise 1/23rd of this value per year. That is to say, we would be indebted about 98 cents per month in extra taxes for the next 23 years, and with the way that taxes are balanced across those making a wage, for most it would be even less.

This is not a fearsome prospect.

Discussion
Unfortunately, I can’t find it but there was a study done which sought to analyze crisis management throughout the world and what economic courses of action seemed to be the most effective. The findings of this report was that the courses of action taken weren’t nearly as important as that action being decisive and prompt. If you waffle about or don’t present a clear and logical plan in a way that makes everyone aware that the problem truly is being dealt with and can be dealt with, then the problem begins to escalate and worsen.

But as you can see, there really was no plan until December of 2007 and this was not actually passed until July of the following year. If you look at unemployment rates over the last few years you will notice that passing into 2008, it was already too late to have saved the people who were losing their homes and subsequently their jobs. Confidence needed to be achieved by mid-year of 2007 and actual policy put into effect by end-of-year. Plans which simply proposed particular values of money with no rationale for where that number came from or where it was intended to go were pointless because money isn’t a plan.

As I see it, there are two problems:

1) Politicians don’t want to present clear plans to the general populace.
2) The general populace, usually, likes the idea of change but not change itself.

These are, of course, interlinked.

Take for a example that a politician is running for governor. He says, “I’m going to invest more in our school system!” This is very unobjectionable. We like our young to get more and better education. More is good, but “better” is subjective. Is it better if students do or don’t wear school uniforms, for instance? Who knows, but the point is that this sort of discussion breeds debate. Debate breeds divisiveness in the electorate. The more ways that you divide the electorate, the more reasons there are for them to not want to vote for you. The person who can promise more without promising better, wins the election.

A number, however, sounds specific. $1 billion is a very nice and firm thing that sounds impressive and useful. You can do a lot with $1 billion. So people think when they hear this number. But if there is no targeted plan for that money then it’s not really doing anything but buying votes.

The government coming in and saying, “All these loans, we’re covering them.” It’s interventionist. Almost always, the populace of the United States does not like the government to actually intervene and change the way we live, the way our businesses operate, or the way our schools teach. Money is fine and can be targeted as wanted, but plans are bad.

President Bush was actually quite a change in that he proposed clear courses of action. For this, I suppose, he must be applauded. Of course his fault was that he was neither quick to make his proposals, and of course the plans were generally ill-advised or poorly carried out, and so left him as a near lame-duck in the last two years of his Presidency, depriving the US of a single leader. And of course his proposals were divisive and highly polarizing to the nation, which is not good for the sort of rational debate and compromises that are necessary for reasoned courses of action to come out of the government.

The $787 billion stimulus package is again money without a plan. That President Obama proposed and approved of it does not bode well for crisis management on his part. Partisan wars between our two parties over health care reform do not bode well for reasoned debate.

President Bush’s term of office was perhaps spectacular for the number of crises which unfolded one atop the other. The dot-com bubble, 9/11, Enron, the Iraq and Afghanistan wars, Katrina, the sub-prime mortgage crisis, and Bernie Madoff’s little foray. We can only hope that America’s luck will be better under Obama, or that reason can be re-introduced into politics. We can’t afford further bungling of our crises nor more attempts to buy our way out of them.

The idea that interventionism is bad is not without merit, but this runs into the Law of Toos: Too of anything, is bad.

Too much intervention, too little intervention…. Where those limits are who can say, but you’re a fool to think that those limits don’t exist.

Sources:
http://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%932008
http://en.wikipedia.org/wiki/John_McCain_presidential_campaign,_2008
http://en.wikipedia.org/wiki/Hillary_Clinton_presidential_campaign,_2008
http://en.wikipedia.org/wiki/Barack_Obama_presidential_campaign,_2008
http://en.wikipedia.org/wiki/Timeline_of_the_United_States_housing_bubble
http://en.wikipedia.org/wiki/Housing_and_Economic_Recovery_Act_of_2008
http://en.wikipedia.org/wiki/American_Recovery_and_Reinvestment_Act_of_2009
http://www.federalreserve.gov/newsevents/speech/bernanke20070517a.htm
http://www.boston.com/realestate/news/articles/2007/12/01/subprime_mortgage_rates_could_be_frozen_for_some/
http://www.marketwatch.com/story/fixed-rate-mortgages-gain-steam-arms-rule-subprime-survey
http://www.npr.org/templates/story/story.php?storyId=9096735
http://en.wikipedia.org/wiki/Tax_rates_around_the_world