Save (for) Yourself, Save the World

’Tis true that we are in great danger;
The greater therefore should our courage be.

Shakespeare, Henry V


I hope everyone had a great Valentine’s Day weekend. And what connotes love better than a meandering missive on personal finance, the economy and government policies? In an effort to spread the love, I am going to try an experiment with my blog. I know there are those who may not be enthralled with following my various diatribes about flawed fiscal plans, corporate greed, housing busts, misguided monetary policies, etc., and are simply looking for some practical advice. Alternatively, there are those that may already be well-versed in the basic elements of sound financial planning and even portfolio management. These people may only be interested in economic analysis and disquisitive ranting. So for a while I will try to cast a wider net – the first part of my blog will be dedicated to some (hopefully) practical household finance issues, while the latter section will be focused upon broader policy/investment issues. Hopefully, everyone will be able to find something of use or interest.

Our new president is also trying to spread the love, $787 billion worth of love to be precise. Upon signing the massive stimulus package into law today, President Obama said the occasion marked “the beginning of the end” to our nation’s economic troubles.

I really like President Obama. He is smart, earnest and hard-working. In many ways Obama represents the very best of our nation, and the principles upon which our country was built. He inspires hope and admiration. I would happily have him as a two-on-two basketball teammate (although I think I might choose a different bowling partner). Moreover, outside of Rain and Stephen Colbert, I can think of few more fearsome competitors in a dance-off. And while my political views may be to the right of his in several areas, unlike some conservative buffoons, I genuinely wish him great success.

Having said that, Obama may as well have been posing in front of the Hoover dam with his finger shoved in a noticeably growing crack while making that statement. Similarly apropos, he could have filed a five-story office building with hundred dollar bills and blown it up. Clearly Wall Street was unimpressed with the fact the Stimulus Plan is now law; the stock markets were savaged to the tune of 4% today.

Obama’s bold proclamation is not nearly as much of a blunder as the infamous “Mission Accomplished” banner above Bush’s head aboard the USS Abraham Lincoln. But it is certainly in the same vein. By raising the prospects that our economic woes may soon be a thing of the past, President Obama risks over-promising and under-delivering.

Rather than seeing this as the beginning of the end, I would argue that we may just now be seeing the end of the beginning. To me, there will be middle and end phases to our economic troubles yet to come. But more about this below.


Of Dead Car Batteries and Moribund Economies

Not long ago I was ready to leave the house to meet some friends for lunch. Upon trying to start my car though, I discovered the engine would not turn over. Marshalling every iota of my meager automotive skills, I attempted to jump the battery. Much to my chagrin, the battery would not even hold a charge.

After postponing what was sure to be a tasty Malaysian meal with excellent company, I called AAA (thanks to my better half’s preparedness/membership). Shortly thereafter a familiar looking gentleman arrived at our house prepared to assist.

“Nice to see you again!” exclaimed a gregarious man with a noticeable Ethiopian accent.

It then occurred to me that he had helped my wife and me before when her car would not start while we were downtown. He proceeded to attach cables to the battery and had me start up the car so it could idle for several minutes.

“How is business for you?” He apparently recalled my occupation as an investor.

“Oh, great! Thanks for asking.”

“Can I ask you a question?”

“Of course.”

“I came to this country years ago with my wife. We worked very hard. Eventually I bought this truck and started a business. We now have a house and children.”

“Congratulations! You have a great deal about which to be proud.”

“Thank you. I look around today and talk to people, and there is nothing but gloom. Nobody wants to start any business. People do not want to spend money. But by refusing to spend money or take risks, does that not just make everything worse?”

“Hmmmm. You are correct in that as people spend less that causes the economy to contract even more. And it is true that jobs are not created if people are not starting businesses.”

“Exactly! And with interest rates so low, does it not make sense to borrow money to do something?”

“Like what?”

“We were thinking about buying another house, or maybe starting another business.”

“Well, I tell people the first goal of investing is not to make money, it is to avoid losing money. The danger is that the economy will worsen, and you will not only lose your own money, but also the money you borrowed, while still owing interest on the loan.”

“But did you not say that the economy is deteriorating because people have these very fears? Isn’t it just these negative attitudes that make the economy worse? Is it not hope and positive thinking that will make things better?”

By this time, we were ready to see if the battery could maintain a charge on its own, and I was pondering the very good questions and observations posed to me. Upon removing the jumper cables and checking the battery with a variety of probes, my new friend said the battery needed to be replaced. While he sprung into action, two points sprung to my mind. But I only felt comfortable sharing one of them.

“What you describe is akin to something known as ‘prisoner’s dilemma’ in the social sciences?”

“Prisoner’s dilemma?”

“Imagine a band of ten criminals in cahoots with one another are all rounded up. The police know, but cannot prove, they are responsible for a serious armed robbery in which several people were assaulted. However, they were all caught having broken into a warehouse. Let us say that should they all be convicted of burglarizing the warehouse, they would each receive a three-year sentence. However, if they were convicted of armed robbery and assault, they would each receive ten-year sentences. The police decide to separate and interrogate all of them. Each is made an offer: Rat out your crew and you will be given immunity from prosecution as well as witness protection.

“Interesting. So what happens?”

“Well based upon social science modeling and experiments, most people would choose to ‘defect,’ or rat out the gang. This, despite the fact that in that scenario, the group as a whole is worse off, serving a total of ninety-years in prison. If everybody stayed quiet, the group as a whole would be three times better off, serving only thirty-years of collective time.

“So let us apply that to the economy. It is true that in the short-term, everyone would be better off if we all began borrowing money and spending once again, as this would certainly stimulate the economy. But the individual will likely be better off saving money and avoiding debt during bad times. So it is safe to assume that households will do what is in their own best interests, even if they know that their actions, if imitated throughout the economy, will cause further economic deterioration. Should you borrow and spend in an effort to do your part to turn things around, you risk financially over-extending yourself at precisely the time when things will probably get worse.”

By this time a new battery was installed and it was time to test it. My engine turned over without hesitation.

“I see. So I should do nothing?”

“Have you started saving for your children’s higher education?”

“Hmmmm. No. Not really.”

“I suspect that will be an investment that will pay dividends far in excess of any stock, bond or piece of property.”

After a warm handshake we parted ways. I had a new battery. I am not sure with what my new friend left.

So what was the second point I did not want to bring up at the time? A concept that is probably heretical to most readers, and is certainly unconscionable to every policy-maker:

What this Country Needs is a Good Old-Fashioned Recession

Throughout the polemic debates raging on Capital Hill about what should be done about the financial crisis, there is one point upon which there is utter and complete consensus: the government must do something to bail out people and businesses who have buried themselves in debt and bad investments. This is a most grave misconception, and one that I am convinced will make things much worse in the long-run. I will make three points this week as to why the approach taken in DC is disasterous policy-making.

1. Capitalism is “creative destruction.” The primary advantage of capitalism is the way in which it efficiently and quickly allocates capital throughout and economy. Adam Smith called this the “invisible hand.” Essentially the market, left to its own devices, naturally adjusts to any economic circumstance based upon supply and demand. As we discovered 20+ years ago when communism collapsed under its own waste and inefficiencies, capitalism is the greatest system in the world when it comes to generating wealth. However, this system is not one without its costs. One of the great economists, Joseph Schumpeter, noted that capitalism's very essence is "creative destruction."

With very few exceptions, when the government intervenes in the marketplace, it does so at the cost of reducing overall wealth. This is not to say that such intervention is never justified (a topic that will have to wait until next week). But to do so to save businesses or people from bankruptcy based upon their own decision-making is horrific policy-making.

I grew up in an era of stereo 8 tapes (for those younger readers, please consult your resident octogenarian for information about this archaic audio format). Back in the day I felt quite cool popping in my Captain and Tennille eight-track tape and turning up the volume (did I mention I was a very pathetic child?) At some point in the late 70’s, people stopped buying these tapes and players. First cassette tapes, and then later CDs, were viewed by the marketplace to be superior formats (for instance, both actually had rewind capabilities). Stereo 8 accordingly died an ignominious death.

I am sure that there were thousands of people whose jobs were tied to the manufacture and distribution of eight-track tapes. The government could have stepped in to stave off corporate and personal bankruptcies by extending loans or subsidies to this industry. But intervention would have extended the production of goods the marketplace no longer wanted, and employed people in positions that would only continue so long as the government maintained its largess.

Moving ahead to the present, by stepping in to "bail out" those industries/market sectors that would otherwise go bankrupt, the government prevents the natural winnowing process inherent in efficient markets. So instead of our economy receiving the proper signals that we need a lot fewer investment bankers, mortgage lenders, auto assembly-line workers and the like, huge quantities of capital continue to be misallocated when Uncle Sam saves jobs/businesses that should go away.

2. A serious recession is both inevitable, and ultimately necessary. The Holy Grail of both economics and government policy-making is ending the business cycle. Actually, let me clarify. It is to eliminate the “bust” portion of the business cycle. Who does not like a boom after all? Booms are like attending weddings with open bars.

But let us return to the dreams of those hoping to make recessions a thing of the past. Somewhat ironically, the greatest hope on this front has occurred when the economy has been poised at the edge of great financial precipices. On the eve of the great stock market crash of 1929, noted economist of his day, Irving Fisher, proclaimed, “stocks have reached what looks like a permanently high plateau." I suppose from ground level, cliffs can occasionally be mistaken for plateaus.

As recently as 2007, Fed and Treasury officials were confident that economic fundamentals were “sound” and future growth prospects looked bright. Once cracks began to emerge in the very foundations of the world economic order, these same officials offered assurances that the government stood ready to act in a way to minimize any slowing of the economy. Now that a full-blown economic catastrophe is upon us, we are promised that ultimately trillions of dollars with be spent in a herculean effort by the government to revive the economy. Moreover, it is taken for granted that such action is necessary given the circumstances. Balderdash!

While I am skeptical that there will ever be an end to the boom-bust cycle inherent in market economies, of this I am certain: A bust cannot be avoided after the most pronounced and unsustainable boom the US economy has ever seen. Marc Faber likens the need for a recession to the human body needing sleep. In an expansive phase of an economic cycle all kinds of frenetic activity and growth takes place. In this euphoric time, companies expand business operations, consumers buy more goods, and everyone takes on more debt. But just as the body needs its time of inactivity and rest, so economies need times of contraction to purge excesses and repair balance sheets.

To push this analogy further, it is possible for the body to stay awake longer than is natural. Initially this can be done by sheer will power. Eventually artificial stimulants are required. Being an inveterate crammer throughout college and grad/law school, I recall the drill quite vividly. Determination was enough through about 2:00 a.m. A candy bar could take me through 3:00 a.m. at which point I started brewing coffee. By 4:00 a.m. I was double-fisting Mountain Dew. Anything beyond 6:00 a.m. and I was looking for a Red Bull IV drip. The later I pushed my body to stay awake, the worse the repercussions. After one grueling 38 hour stint without sleep, I did not stir for 14 hours. It took me a week to feel like myself.

So it is with the economy. Yet the Fed has for years been artificially stimulating the economy through below-market overnight interest rates (see blogs below). This is the economic equivalent of mainlining NoDoz. It should be no surprise that our economy soared to heights not previously achieved. But just as there is a law of diminishing returns when it comes to taking stimulants to stay awake, the current zero-interest rate environment appears to be doing little to revive our economy that has already begun to slumber.

By preventing a serious recession at all costs in the futile attempt at staving off inevitable, and painful, economic adjustments the economy must make (reducing debt and consumption), the government simply prolongs and intensifies the pain. Moreover, thanks to its massive non-market based intervention in the economy, it reduces the overall net wealth of the nation by untold billions. It is truly execrable.

3. The government’s solution to drunkenness? More alcohol! Listening to politicians, pundits and policy advisors alike, the one message that gets through is the need to “stimulate” the economy so we can get back to the business of our nation. What is that business? Why, it is getting the consumer confident enough again to consume! It is getting the banks stable enough to resume loaning money. And above all, it is getting everyone, individuals and businesses alike, secure enough about the future to start borrowing again. We are constantly bombarded with talk of the “credit crunch.” The solution, taken for granted by one and all, is to inject hundreds of billions of dollars into the banking system to make credit easier for all to obtain. Indeed, a particularly important and popular element of the of the stimulus plan passed last week are tax incentives and rebates for first time home-buyers as well as new car purchasers.

Am I the only one that thinks this entire plan will not just be ineffectual, but counter-productive? Just prior to the financial crisis, household debt relative to income soared to unprecedented levels, while at the same time net personal saving in the US went below zero for the first time in 80 years! Consumption as a percentage of the overall economy reached 70%, far exceeding its historical norm. The ratio of household debt to assets had soared more than 50% in less than a decade. According to a recent research report by Merrill Lynch, overall private sector debt exceeded $15 trillion by the end of 2007, reaching a new high even as a percentage of national income.

In the brief period of time since the financial crisis started, 10% of mortgage borrowers are either behind on their payments, or in a state of foreclosure (and indeed the new administration is proposing a $50 billion plan in an effort to arrest further foreclosures). And while savings rates have climbed to a paltry 2% of national income, this is almost 85% lower than the level it was at the beginning of the 80’s.

So let me get this straight, the uniform consensus on Capitol Hill is that the solution to the financial crisis is to do everything possible to encourage further consumption and borrowing? Does it even make sense to anyone that long-lasting economic growth can be achieved by consuming more and more consumer goods that eventually depreciate in value to zero? Or borrowing ad infinitum? As I have argued before, whether we are talking at the household or macroeconomic level, I have never heard of spending one’s way into prosperity. Nor can one borrow their way to riches (at least riches that will not have to be paid back with interest).

Real economic strength is based upon savings and investment, not borrowing and consumption. More than anything else, we need to encourage Americans to rebuild their balance sheets, eliminate debt and set aside money that can be invested. This is in the long-term best interests of the US.

But far from encouraging and fostering this transition, policy-makers are adamant in their efforts to eliminate the short-term pain that inevitably comes with such a paradigm shift for our economy. In so doing, I am convinced they will retard the very processes already naturally and necessarily at work in the economy.

Adam Smith had it right. This is obviously a sprawling, dissertation-worthy topic, and I have not done justice to any of the points above. But I will attempt to sum up my simple-minded perspectives.

Whether it has been from my closest and smartest friends, or new friends that know how to replace a car battery, I often get questioned about the “savings paradox.” This is the concept that during economic crises individuals who look out for their best interests by saving more actually do harm to the economy as a whole, and hence ultimately themselves, since they are not spending as much. And once this behavior is replicated, the economic damage spreads.

My response: By saving money you are actually helping the economy make what will inevitably be a painful, but necessary, transition towards sustainable growth. This process would occur naturally, thanks to the “invisible hand” at work in the marketplace. But allowing this process to unfold in the least destructive manner possible would require courage, and lots of it. Americans must be courageous enough to suffer through a painful period of economic dislocation. Moreover, courageous politicians must emerge to tell Americans what they need to hear, not what they want to hear. Sadly, courage appears to be in short supply, and no where is this more evident that in DC.

So the main danger is that in a desperate attempt to prevent exactly the contraction process the economy needs to purge the excesses that have built up as a result of a rampant and malignant credit bubble, the government will waste hundreds of billions of dollars and prolong the recession/depression.

This is not to say that the government should stand idly by and allow the effects of economic dislocation ravage the members of society already living at the margin. But that discussion, along with the ways in which the current government policies violate basic tenets of social justice, will have to wait until next week.