The Current Economic Conundrum

My wife informed me that I must be more brief in my posts. So while I make no promises, I will try my best.

The market has been all over the place the last couple of months and pundits are on both sides of the fence as to when and how this slump will end. What I want to do is briefly share four things that explain the current environment and offer an ominous prediction. I'm not saying these are the only four drivers, but they make a lot of sense to me. These are simply four "conclusions" I've reached through informal conversations with economists, and really old bankers.

1. Too much debt, or, in finance speak, "Leverage." Finding the right amount of debt a society should use is difficult. People need access to mortgages and banks need access to collateral. However, it turns out that too much debt is bad for society. That may be obvious in today's environment, but some economists actually saw this downturn coming years ago. The reason too much debt is bad is because it increases the riskiness of societal wealth without creating a proportionate economic gain. In other words, too much debt, or leverage, creates a cycle of boom and busts that cause people to lose their home and job more often than would be the case. Since 1990, the volatility of personal income (measured by standard deviation) has remained the same. While at the same time, household debt/income ratios went from 80% to 130% over the last ten years. So, as a society, we've increased debt without increasing the stability of personal income. And societal wealth growth (measured by GDP) averages 3.4% and is unaffected (directly anyway) by the use of leverage. (FYI, sources are the Federal Reserve, BEA, and SED).

2. Uncertainty. Due to some very complex financial engineering, there is a high degree of uncertainty on Wall St. these days. Nobody has any idea how bad the current mortgage defaults will effect the economy. Note, everyone is in agreement with regards to the fact that the news is "bad," but nobody can quantify it. And being able to quantify the impact of certain events is a main premise of risk management. In an environment of high uncertainty, markets tend to overshoot (overly optimistic or pessimistic depending on the news). Everybody is on a train and no one knows when to get off. The only thing you know is that nobody else knows when to get off. This is precisely why banks have been writing off loans for the last three quarters, rather than coming out at one time with the appropriate number. They are clueless

3. Oil (and other commodities). What is so interesting about oil is that demand has increased over the last five years even with rising prices. Why is this? Because of the growing middle class worldwide that want to drive cars. Although demand for oil in the U.S. may decline, it will not in India and China. The other problem elevated prices create is delayed exploration in new fields. Why increase the supply if that will drive down my price? This is the thinking of most producers. Obviously high food and energy prices effect consumers to a greater extent when they don't have any money and are unemployed.

4. American Short-termism. There is no incentive for publicly traded companies to manage for the long-term. Wall Steet CEO's are rewarded and evaluated against quarterly earnings. This creates an incentive to do what may be profitable today, at the expense of long-term economic viability. Citi Group's CEO said, last June, "As long as the music is playing, you have to dance." Well, now it's not and he got fired. However, he would also have been fired for not taking advantage of easy money (i.e. debt). So this model has to change.

Conclusion. With the global middle class tripling over the next 15 years I predict the U.S. will not be the global economic leader it has been for the last 20 years. It's not only the demographics that are not in our favor, but the huge amount of debt we carry. At some point, you have to pay the piper and I think the time has come for the U.S. No other country (accept the U.K.) is more leveraged that we are. If our major lenders (China and other developing countries) wanted to redeem their loans (because the U.S. economy is no longer the safest) that will mark the end of our high consumption economy as we know it. It's ironic isn't it? That these developing economies have aided our growth over the last 10 years.