Friday, January 18, 2013

The Tragedy of Living in the Present

A family living in the 50s, 60s, and 70s built their wealth primarily through real estate, ie the home that they lived in. When the man of the household retired, he'd be presented with a gold watch from the one company he worked for his entire adult life, he would finally own the deed to the house that he lived in (or would be really close to it), and he would have a generous pension and Social Security to pay for his retirement. Life was good.

That kind of institutional stability is now gone. The defined benefit pension was eliminated in favor of the defined contribution retirement account. Congress spent the huge surpluses that Social Security generated and replaced them with IOUs that future Congresses can ignore. And the American family started living beyond their means, using debt backed by the value of their homes to have the latest and greatest of everything.

The two bedrocks of American middle class wealth, the pension and home equity, are now relics of a bygone era. That's why wealth collapsed in 08. That's why families are now more worried than ever about their financial prospects. The game changed and nobody told them that it did. Salesmen and finance types marketed immediate gratification, long term liabilities be damned. And because the average American was so financially illiterate, they bought the pitch with ease.

The few people who realized that it now took decades of fiscal restraint and smart investing (in index funds that had a prudent mix of both bonds and stocks) did very well. So did the people who went into finance right as the stock market went on one of the biggest runs in the history of the American economy. Everybody else was left in the dust, happy to buy the big screen TV on credit and renovating their kitchen with granite countertops and stainless steel appliances.

But the American economy grew. The insatiable appetite of the American consumer, backed by finance companies who were all too willing to extend them credit, encouraged manufacturers and service providers to provide more and more stuff. But while American households were all too happy to live paycheck to paycheck, the shareholders and bondholders made out like bandits, because they were the only people who were willing to invest money to build the factories, office buildings, retail malls, and roads to get all this stuff to the average American consumer.

Consequently, when the music stopped and the punch bowl ran dry, the only people who recovered were the people who had significant savings. The stock market is now back to roughly where it was before the recession. The bond market is roaring. And the people who saved and invested came out largely unscathed. That's what gave rise to the plutonomy. And that's why the recovery has been so dependent on the rich and upper middle class. They're the only ones left with any money to spend. Everybody else already shot their load.

The new mantra of academia is to inflate our way out of the crisis. And since the debtors outnumber the creditors, there's a very good chance that this is exactly what's going to happen. Because the people who spent and spent and spent did so on borrowed money. If they could just default on it or pay it back with less purchasing power than they originally borrowed, it would repair the average balance sheet fast enough so that the average American could feel comfortable spending themselves into oblivion again.

Although if it does happen, and we decide that the creditors are going to have to take a big haircut, you won't see the widespread availability of credit anymore. Consumer access to credit dropped to just about zero during the recession and it remains anemic still, as businesses wait and see whether the Federal government wants to make all of their savings and investments (to them, a consumer debt is a credit on their side of the ledger) significantly less valuable.

In short, if that does happen, this is the new normal. Because the investors aren't going to invest nearly as much anymore. They're chasing yield now, but if the bond bubble pops, investors will be much less likely to provide the capital for our credit markets to function as they did when times were good. That means a European growth trajectory. And it means an entrenched but dwindling elite, as more and more people become dependent on government policy and regulation to supply their daily bread.

One of the readers of my blog asked why I don't believe in demand driven recessions. I do believe in them. I just don't believe we should mitigate the consequences of it. If it goes deflationary, I wouldn't mind it at all. Short term, the consequences would be pretty severe. But, as with all things, this too shall pass. And when it does, the country will be stronger for it.

1 comment:

  1. From what I can tell your argument seems to be that we suffered a big wealth shock which reduced output and employment. However, you can't reason from a wealth change because wealth shocks on their own don't cause recessions, it's the driving forces behind them which (sometimes) reduce output.


    1) 1987 market crash. Huge wealth shock which had no effect on employment and output. Central bank kept NGDP chugging at its 5% path level and, unsurprisingly, RGDP moved along with it.

    2) People forget that the housing crash began years before the recession, however RGDP and employment was more or less completely stable. It wasn't until late 2008, when NGDP crashed, that RGDP and employment tanked.