[It was nearly a year ago that our good friend Doug Behnfield, a financial advisor based in Boulder, Colorado, lucidly described here how America was headed into an economic coma that would last for many years. With the financial phase of the crisis winding down, says Doug, we are about to enter a prolonged period of asset deflation, high joblessness and stagnant-to-negative GDP growth. A chief cause of this will be by-now-unavoidable, drastic cutbacks baby boomers must make in their retirement plans. For a close-up look at what to expect, read Doug’s essay, below. RA]
Now, let’s get this straight. We are in the early stages of a secular credit collapse following the biggest credit bubble in human history. The credit expansion that began in the late 1930s finally became a bubble as a result of a universal, irrational and linear belief in real asset appreciation that developed in the 1990s and reached its glorious peak in 2007. The credit collapse began with the financial crisis of 2008. That was followed by all the king’s horses and all the king’s men brandishing marvelous new tools trying, but failing to put Humpty Dumpty back together again. We got a pause in the collapse and a spectacular bear market rally, but now we are rolling back into contraction. Six months into the transition, it is time to deliver a forecast for the next stage in the new paradigm that began with the inflection of the secular credit cycle. The First Stage was the Financial Crisis. The Second Stage is the Economic Crisis, with all its attendant deflation and GDP contraction.
I am reminded of a quote that Art Zeikel included in On Thinking. The quote was from economist Dick Stoken: “Because human psychology is slow to change, a broad economic move usually occurs in three stages. The first stage begins when some unexpected event shatters an overdone psychological environment. Yet, while some people respond immediately to this new lesson, most people, as they find it outside their past experience, do not believe it. They need more evidence — that is, a second stage. Typically, the majority become convinced during the second stage and therefore the psychological background changes. People begin to act differently, and their behavior soon affects the performance of the economy (my italics).”
The event that shattered the overdone psychological environment this time around was the abrupt reversal in the market for residential real estate. Real estate had become the foundation for practically the entire society’s financial plan, not to mention the primary source of discretionary dollars for most households’ profligate consumption. The trajectory of home prices went from straight up to straight down practically overnight. But that was after 70 years of only brief and regional setbacks, so it is understandable that most people didn’t rush out and put a sign up in 2009.
No ‘Rubber-Band’ This Time
In similar fashion, every post-WWII recession had been relatively brief and quickly followed by new highs in GDP, employment, corporate earnings, and tax revenues.
Due to the severity of this financial collapse, unprecedented fiscal and monetary stimulus was brought to bear, followed by a strong and noisy consensus that, due to the magnitude of the “Great Recession” the subsequent recovery would be awesome. Much like pulling on the rubber band. So it is understandable that small businessmen particularly have tried to avoid losing longstanding but superfluous employees that would be a source of profit in the recovery just around the corner. By the same token, for the 90% of people still employed, it didn’t make sense to sit everyone down and radically cut the household budget or lower expectations on what constituted an affordable college.
But we didn’t get the rubber-band effect. We got “pushing on a string.” And there are costs associated with hanging tough through the valley. Reduced revenues, whether at the corporate, household or government level, must be compensated for by increasing debt or reducing savings if cuts in spending are deferred. So it is reasonable to assume (at the margin) that balance sheets have actually suffered in the last 4 years since the economic contraction began, for entities that have not experienced stable or growing revenues. Admittedly, overall household debt to disposable income has decline to 125% from a peak of 134% in 2007. However, government transfers have taken on a much larger role in the denominator. Cash on corporate balance sheets have also ballooned, to more than $1.8 trillion. But how much of that is in the financial sector or reserved because management is preparing for winter?
A New Layer of Recession
The question for the thoughtful and objective observer is: What happens if the next recession begins (or the original contraction continues), before organic growth has resumed enough and balance sheets have been repaired enough to weather it? And: What are the policy options if the Fed has not had the opportunity to reload the gun and the society will not politically support even more extreme fiscal stimulus than the first round, which appears to have been ineffective? We are about to get the answer. If Dick Stoken is right, the reality of this new paradigm of secular credit contraction (collapse) will come more into focus by the broad population and behavior will change. One of the primary tenets of Buddhism is that man will not change until the pain of his suffering is greater than the pain of change. This most likely means that household economic behavior will come more into alignment with rational solutions for reestablishing financial security. As an aside, last week, the latest round of policy response to the credit crisis in real estate by the mortgage bankers (Fannie and Freddie) entered the rumor mill. Would Obama execute an “October Surprise” by offering an $800 billion jubilee to upside down mortgagees? The consensus was that such an act would be, among some other really bad things, stimulative. We have been saying for several years that like any other lousy investment, mortgage lenders would have a lot to write off before this is over. But stimulative? Give me a break! This is one more example of asset destruction that is the bedrock of a credit collapse. It matters not whether the asset (a mortgage) is owned by a bank or a ward of the state. Credit is being dissolved. There is not one stimulative aspect to it.
Frugality Is Coming
Whereas deteriorating household balance sheets were tolerated when the prevailing wisdom was one of linear economic expansion, it becomes unbearable when the perception is that the economy is in secular contraction. For the 55-year-olds in 2007 who are now 58, there is no doubt that their household economies are in secular contraction, regardless of what the global economy has to offer. Two years ago we researched what the 80th percentile, 55-year-old householder looked like financially and it turned out that he was upside down! That is to say, financial assets available to fund retirement were substantially less than mortgage debt. And they have $150,000 of household income to fund a major portion of at retirement. For the Baby Boomers, the evidence is rapidly becoming unavoidable that a change in behavior toward extreme frugality is the least painful alternative. All the things that home appreciation or at least the prospect for wage or stock market gains used to pay for are being reassessed. In their place, the savings that go along with a tighter budget is likely to be combined with productive life style alternatives to solve the problems associated with the legacy of the unsuccessful planning decisions of the past. (Those included leveraging your way to prosperity.)
We have focused on the Baby Boom Cohort for a variety of reasons, but the main one is that, along with their traditional role of driving the fashion for the population as a whole, they have entered the stage in their lifecycle characterized by maximum political power. Local and national politics should reflect the mores of this cohort like never before as their economic behavior changes. It is difficult to imagine that the political establishment will not be beset by some revolutionary forces as Baby Boomers embrace a strategy of frugality and financial rebuilding. The Age of Aquarius meets AARP. The old paradigm of conspicuous consumption is yesterday. As Ringo Starr would say at age 70, “Peace and Love.”
Postponed Retirements=Fewer Jobs
There is much work to be done, and none of it will bring back the credit expansion any time soon. Severe budgeting and the attendant saving will bring forth the “Savings Paradox.” Retirement will have to be postponed for the Baby Boomers, making it especially hard for those at the entry level to find employment. In an effort to liquidate debt, home prices will be under extended selling pressure. “Pay as You Go” is making a major comeback. Government employment will be a major source of economic contraction. Keynesianism is toast.
So, there you have it. A very deflationary outlook favoring investment strategies that capture safe and durable income, even as asset values come under increasing pressure. It is not that farfetched, but who among us wants to question the quality of the Emperor’s robe? The most startling possibility is that, even as the vast majority of pundits debate how “gradual” the recovery will be, we have already entered a period that seems destined to mark the most severe contraction since 1937.
In an act of heroism, Wall Street Economists are upping their estimate for the likelihood of recession in 2012 to 35-50%. That means chances of avoiding it are slim to none. We have experienced the unthinkable and we haven’t even gotten to the economic stage of this crisis yet. Just the initial, financial stage. Sub-11 million auto sales, 300,000 new home sales, a 33% decline in Case-Shiller. 18 million unemployed, a $1.4 trillion deficit and on top of it all, what do you get? 3 years older and deeper in debt. The shift to long term government bonds is just starting up again.
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The only reason we are not already in the depths of a 1930’s Great Depression is because of the Federal government doling out money. Take away Fannie/Freddie/VA/FHA/HUD and make the banks foreclose when they should have years ago. Take away Unemployment Insurance and the FDIC con game. (The banks are all insolvent.)
Take away food stamps and farm subsidies.
Take away all the Federal loans after all the fires, floods, and tornados. (No one gave the Oakies any low cost loans during the Dust Bowl) Take away all the Federal government jobs created since LBJ was President.
Disband our huge military and layoff all the MIC workers. What’s left that is self sustaining? Not much. They have been shoveling make believe money into our economy for decades to mask what has happened.
I hope they can get away with it awhile longer.