Depression Economics

I’m no economist. But I live at the mercy of the economy, so I read quite a bit on the subject with hopes of learning a thing or two. Understanding the causes for inflation was relatively simple concept for me to grasp. With an ever-increasing supply of money and shortages of essential elements, higher prices are inevitable.

But how inflation morphs into deflation is another matter. I never could quite understand how that could happen, if not created by central banks removing money from the system. Until now.

I am beginning to see how money disappears.

It started when lending institutions loaned money to people on no-money-down, adjustable-rate-mortgages for homes and real estate, and in so doing created a buying frenzy. Good sales created competition and drove up real-estate prices. As values for real-estate grew in what was really a stagnant economy when looked at just from the standpoint of producing and selling products, people took out additional equity loans. Real-estate outpaced other goods in value for a number of consecutive years””somewhere around 15% per year. This could not go on forever. And it hasn’t.

Wages couldn’t keep pace with the rise in value of real-estate, not without breaking companies having to compete with off-shore businesses and producers.

Now interest rates have risen; mortgage payments are re-setting at higher numbers and people are not earning enough money at their job to make payments. Gas and food prices, not included in the government’s inflation rate numbers, are on the rise at an exponential rate.

So people load additional debt on credit cards.

Then they put the house up for sale. But it doesn’t sell. So they lower the price. And it still doesn’t sell. Money they thought they had in equity vanishes into thin air. At some point, they owe more on the house than it is worth.

Home owners can’t keep the job if they don’t have gas, and everyone must eat. The credit card is essential for these expenditures, so it gets paid before the house payment. With time, the home owner gets farther and farther behind. The day comes when the bank forecloses. The home-owner walks away from the home and finds a cheaper place to rent.

But this owner is not alone. Many of his neighbors are in similar situations””stretched to the limit with debt.

Banks try to sell homes to recuperate money they loaned and they don’t sell. So money the bank thought it had in the form of promises to pay isn’t there. Vanished into thin air. Many of these loans have been packaged and have become part of someone’s retirement fund or investment package. And that retirement fund or investment package ain’t worth a nickel, because masses of people quit making their payments. They are written off of the books; the money they represented also has vanished into thin air.

Money we thought we had was nothing more than a figment of our imagination and a few binary numbers in a computer. Unfulfilled promises based on expectations of more and more growth at every level.

When all of his happens in enough places at the same time, the people wake up and realize they have no money. They tear up the credit card, leaving another unpaid debt, and consequently destroy more money, and start paying with cash which means they quit buying so much stuff because they don’t have enough money to do so. The stuff doesn’t sell, so the store lowers its prices. And it still doesn’t sell. Before long, the store is in trouble. As are the employees of the store. Stores close, more jobs are lost.

New construction comes to a standstill and construction workers lose thier jobs. Quit making payments. The snake eats its own tail.

Now you have deflation. Collapse of an economy. A Depression.

I wonder if printing and reintroducing new cash can keep up with the disappearance of all of this money and forestall a collapse. I guess time will tell, because I doubt the fed is going to quit printing money as long as the rest of the world allows them to.

If the fed does tighten cash supplies, what happens when China and a handful of Saudi princes, each of which sit on a trillion or so dollars decide to buy our country? If the fed keeps printing money and we keep buying stuff made in other countries without selling them something in exchange, they end up holding more dollars (now you know why bush wanted to sell our shipping ports).

Our economy is based on its ability to grow continually. But there are limits to growth and we’ve come near realizing what those limits are. This planet has given us all it had to offer and we’re still not satisfied.

Something has to give.

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  • I really like the way your put this in real terms and how financial disaster rolls out for ordinary people stretched to the limit. The financial studies also show something you’ve brought up: most consumer borrowing is not wasted on frivolous luxuries. The real culprits are the vicissitudes that strike everybody at some point in their life – a medical crisis, loss of a job, or a divorce. As you say, people still have to buy gasoline for their car and food for the family, until even the credit card limit gets overwhelmed.

    The Fed can’t just keep printing money (in cash form or in the electronic form that most of us use these days for money) to stave off this disaster. It all depends on the banks and their willingness to keep lending. No matter how much money the Fed makes available to banks, if the consumer is no longer viewed as a reasonable credit risk, the economy will sink into recession.

  • As I understand it, the BEA has been including real estate in the GDP calculation. If real-estate values fall, does the BEA decrease the GDP number, or is this a one-way proposition?

  • The jury is out on the deflation/inflation question. The Fed will certainly try to reflate as much as they can.

    Numerian is right to observe that “it all depends on the banks and their willingness to keep lending.”

    Credit needs to be created in order for the newly created money to get into the real economy. I expect that when push comes to shove that we will see big government spending to starve off a deflationary spiral – maybe even government guaranteed mortgages.

  • Bushco’s policies has been strongly inflationary.

    The buying power of the US dollar has roughly halved during the last seven years. (Compare it to gold, Euros, or whatever.) So, a sensible interest rate would be around 10%. Basically, if you had taken out a loan at anything less than that, and bought your choice of any number of things like oil, gold, or so on, you would have profited.

    So, even without people defaulting on loans, these low interest debts are sucking buying power out of the economy.

    The depression scenario you’re looking for is closer to Weimar Germany, or Brazil than the US 20’s.

    I expect that the foreclosures aren’t really being caused by people loosing money, per se, but rather because people are overcomitted – that is excessively gambling – on real estate investments.

  • If you pay attention to the business of a community, you tend to see it the way Don does. Because it happens before your eyes. You know who is expanding and whether he knows what he’s doing. More importantly, you know who is and who does not.

    You see the results of cheap money.

    You see a whole town with new houses that hasn’t grown. You see who’s living in them and, lo, they basically came from same town. You see a build-out of fast food places for the same mouths. You see guys building warehouses that weren’t necessary 5 years ago, chock full of building materials. Everybody’s got a new pickup. Store bought new blue jeans.

    You know who has the notes at the bank to do all this. You can hear people who have never done development or business talking big plans. Drinkin’ beer and talkin’ big keeps the bars in business.

    It’s the same in New Yawk. It’s just harder to see. So you make an economic model in New Yawk, because you don’t know your neighbor, and usually don’t need or care to.

    As you do in a place like Seguin.

  • I’ll try adding another piece.

    While this is going on, over at the Club, two friends are drinking $500 whiskey and discussing finance. One says “I’ll bet you a bazillion dollars that the yen outperforms the real this week”, and the other says “You’re on!”. As usual, at the end of the week, the loser hands the winner an IOU. But that bazillion dollar IOU goes into the winner’s balance sheet and gets recorded as though it’s “real” money. Eventually, one of these guys decides he wants to buy a small country, so he goes to his friend and tries to cash in the IOUs. Ha! The world’s money supply shrinks by a few bazillion dollars that never actually existed. Perhaps more importantly, membership in the Club is revoked for both, unless their Daddies can smooth things over.

    Housing slump takes toll on Florida’s economy
    Florida’s declining housing market is sending shudders through the rest of the economy, state economists said, and will leave the state with $1.5 billion less to spend.

    Miami Herald, By Gary Fineout, August 2

    Tallahassee – Floridians are spending less on big-ticket items — cars, furniture, appliances — and economists say it’s due to one main ailment: the slumping real estate market.

    The principal problem, state economists said Wednesday, is that home construction and sales of existing homes have dropped even below the slowdown they had anticipated earlier this year. The level of sales of existing homes has dropped to 1997 levels. And the sluggish housing market has eroded consumer confidence and dragged down the sales of other expensive items such as automobiles.

    Auto sales in Florida have plummeted in the past 18 months: During one three-month period in 2005, the state took in $1 billion from taxes on auto sales. The past three months: $906 million.

    Sales of appliances and furniture have tumbled as well, according to forecasts, with state revenue from sales of those items dropping from a high of $428 million during fall 2006 to $402 million in the past three months.

    At the same time, Floridians continue to spend as much money as they ever have in restaurants, bars, movie theaters and clothing stores. That has led economists to conclude that Floridians are avoiding more expensive purchases because the real-estate downturn has them worried.

    ”We think people are hunkered down,” said Amy Baker, coordinator of the state Office of Economic and Demographic Research. “They don’t feel as wealthy. They stop buying things.”

    “Vanity, Vanity, all is Vanity.”

  • I would never have seen or understood what was happening if people like you, Bonddad and Mauberly hadn’t beat me over the head with so many good articles like this one.

    It takes a while for a common man to grasp this stuff. You have done a good job.

    I did inhale.

  • I’m going to pick one quotation to nitpick a litte — Wages couldn’t keep pace with the rise in value of real-estate, not without breaking companies having to compete with off-shore businesses and producers. In fact, as I understand it, GDP growth has been pretty strong, but it’s all gone into upper management looting compensation and profits rather than wages. Changes in policy and law have made this shift of wealth to the have-mores possible. Even in talking about how things work in the current environment, let’s always remember that the current environment is not inevitable. There are alternative globalizations, and only propaganda says that there’s just no repealing the laws of economics that pamper the powerful.

  • There is an interesting symmetry in all this. I am reading a book on China in prep for a trip to Tibet. In a description of the 1911 revolution that ended the last dynasty…the writer ascribes a weak imperial oligarchy selling off China’s assets to foreigners. Specifically, selling rights to the railway system. When you think about all the American angst about the Japanese in the 1980’s, it is going to be interesting when the Chinese and Saudis start buying in a serious way.
    Our oligarchs and plutocrats are creating the conditions for a major sell off coming up soon. And as the Bancroft family has recently shown, it really is just about the price.


    …Elaine Meinel Supkis: Great Depressions like the one that hit in 1929 are very rare. They usually happen only after two great empires exhaust their finances. WWI involved two of the biggest industrial powers in a massive death-struggle that didn’t destroy their industries but wrecked their currencies and beggared their workers. Russia was a major empire but a minor industrial power so when the workers there revolted, the loss of this sector’s industrial base had much less impact than the collapse of Germany’s currency and its huge war debts.

    This chart is from one of my most dog-eared books, one of the greatest works explaining relative power and why empires collapse, ‘The Rise And Fall Of The Great Powers’ by Paul Kennedy. The chart shows how England, the leading nation in the world, supposedly the richest, spent the most money during that grinding, depressing stalemate of a war.

    Germany spent $3.9 billion less than England. Inflation since 1913 has been ferocious. This probably would represent well over several trillion dollars in today’s currency. Even today, no nation can take a financial hit that big and stay solvent. Europe’s industrial production fell 30% and the US, fattened off of billions of dollars of loans to all parties in Europe, lived high and mighty during the 1920’s. But with industrial production lagging, Europe spiralled downwards. The US cheerfully gave everyone more and more loans and the promise of being repaid was fantastic! Why, these were basically AAA subprime loans.

    Then Germany couldn’t pay and kept asking for better terms. This was OK with the US but not with bankrupt England or France. So they demanded full payments and Germany defaulted. This triggered the Great Depression. Even though the US was now the world’s largest manufacturing power, our currency was mostly for home use so the British had to keep the pound strong. Trying to do this made things worse.

    And so it is today: our empire won’t retreat from its distant borders but these same borders are bankrupting us for we never recovered from the Vietnam War, we literally papered over the mess which remained and continues to poison our nation. The military/industrial complex is not making us rich, it is making us poorer. And the paper being laid over all this is the same paper the Germans used in 1924 to paper over their own bankruptcy: printed money.

    When an empire does what we are doing today, society falls apart. And if this happens, there is no easy way out. Individuals can avoid the worst by avoiding debts but outside of that simple thing, there is no other answer. Of course, the true answer is a strong working class that believes in unity and not underselling each other. Alas, the USA has a long and tragic history of slavery. And the legacy of this culture divides the nation and half loves slavery and enables wretched working conditions and thinks the road to wealth is via cheap labor.

    Germany has an advantage here: their recent attempt at slavery, the Nazi empire, was a total disaster and they don’t want a repeat. I only wish the USA felt the same way. For no nation gets very rich for very long if the working class is poor and can’t work their way into the middle class.

    Question: Would you explain what is meant by “reserve currency” and how it serves the greater political interests of the United States? Do you think that preserving “dollar hegemony” was an important part of the decision to go to war with Iraq?

    Elaine Meinel Supkis: It may sound trite but thinking about great banking matters as if it is one’s own bank account no matter how small, works. Namely, it is dangerous for anyone to live life where everything is juggled and there isn’t a penny to spare. Then something bad happens and boom. You go bankrupt. This is why savings accounts matter and why inflation is so deadly. No one in their right mind keeps a savings account because it can’t grow, it shrinks!

    The Federal Reserve was set up to maintain a reserve funds that supposedly wouldn’t be touched by politicians. But alas, this is a fiction. Just like your own bank account, if one is married and sharing an account and one party keeps raiding it and spending it on guns and cars or fur coats or whatever, it runs out of funds and then something bad happens like a hurricane hits, and the cupboard is bare.

    In the case of empires, a way to gage solvency is, how big is their own reserves compared to the size of these same currency reserves held by potentially hostile rivals? In the case of the USA, we send dollars out as fast as we can print them. If too many people getting this flood of money, around $800 billion a year now!!!!!! If they don’t keep a big chunk in bank vaults, the value of the dollar drops. So they keep it in reserve, in case of a ‘rainy day’. Like 9/11.

    And if we think of these funds as boats, then China has Noah’s Ark, Japan has an aircraft carrier, Europe has a holiday cruise liner, Russia has a very fancy yacht and the USA has a rowboat made out of an old bathtub. That is leaking.

    China has $1.3 trillion in its reserves and is therefore, King of the Mountain. Japan has $900 billion and is no longer holding new currency so all the red ink in trade is no longer staying away, it is floating back home to here, as inflation. Europe has about $600 billion and Russia, $330 billion. The USA has only $66 billion and the numbers released today by the Federal Reserve shows that number is DROPPING. Yikes.

    I did inhale.

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