A Long Economic Winter

Richard Benson is president of Specialty Finance Group, LLC , offering diversified investment banking services. This article was originally published Oct. 15, 2002 on his website. The recent AOL writedown appears to provide an example of the vaporizing "Fictional Equity" mentioned below.

Simple arithmetic, knowledge of how the world works, and common sense, are all that are needed to see that a long Real Recession lies ahead. The pillars of the U.S. economy: Business, Real Estate, Financial Markets, the Consumer, and, the Government, are still pointing down. In order to meet demand, businesses still have too many workers, too many plants, and too much capital. The $8 Trillion drop in equity values will force companies to write off at least another Trillion in corporate “Goodwill” from their balance sheets. Companies that acquired other companies for stock during the bubble, clearly overpaid. That “Fiction” was booked as Equity in the form of Goodwill. Now that the “Fictional Equity is vaporizing, it is leaving companies with new problems meeting debt to equity covenants with their banks and bond holders. In addition, the drop in equity values has “ripped up” company pension funds. The S&P 500 pension funds alone are suddenly $280 billion under-funded, and major corporations that keep an assumption of an annual 9 - 10% return on their investments are long past the “Laugh Test” for credibility. Corporate revenues are not “Snapping Back”. Indeed, corporations have far too much debt to service, and corporate credit spreads are at record levels. The junk bond market is rapidly expanding because of “Fallen Angles”, and in the next year or two we will certainly see many “household” names of major firms go bankrupt like United Air, Household, and Ford. United Can’t afford to pay its airline pilots up to $300,000 a year; Household can’t keep making credit card loans to people who will lose their job; Ford can’t fund its pension fund and sell cars to people with bad credit, at no profit and at zero interest. The Federal Reserve has tried adding massive amounts of liquidity, and the credit markets are finally waking up to the reality that liquidity doesn’t make “Bad Loans Good”, it makes “Bad Loans Bigger”. Companies can no longer borrow their way to meeting cash-flow needs. Companies are forced to cut new investment and slash employment. If there is any need for new investment, it will certainly be in China, where labor cost 10% of what it does in the U.S. When history is re-written in order to match the actual acts, much of the recent U.S. “Productivity Boom” is nothing more than a strong dollar, importing parts made with “cheap Asian labor”, and final assembly in the U.S. Business is going to continue to be a big negative for the economy and the job market.

Commercial Real Estate is already rotting, and single family real estate has peaked and started a very long slide. Commercial buildings are still being finished for tenants that no longer exist. Commercial vacancy rates are way up, but do not reflect the large amount of “sub-lease” space that is on the market.

The owners of commercial properties with mortgages on the buildings don’t want to look at what will happen when primary leases come up for renewal, and the major tenant decides to reduce the space they are willing to pay for back to what they actually need. The smart property owners are selling now while there is still an impression that Real Estate is better than the stock market. Major corporations, like Citicorp, are selling their corporate headquarters because they need the money. More firms like K-Mart will file bankruptcy and significantly cut the number of locations they lease. New construction for commercial properties has to collapse. Who needs them? Single Family housing foreclosures just hit a 30-year high. This fact undermines the durability of the “Housing Price Bubble” and record cash-out mortgage re-financings.

Housing has helped to hold up the economy but winter is coming. The re-financing binge is running its course and will be ending by the first quarter of next year. The real damage to the housing market has yet to come. New housing construction and record low interest rates have pulled consumers out of multi-family rental units, pushing rents and commercial property prices down. This has encouraged the consumers to greatly overpay for their homes. When this individual loses their job, they will lose their house to the bank. Their new home will become the old apartment they used to rent.

Banks and the GSEs are acting as if housing prices can only go up, and have lent to very marginal borrowers. The good news is that home ownership is at record levels for the population. The bad news is that the records for homeownership will be replaced by new records for housing foreclosures. Look forward to a very long winter for housing and commercial real estate.

The financial markets are still signaling “Major Bubbles”. While the stock markets have started to correct, and have wiped out $8 Trillion in the U.S and at least $20 Trillion worldwide, the major bubble in the debt and credit markets is just stating to unwind. The Federal Reserve created the bubbles and has been desperately trying to protect them with massive injections of liquidity, and encouragement of credit creation. However, the credit markets are beginning to catch on: adding liquidity to markets doesn’t make “Bad Credits Good”; it makes “Bad Loans Bigger”. Too many credits are already too big. Argentina has defaulted. Brazil will default. Turkey will default. United Airlines and Conseco will file bankruptcy. There is a huge list of companies and countries that cannot pay back what they have already borrowed. Lending them more money will change the date of default and increase the amount. The credit markets are saying that you just can’t find anybody that wants to be the “New Lender” to help “Bailout the old Lender.” The problem for the financial markets is that one firm’s debt is a financial institution’s asset. As loans default, they destroy real equity capital in banks, insurance companies, hedge funds, CDO’s, etc.

The capital markets and financial institutions depend on leverage. As equity is destroyed, their ability to leverage and lend is destroyed. Downgrades of a bank like JP Morgan Chase make it harder for them to take on risk. They already have over $20 trillion of derivative exposure. If JP Morgan Chase’s derivative book for interest rate swaps, credit derivatives, structured equity notes and other market bets were put back on balance sheet, they would make the balance sheet of Long Term Capital look quite conservative.

In the financial system there are over $100 Trillion of derivatives. Most of these were booked based on pricing models that assumed that markets do not move more than three standard deviations from long-term trends or averages. We now live in a world where many markets have easily moved four or five standard deviations from the norm. Major financial institutions have tremendous losses that have not jet been realized. The only steady source of earnings for the financial sector is funding long term Treasury notes and mortgage assets with short term CP or Fed Funds. If you think an economy is healthy if it offers a return on a 10-Year Treasury Note of 3.60%, it means you don’t think.

The “Bond Bubble”, based on low and lower short term interest rates, is a catastrophe waiting for the first time the Fed raises interest rates. If the Fed is true to form, it will cut short term interest rates to make this Bond and Agency Security Bubble as big as possible. The financial markets do not offer a quick fix or a long term solution to our current economic problems. Indeed, the financial markets are the problem. Only “de-levering” the financial markets will restore them to health. However, de-levering means less debt, less borrowing, more saving, and much less spending. Less spending means less economic activity.

Will the consumer spend us back to prosperity? The answer is with what? The consumer has been conditioned by the stock market bubble. Since the stock market would take care of his retirement, there was no need to save. Indeed, the consumer could spend every dollar he earned and every dollar he could borrow. This leads us to a world where 1.6 million consumers are now filing for bankruptcy every year. This year the U.S. Treasury will collect $180 billion less in taxes from individuals than last year. That means that $600 billion of income and capital gains has gone missing. This year single family mortgage debt will be up $600 Billion. Borrowing helps keep spending alive. But at some point, decreasing incomes and increased borrowing just don’t add up, particularly when pension funds and 401K’s have been nuked by the Bear Market. Borrowing to spend means that you are spending other people’s money. It’s wonderful; it's fun; Unless, of course, you are the lender. With low incomes, no bonus, job loss, no new jobs, record bankruptcies, and record home foreclosures, we are starting to see consumer spending sag, and slowed down lending to people who can’t pay. The consumer pull-back will trigger the Long Economic Winter.

With Congress approving going to war, you would think that the boost in Federal spending needed for the war effort would boost the economy. The government is not doing enough. While the Federal budget is going into deficit, more of the deficit is coming from a drop in tax revenue than new spending. Moreover, state and local governments are headed for $80 Billion in deficits; except, these governmental entities are not supposed to run deficits. While state and local borrowing is rising, so will taxes and cuts in programs and employment. Because of the November elections, needed fiscal policy will be postponed until next year.

Without massive, immediate fiscal stimulus to offset the major negative forces from business, real estate, the consumer, and financial markets, common sense and arithmetic add up to a very Long Economic Winter.

You'll know when resources are grossly mismanaged because you'll see Productivity decline. Look at Zimbabwe today, for instance, a nation that once was so productive that it exported food now must import emergency rations just to survive yet another day of its self-imposed famine.

I've spent enough time knocking around in the third world to know a kleptocracy when I see one.

Obviously we are not going to turn into Zimbabwe. However, when we spend billions on laser fusion when we lack energy independence (and fission works just fine) or we allow a an education cartel to cripple the minds of our youth, or when we allow a real estate cartel to accumulate enough leverage to threaten the entire finacial system (in the name of affordable housing??), don't expect me to remain silent.

"Obviously we are not going to turn into Zimbabwe."

Hey, we agree on something! Sadly, there are posters on FR who think that we WILL experience a great depresssion so vast and mighty that we turn into worm-scavenging cavemen.

"However, when we spend billions on laser fusion when we lack energy independence (and fission works just fine) or we allow a an education cartel to cripple the minds of our youth, or when we allow a real estate cartel to accumulate enough leverage to threaten the entire finacial system (in the name of affordable housing??), don't expect me to remain silent."

I don't want you to be silent. I'm just trying to put reality into perspective for you. Billions spent on nuclear fusion over the last two decades are inconsequential to a $12 Trillion annual economy, for instance.

Our education cartel is harming our society, but only at the margins. Even the poorest inner-city student can attend a well-respected engineering university and make up for the earlier educational deficit in his/her life. In the grand scheme of things, the U.S. is turning out enough engineers, scientists, researchers, et al to continue our technological dominance. Moreover, inefficiencies in this system are prime areas of opportunity for entreprenuers.

There is no real estate cartel. No real estate company controls any significant amount of real estate. Now granted, the masses who own real estate do broadly agree on a few large, well-established government policies (e.g. the mortgage interest tax deduction), but you do need to realize that the masses are something completely different from a "cartel". Masses=democracy, not cartel.

The closest thing to a real estate cartel would be the mortgage industry, but trading paper debt is hardly a political position of strength.

"Actually, productivity is a two-edged sword: increases can result in a situtation where resources that were previously well-allocated become misallocated, because they are no longer needed given the new, increased level of productivity."

No, that's not a two-edged sword.

Productivity is NOT a zero sum game. If resources are better allocated/used, then the sum total of our society is better off (read: more profitable, better quality, longer lives, richer, and quicker in every sense of the word but dead).

Our "jobless" recovery is better for society than it would have been to have had no layoffs but lower productivity.

Let me give you an example.

Some decades ago my father went to India/Asia where he was consulting with some local muckity mucks on a rather large construction project. There were 200 or so Indians who were digging a ditch with shovels. Later he was shown several hundred Indians who were pounding rocks into dust for cement, and they were using hammers.

My father told the chief contractor that he could dig the ditches faster and for less money by bringing in a backhoe for an hour, to which the man told him that "we don't want to do that because we want to employ as many people as possible".

My father replied "then you should take away their shovels and give them and another thousand workers spoons to use for digging"!

Well, a "jobless" recovery is when you bring in the bulldozer or backhoe and get the job done faster, for less money, with fewer workers (i.e. you're more productive).

India would still be in the Middle-Ages if it had continued to "employ as many workers as possible". That's the wrong goal.

The goal is to become as efficient as possible. The more efficient you are, the more productive you are. The more productive you are, the more you advance your society at large.

Digging ditches with spoons and pounding rocks into dust with hammers might employ a lot of people, but it won't advance your society and it won't raise the standard of living for everyone.

Believe it or not, those workers were eventually better off being fired and replaced. India is now a technological powerhouse with a vastly higher standard of living than it had 50 years ago. Smashing rocks into dust by hand was never going to get them anywhere but dead and broke.

And they finally figured that truth out...

Your argument rests on the assumption that "productivity gains" necessarily are achieved by actual strategic improvements in the infrastructure of production. Unfortunately, that has not recently been the case. Instead, the gains in productivity over the last few years have largely resulted from tactical measures that are penny-wise but pound foolish. Businesses are cutting expenses to meet profitability estimates, without much regard for long term (strategic) concerns.

Your argument also rests on the assumption that the heart of our economic problem is lack of productive capacity, where an increase in productivity would be helpful. But that, unfortunately, is not at all the problem that confronts us. Rather, the overriding strategic issue is overcapacity and other deflationary pressures. In such an environment, increases in productivity make the situation worse, not better. Otherwise, we would all be rejoicing over the extra supply of inexpensive goods coming from China, and inexpensive services coming from India (for example.)

Even in the case where strategically-beneficial productivity gains are occurring, there is still the high probability that the short-term (over the next dedade) consequences can be quite negative. Putting a lot of people out of work may eventually result in a much stronger economy, but will surely result at first in a recession or depression.

"but will surely result at first in a recession or depression."

Nonsense. You will not find that recessions always follow productivity gains.

In fact, productivity gains do not always even result in lost jobs/livelihoods. The biggest example of that point was probably the INCREASE in jobs/hiring/slavery that followed the invention of the cotton gin.

Likewise, more shipping jobs were created by the invention of the steamship, even though numerous "sailors" on the old wind-powered sailing ships got laid off in the process.

You will not find that recessions always follow productivity gains.

I nowhere said that recessions always follow productivity gains. I contend that the productivity gains we have recently experienced are a) occurring at the wrong time, when the last thing we need is greater production capacity, and b) being achieved largely by tactical means that don't actually result in strategically-significant improvements to the health of the economy (unlike the example you gave.)

Here's a counterexample: The 1920's saw very significant increases in productivity as the result of electrification, but the result was the Great Depression. I contend that the productivity increases due to computerization and the internet will have a similar result--in spite of the fact that we will be better off "in the long run" because of our investments in these productivity-enhancing technologies.

Finally, please consider the argument in The Collapse of Wall Street and the Lessons of History.

"Here's a counterexample: The 1920's saw very significant increases in productivity as the result of electrification, but the result was the Great Depression."

The premise of your example is flawed.

Look, I walk outside early every morning, and every morning the sun rises. By your logic above (of first electrification and then Depression), my walking outside every day makes the Sun rise because one follows the other. Yet clearly that's not the case.

Productivity is always a plus for the macro, sometimes a short-term minus for the micro.

Adding electricity did not create poor farming techniques that contributed to the Dust Bowl weather catastrophies. Adding electricity did not cause the Fed to tighten credit or the Congress to raise taxes or the French to dump their Gold reserves, much less indebt Europe in post-war poverty and massive death as a result of a useless war that they hoisted upon the world.

The premise of your objection is flawed.

At any point in history you care to examine, there are always many events, conditions, processes and phenomena occurring, many of which will be blamed (or credited) by one theorist or another with causing subsequent changes to economies, markets, societies, cultures and political alignments.

Consequently, just as you can claim that the Great Depression happened for other reasons, and in spite of the rising productivity resulting from electrification, I can just as easily claim that another Great Depression is coming soon to a world near you, in spite of rising productivity.

I can also claim that rising productivity may be detrimental in some circumstances (but clearly not in all circumstances), because there are multiple cases in the historical record of bad economies following periods of rising productivity.

Capacity utilization is falling. Sales are declining. Businesses have no pricing power. The car manufacturers have to offer zero percent financing, with no payments for a year, and an 8-year loan, in order to sell new cars. In such an environment, the economy needs greater productivity about as much as an overweight person needs to eat more calories per day.

Look, when capacity utilization is this low, the cheapest way to increase production is simply to use more of the existing, but idle, capacity. In fact, the major reason that the productivity numbers are increasing is precisely because of the decreased capacity utilization: it's the high-cost production facilities (and producers) that get shut down first. The least-productive employees who get laid off first. The worst-managed businesses who go bankrupt first. That's what's behind your increase in productivity.

Finally, the core point I wish to make is not that the increased productivity in the 1920's was causative, either partially or wholly, of the Great Depression. My contention is that a) the Great Depression happened immediately after a period of significantly rising productivity, and b) it makes sense that the economic dislocations that resulted from replacing human labor with electric motors would, initially, cause economic hardship. People do not instantly adjust to changes in the job market of that magnitude. Nevertheless, there is no scientifically-accepted way to quantify the significance of this effect (if it exists), relative to whatever other factors may also have caused the Great Depression.

Bottom line: rising productivity does not reliably prevent subsequent recessions and depressions, and may even contribute to them.

If rising productivity led to depressions, then lowered productivity should lead to the inverse.

Which is true?

When the intrinsic unit cost of production decreases, the same amount of capital can be used to produce more units, and the price per unit can be lowered (or else the profit per unit is increased). To that extent, rising productivity is always beneficial.

However, there is more than one way to achieve increased productivity, some of which cause net harm to the economy. I think the problem here is that a distinction needs to be made between the concept of "lowering the intrinsic unit cost of production" and "increasing the ratio of units produced to hours worked." I have been addressing the latter, and I suspect that you and Southack have been addressing the former. The distinction is crucial.

To simply find a way to use the same resources (including people) to produce widgets more cheaply is one thing. To fire all your workers, and stop doing business with all your vendors, because you have a magic device that produces as many widgets as you want very cheaply, is another. The first case is unquestionably very beneficial. The second case very well may not be--especially at first.

Of course, the official productivity numbers measure the ratio of units produced to hours worked, and not the intrinsic unit cost of production. This is why I am not impressed by the productivity figures. I don't believe they mean anything other than that the less effective workers have been fired, the less efficient machines have been mothballed, and the most costly factories have been shut down.

In an economic expansion, as demand outstrips supply, ever more marginal workers get hired, the less efficient machines come on line, and the more costly factories restart production--with decreased productivity as the result. Nevertheless, this is widely viewed as positive. And that should answer your question.

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