Where is Our Economy Really At?

The US Government economic stimulus package involves the distribution of $787 billion into the US economy. The American Recovery and Reinvestment Act of 2009 is the rubric under which these record levels of spend have been authorized by Congress. The plan is to essentially "jump start" the American economy in the hope of longer lasting echo effects, which will create enough consumer confidence to perpetuate the recovery. Funding has been allocated and is flowing into the health and education sectors, infrastructure development, and other programs targeted at propping up private sector interests. Whether or not this spend is sufficient, soundly conceived, or is merely deferring the eventual bottoming of the American economy is at this time unknown.

Yet we only seem to hear press reports proclaiming that the economy is in recovery. Is this wishful thinking or reality? Granted, "positive thinking" can result in significant changes in peoples' and nations' attitudes enough to create economic change. However, lasting change can only occur when financial fundamentals are allowed to prevail. The pundits cannot agree on what is truly occurring in the American economy. The bulls, led by the media corps, say the recovery is underway. The market specialists and enthusiasts are holding their money in safer investments awaiting the second installment of this economic perfect storm.

Back to Basics

Basic economics tell us that a household earns money and spends it on goods and services to live and to enjoy a quality of life. Households acquire these funds (usually) through working, through credit, or through investment vehicles. Household income is used to pay down credit debt, to invest, and otherwise generates economic activity and growth in the economy. When working incomes are not sufficient to pay down living expenses and credit debt, then banks will foreclose on assets owned by the household in order to achieve sufficient return on investment or to protect against risk of loss. However, when households do not have enough equity in the assets they own for banks to recover their loan payments, then banks become property owners. This was the basic reality in the housing bubble we experienced over the past two years and still persists in many areas.

When households' incomes are aggregately insufficient to cover off their costs (e.g., living expenses and debt), then households will turn to all other forms of capital available to them in order to live. Personal savings, investments, help from family, and even crime (in the most extreme cases) will be the "opportunities of last resort" for a family unable to meets its basic living expenses with income. A shortage of financial resources and mounting, over-leveraged debt levels present extreme financial risks for households.

The Roll of Investment Banks

Debt securitization is the term used to describe Wall Street's category of investment vehicles to leveraged participation in the housing market boom (and eventual crisis). Wall Street investment banks and other lenders decided to roll mortgage-backed securities into investment vehicles and sell them to investors. The cashflow from the households' payments on housing debt was used to cover off return on investment for banks and to generate cashflow for investors in these new debt instruments. So what happens then when households begin to default on their mortgages en masse? Recession!

This is precisely what happened and why we saw the investment banks, Freddie Mac, and Fanny Mae take nosedives. When debt cannot be serviced due to insufficient cashflow from households, then the proverbial "house of cards" comes tumbling down. Further, the spiral downward actually increased in velocity as "short sellers" capitalized on the downward market momentum by borrowing and selling stocks at price X and buying back and returning stocks at price Y (and of course keeping the difference).

Meredith Whitney, a Wall Street bank analyst formerly with Oppenheimer, accurately described these phenomena (analytically) in the many interviews she has given prior to and since the economic downturn. She has now been vilified by the press and by Wall Street as being "bearish" on all accounts and not a supporter of the economic recovery. Our take differs. What Ms. Whitney has simply captured is: "what will happen, what is actually happening, and what could happen". Unfortunately, this is at odds with what the government, Wall Street and the media want and do report. The question remains, has the economic shakeout been sufficient at this time to remove all dead assets or debt from the banks books; to remove inadequately capitalized financial investors from the market; and sufficiently strong enough to warrant the current pre-emptive announcements about an economic recovery? Many would answer with a resounding, No! Yet, the American media continues to report the economy is in recovery; but with no real, lasting, supporting evidence.

So, Where are we Now?

So this brings us to the question of whether a second economic dip or even crash will occur. Well, the very real challenges facing America are these: the government is "broke"; is engaged in (minimally) two wars costing billions of dollars annually; the number of jobless in the US continues to rise (or at least not fall); households have "reined in" their spending; the medium to long term sustainability of government bailouts is questionable (e.g., banking bailouts; the domestic car company bailouts; and other stimulus packages). Also, these bailouts have improved the supply side robustness of the economy, but without really affecting the demand side. The demand side - or what people eventually want/need and end up buying - dictates the robustness and sustainability of an economy. Supply robustness without a pre-existing or at least subsequent demand, serves only to artificially inflate inventories and temporarily accommodate the purchases of those with sufficient resources to spend.

Let us also not forget about the baby boomers. Over one third of the population in North America is now in "saving mode"; with many exiting the workforce. However, given the economic downturn, many have lost their savings and portfolios, and are now having to extend their working years. This will increase or prevent younger workers from acquiring jobs at all levels and result in a downward pressure on income generation and ability to spend. Those who are still able to retire are not spending at the rampant pace they once did in their early or peak earning years. As a result, the productivity and expansionary activity of the economy is limited. Sure the Millenials and pre-Millenials are spending their parents' wealth on i-phones, snow-boards; "mod" clothing, music, and the other items teenagers typically spend on, but this trend is not sustainable.

A Crash - Imminent or Illusion?

The fact remains it was greed which drove the fake economic bubble of the Bush-Cheney administration. Low interest rates; the sale of the American Dream of home ownership (even for those who could not afford it; perpetuation of credit leveraged spending; the rampant spending on war efforts have all contributed to the current economic situation. Think about the plethora of home renovation "flip this house" style shows on television. Are they still prevalent? Not as much. Several questions are predictive of whether or not the economic recovery is permanent or simply an illusion.

1. To what extent does the American economy drive the world economy (this used to be a blanket statement rather than a question).
2. Have banks learned their lesson and will they now base loans and transactions on realistic and risk-adjusted probabilities of return?
3. Have new housing starts increased across the country or just in small, selected pockets where economic robustness is high or which were never materially affected by the downturn?
4. Has the prevalence of credit-based spending in the general population of households been reduced to reasonable and rational levels?
5. Have the confidence levels increased sufficiently that households are now spending household income on goods and services and not relying on adding to mountainous debt in order to survive and/or thrive?

At this time, the responses to these questions is decidedly negative. Whether or not we are out of the storm, or temporarily situated in the eye of the storm is currently unknown. However, the majority of economic indicators and many basic prerequisites for economic recovery are simply not in place. Un-boarding our windows and setting up the lawn furniture may be a bit precipitous, given that on balance, the contributing factors and drivers of the economic downturn have not abated in severity or numbers. Pick a safe harbor and wait out the storm. Encourage the government to stop spending rampantly on economic sieves, and stay tuned for further vicissitudes in the market and a further shakeout of bad debt and debtors from the economy. The summer of 2010 will see a return to some semblance of normalcy to our economy. It will be punctuated by a newfound knowledge of risk and prudence (obviously with some exceptions). The return of the sleeping giant on the economic world stage will occur. However, for now, be patient and prudent.