How Did We Get Into This Mess?

As we approach the end of the year, I thought I would use today’s blog to paint the picture of how we got into the financial predicament we are in. I get this sort of general question from readers who are not in the financial business, and it provides a good back-drop as we reflect on the year that was, and the ones which will be.


What is at the heart of the “mess”, as I call it, is a huge build-up of debt over the last 40 years. Keep in mind that modest amounts of debt are usually OK, but when easy money allowed folks and governments to borrow more than they had real prospects of paying back are allowed to occur, it only spells trouble. Eventually, the time will come when accounts need to be squared away, and losses taken by those who foolishly lent all this money.


Along the way, this borrowing binge came with unwanted side-effects. In the US, we became so infatuated with easy housing credit, that house prices rose dramatically, 200% from 1995 to 2005, that the increase in wealth which this engendered, spawned an economic boom. In turn, this encouraged American enterprise to focus a disproportionate amount of resources towards the housing business, be it construction, real estate brokerage and related services, or finance. In fact, while the real estate boom was occuring, financial companies grew to represent over 20% of the S&P.


On the back of the economic miracle in the US, our trading partners started to pick up various industries and other “out-sourcing” functions which were previously performed domestically. Of course, this did coincide with the explosion of the internet, and low communications costs, but the fact of the matter was that our economy seemed to be self-sustaining, with such a large share of employment coming on the back of the housing boom. The US’s trade deficits started to balloon, to 6% of GDP in 2005, but we did not care because we seemed to be operating at full employment. Coincident with this, the US government was also adding to the economic miracle by running persistent budget deficits. Apparently, the Bush tax cuts, enacted in 2001, did very little to actually stimulate the economy. And now that we are 9 years into them, it appears that the expansion in growth has done little to bring the budget deficits down. I would consider these tax cuts a failure. Yet our politicians do not know how to do anything better or different. 


And this brings us to the subject of the US’s budget deficit. As our trading partners ran surpluses, they gladly purchased our debt. In fact, China’s purchase of 10 year US treasuries in 2004 created the conundrum of the flat yield curve, even as the Fed was raising short term interest rates. The US government has done a good job of running deficits, and with a 4 year average, 2009-2012, around $1.3-$1.4 trillion, the debts over this period alone equals 40% of our GDP. By the time 2012 ends, our Debt/GDP will be approximately 120%. In pure simple English: We are tempting fate.


Yet our politicians refuse to use their spending ability to invest in infrastructure, something which we outlive the short term spending boost the tax cuts create. And our politicians do not have the courage to accept the fact that as a nation, we need to slow down our spending, because we will not be able continue to borrow our way to prosperity. I do expect that over the course of 2011, that Congress will come up with about $100 to $200 billion of annualized spending cuts. And when they do, expect them to project these savings over as many years as is necessary, so the total savings is advertised, as being in the trillions. Unfortunately, a 1% rise in interest rates will offset these savings. And unless the Fed monetizes debt at the rate of $75 billion a month, then (treasury) supply concerns will continue to put upward pressure on interest rates.


The structural part of the problem, is that during the housing boom, we ceded a decent chunk of our economy to our trading partners. Many of these jobs are not coming back, and now that housing is in the doldrums, and is expected to remain there for the next 5-10 years, those jobs are not coming back either. This creates concerns over whether 9% is our new unemployment rate. It very well could be. Of course this is an unacceptable proposition, so I would expect our politicians to deficit spend ourselves until no one will lend us money. What our politicians are missing is the perspective that the surge in joblessness, has gone too far, and that radical thinking needs to take hold. This means that we invest in our future, which includes a greater emphasis on education (think math and engineering), and infrastructure to foster a 21st century society. I used to think that Obama would embrace new initiatives to lead our country forward, but it is becoming increasingly clear to me that he is only leading us into a downward spiral. I now believe that it will be from the depths of a downward spiral or collapse, which will cause structural changes in our society. From there, we will have a shot of achieving the greatness which the US has embodied in the 20th century. Unfortunately, we will be led into an abyss, before this occurs.


A different set of problems exists in Europe. Europe seems to have similar housing problems, but the fact that home mortgages over there come with recourse against the borrower, has caused many borrowers to try to hang on. And as such, home prices have yet to collapse as dramatically as they did in the US. Yet there are very real issues in Europe about a society which is just carrying too much mortgage debt. As I documented the looming housing problem in Spain, over the past few weeks, it is just a matter of time before these chickens come home to roost. The other debt problem in Europe has to do with the debts of the peripheral members of the EU, affectionately known as the PIIGS (Portugal, Ireland, Italy, Greece and Spain). Not only are these countries accumulating debt faster than they can, but their debt is scattered throughout the balance sheets of the (mostly EU) banks. Up until recently, these IOU’s were deemed to be risk-free, yet as recent events show, they are anything but risk-free. 


In effect, you have a banking system, which is for all practical purposes, insolvent. And this is the beauty about the current situation in Europe. If everyone pretends that these debts are good, and trade them accordingly, then they must be. The alternative would be a bail-out and collapse which will entirely trashes the EU, and in the process, create negative feedback loops into the global economy. And unlike the US, which might have a large chunk of the population who are upset that the government bailed out the banks in 2008 and 2009, the EU is comprised of many different countries, and it remains to be seen if France, Germany, and the other ‘strong’ countries, have the will, as determined by their particular populations, to foot the bill for the PIIGS, which can easily top €1 trillion before this game has played itself out.


What is so remarkable about the current situation is that the two largest economic blocks, the EU and the US are over-indebted, and headed for a catastrophe. Europe might get there first, because they do not have the ability to run persistent deficits as we do in the US. This in turn puts the end game into focus, as no one likes to deal with the impact of (EU) austerity measures, which the EMU (european monetary union) is forcing. In a normal (non-EMU) environment, each country could devalue their currency, which would effectively wipe away their un-payable deficits.


Our politicians gladly (just) voted for a slew of tax rebates for Americans, because they have no sense that there are any consequences for doing such. Unfortunately, by the time they realize that there are consequences, they will have used their last ‘get out of jail free’ card. And when this happens, there will be a collapse of monumental proportions. Who actually bears the burden of paying back the US’s debt remains to be seen. Here are some of the ways in which our debts will get paid for:


* economic collapse once the government realizes it cannot keep printing money and running deficits. It could always do so by printing money, but eventually:


* money printing creates inflation, or we will experience


* debt default/devaluation of our currencies; (unlikely, but you never know).


Of course, the corollary to today’s blog is one entitled “Are we there yet?” And to that, I tell you that we are not there yet. We are starting to see some signs that we are getting closer, which is engendered by higher precious metals prices, as investors shift away from fiat currencies. And the current up-tick in US interest rates is also a harbinger that we are getting closer. In the meantime, the politicians have delivered yet another $1 trillion gift to its constituents, so for some time, all will seem to be well. Just in time for the holidays.