The Economy’s Hall of Mirrors

Dear Reader,

Help me understand what’s going on here.  Since the beginning of the year the S & P Index has lost nearly 50 percent of its value.  And it still seems like it’s only downhill from here.  How can this be?

I hate to echo the words of the failed Republican candidate John McCain, but I just have to.  Come on, honestly, aren’t the fundamentals of our economy strong — at least if those fundamentals primarily mean productivity?  Has the world’s productive capacities shrunk 50 percent in the course of a year?  Of course not. If stuff is being produced, and the people producing it are also consumers, aren’t there enough goodies to go around?  If consumers weren’t spooked, and if their credit wasn’t tightened, would they be any less acquisitive?  I think not. If we were in a drought or some other calamity and unable to produce, I’d understand the collapse, but fundamentally we still have the same amount of goodies and roughly the same relations of production as we had a year ago. So what gives?

I think there are three real reasons for the economic disaster: an economic system that betted on and built itself up on a lot of bad home loans, the caving of this system, and then the resulting credit crunch. All these problems seem to emerge from extreme carelessness in extending credit.  In the old days, the problem would have been localized, with irresponsible lenders holding the bag for having given credit to uncreditworthy borrowers.  But in a globalized and extremely intertwined economy, that problem exponentially reverberated throughout the whole system.

Still, isn’t the problem just that we have a lot of banks now holding a lot of houses, and yes houses that may have been overvalued?

It’s hard to say, though, what the proper value of anything is other than what people are willing to pay.  So I don’t really buy that all these subprime loans were a problem of a housing bubble.  If the loans had been made responsibly, there’s no reason that housing values wouldn’t have held and continue to increase.

It feels like the end of a boxing match, with both boxers having been so slammed around that they’re both delirious and sinking, when in reality all parties are really strong.

In the meantime, though everyone is spooked and everything keeps crashing.  Is the economy merely and only a mirage, a matter of perception, illusion, and fancy?  It seems like it doesn’t really matter that people have the resources to buy stuff and companies have the resources to produce the stuff that people want.  I’d really like a new Mac (the one I’m typing on is a few years old) and I do have the money in the bank to buy one, but damn if I’m going to.  And that’s only because everyone else if freaking out, so I do, too.

Perhaps the other problem is credit itself coupled with the push to buy as much as you can manage to borrow and the disincentive to sock the savings away.  Perhaps what we have is an unsustainable system coming home to roost. We have an economy that thrives when people buy beyond their means. But if they keep buying beyond their means and there’s a hiccup of any sort, the whole hall of mirrors splinters into fragments of glass.

3 thoughts on “The Economy’s Hall of Mirrors

  1. If people aren’t buying, then production will stop. I think that’s what’s happening now.

    How we got here: bad home loans are one thing, but I think there’s more to it. This American Life did a great story a number of weeks ago explaining how Credit Default Swaps acted like insurance, except more than one person could bet on a loan defaulting. When loans went bad, the insurance company had to pay off ALL the people betting against them. The biggest problem was that this was an unregulated, opaque industry, As a result, no bank trusts any other bank because they’re not sure if they bank they’re lending to is on the wrong end of Credit Default Swaps and therefore unable to pay back the new loan.

    What we’re seeing is a complete meltdown of trust. “Fundamentals” is an accounting term. It doesn’t take into account trust. Without trust, the system grinds to a halt.

  2. I’m not an economist, but here’s my understanding:

    1. The fundamentals of our economy are not AS strong AS WE’VE BEEN PRETENDING. We’ve been borrowing from China to cover our spending… to the tune of $1.4 trillion. That’s unsustainable, and the housing and equity markets ‘bubbled’ with this loaned money, and are now crashing in fear of its withdrawal:

    2. The yen carry trade had a lot to do with it, too. Ever since Japan’s economy entered its long period of stagflation, Japanese interest rates have been very, very low. So people, especially hedge funds, have been borrowing yen, converting it into other currencies, then investing the money elsewhere in the world. There’s a lot of money to be made in this way, however, currency exchange fluctuations in the yen-dollar exchange rate, especially, make these transactions extremely risky. Some analysts have estimated that there were a trillion dollars in positions structured around the yen carry trade, and when the yen strengthened in August, those positions had to be unwound all at once, which meant selling off the assets and converting back to yen. All that happening at the same time further strengthened the yen, making it all the more urgent that investors unwind their positions.

    3. Equity prices don’t exist in a vacuum, though you wouldn’t know it from the last decade: they’re largely tied to a company’s profitability. When I buy a stock, I can only make money in two ways: if somebody else buys it for more than I paid, or if the stock pays a dividend, i.e. a distribution of profits. Moreover, the person who buys it from me will only do so if he or she expects to make money, requiring either a third buyer or a dividend disbursement. So without profits, stocks have no value. More to the point, a stock’s value can be calculated against its potential dividends, and it doesn’t make much sense to buy a very expensive stock with very low or non-existent dividends and no prospects for better dividends in the future. So if something happens to the overall economy to make it seem like companies will be less profitable than we had expected, the economical thing to do is sell those stocks rather than risk one’s capital. And if everyone, collectively, realizes that we’ve been investing in stocks for a while now with no dividends in sight, we all madly rush to get rid of our stocks before the next guy does. While the market can swing wildly in these moves, the prices do somewhat reflect people’s predictions about the future profitability of the underlying businesses.

    (Of course, there are other reasons a third party might buy the stock: if they’re looking to gather a majority share or take the company private by owning it outright, for instance, or if the company decides to repurchase its own stock from investors, but the basic issue is still there: without profits, there’s no equities.)

    4. In a certain sense, the same thing goes for houses. People can only afford to pay so much for a house, and housing prices have historically grown at about the rate of incomes. So: if incomes fall, housing prices will do so, too. And if housing prices have been bid up in a flurry of speculation, then they’ve got a long way to fall before they can reflect the incomes of the workers who inhabit them. Add to that the way that foreclosure works in this country, where many people will simply walk away if their home’s nominal value drops significantly (since they’d actually be paying more in mortgage costs than they can except to recoup,) and the way a foreclosed home tends to drag down other properties in its neighborhood, and you’ve got another one of these stampedes.

    5. Of course, profits and income are related, which is what really puts the jets on the freefall. Lower home prices mean less consumer spending, which means less profitability, which means lower equity prices and also means jobs lost, which means more foreclosures AND less consumer spending, which means lower home prices and lower profits, etc. That depressing cycle drives people to unwind their carry trades faster to avoid further currency fluctuations, and gives China reasons to look at investing their profits elsewhere than in US debt.

  3. This article outlines the economic dampping in pre-economic crisis era.I think it was just badly constructed, unstable economic model that lead to current meltdown.However I agree to the fact that resources and consumers were never at declining rates . The real problem i think was in the workflow due to bad economic model. we need to really work hard to comeup with suitable future economic model in order to avoid any recurrences any more crisis.

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