ARTHUR TO THE RESCUE
America's Broken Economy: How, Why, and the Only Solution
America's economy is broken. We hear it everyday when we turn on the news, open our Internet browsers or listen to talk radio. Everywhere you look... more bad news. Layoffs, stock market misery, falling home prices, massive unemployment and, worst of all, President Obama pontificating about economic Armageddon. The government's response has been underwhelming... stimulus, bailouts, blah, blah, blah. None of it seems to make any difference. Realistically, the government cannot do much of anything in the short term. Anyone who understands anything about economics could tell you that and yet we have dozens of classically trained economists recommending every possible solution with no clear consensus. Why? No one wants to talk about the real problem... you and I. That's right, the system did not fail, we did.
The blame for this entire debacle is solely at the feet of the American people. I know you are thinking "Good God Arthur, isn't that a bit harsh?" and you are right, it is harsh. The truth hurts. I am not one to mince words and I call it how I see it. What we are witnessing right now is a national case of "pass the buck". Republicans blame liberals. Liberals blame the conservatives and supply-side economics. Rednecks blame the Mexicans. Rich blame the lazy poor, poor blame the greedy rich and the middle class blames everyone but themselves. Let's examine the real reason we are in the midst of worst economic times of any of our lives.
We have all heard of the "greatest generation". They were the folks who survived the Great Depression in their childhood years, fought and secured victory in WWII and saw us through the Cold War. That generation experienced life before the advent of radio or television and many survived to see the information age. This generation persevered through economic misery, poverty and unprecedented bloodshed while leading us to unparalleled political supremacy, a luxurious standard of living and explosive economic growth. Some of them reveled in the past while others forged the future. One thing this generation had in common was respect for hard work, a positive view of our nation and a level of frugality that subsequent generations never fully understood. Most of us can remember our grandparents who lived simple lives but seemingly had limitless money to give to the church or piss away on worthless family members. They had this money because they saved and most of them did it in arcane ways.
They had coffee cans, swollen checking accounts, certificates of deposits...you name the boring and low risk avenue for money and they had it. Their children, The Baby Boomers, would try in vain to get them to put their money into the stock market or real estate and they would typically refuse. They had seen economic disaster in their lives and they didn't trust fancy investments. Their kids would usually walk away mystified by their parents' stubbornness and backward view of how money worked. The "greatest generation" valued monetary security over the promise of exponential returns in the stock market or real estate.
Meanwhile, banks loved these codgers with massive checking accounts and low return CDs. They had a seemingly never-ending supply of cash. This pool of money made banking easy. Banks had an ample supply of cash reserves and could make loans to aspiring homeowners and businessmen knowing their customers were not going to be making withdrawals. In the meantime, America's economy exploded. The era from 1945-2000 was unprecedented in economic history. The average Americans' standard of living improved by leaps and bounds. In 2000, something went awry. The stock market collapsed for no apparent reason. The "tech bubble" burst and we all watched in horror as our 401k's disappeared. The stock market in 2000 was the canary in the coal mine and no one noticed.
Anyone my age (30) can attest to the fact that our grandparents started dying en masse in the late 80s and 90s. When they died, many of them left sizable estates to their children. These children, The Baby Boomers, had never lived through a true down period in our nation's economy. They immediately took that "old money" and dumped it into hot stocks, mutual funds and real estate. Many of them were so glad that they could put that money that had been sitting in savings accounts to "good use". They never understood how their parents could be happy with 1-3% returns. To them, the stock market was every bit as safe as coffee cans AND you could get 10-20% returns quite easily. For their entire adult lives, the stock market had averaged a 7-9% return so why would they not put their parents' money there? So they did...
While the Baby Boomers dumped billions of recently freed up dollars into the stock market, banks saw their current reserves slowly melt away. The Baby Boomers were doing very well financially but what smart 40 or 50 something would have $50k in their savings accounts? Their approach to money management was diametrically opposite from their parents. They would use their checking accounts for day to day expenses and the excess was sent off to their brokers or money managers at the "hot" mutual fund companies. The end result of this changing lifestyle paradigm was that banks had to find a different source for cash reserves. Banks knew that Baby Boomers were not going to be happy with CDs or savings accounts, they were off chasing the limitless returns of the stock market. There is an old saying "necessity is the father of invention" and banks starting inventing new ways to create money. One of these brilliant ideas was the mortgage backed security.
A mortgage backed security is nothing more than a bundle of mortgage loans packaged up and sold to a willing investor. I will give you a simple example of how this works. Let's say Bank Z has 10 mortgage loans on their books for a total of two million dollars. That is two million dollars that they just sent out with the promise of future payments on a monthly basis for 30 years. Instead of waiting for those monthly payments they simply would say "Hey Bank B...do you want to buy these 10 loans for 3 million?". Bank B would estimate they would get eight million dollars over the next 30 years and say "Sure, makes sense to us". Bank Z gets three million dollars. Pretty simple right? Bank Z then takes 300,000 of that and puts it into reserve and loans out 2.7 million dollars with more mortgage loans. Then...they bundle up that 2.7 million dollars in mortgage loans and sell it again. Pretty easy way to make money if you ask me.
This "easy money" encouraged banks to give loans to anyone who would take them. Why screen for risk or ability to repay when you are going to sell the loan a month later? The correct answer is...don't screen and let the next creditor worry about the potential default. Often times, the purchaser of these loans would simply bundle these loans in larger bundles and sell them again. So where did these loans end up? Many of them ended up in the hands of Freddie Mac and Fannie Mae. Fannie and Freddie are corporations that had "implicit backing" from the federal government. What does "implicit backing" mean? It means that government would bail them out if they needed it. So...what incentive did the brain trust at Fannie and Freddie have to turn down loans? None. This artificial federal interference distorted the entire mortgage market. Banks knew that as long as they met minimal standards for loans (the same standards continually that dropped as the mortgage market heated up) they could sell these loans to Fannie and Freddie.
Starting in 1995, Fannie and Freddie were given credits for purchasing loans that were considered "sub-prime". Sub-prime loans are loans that are considered to be relatively risky. Some of the common characteristics of sub-prime borrowers are low credit scores, inconsistent income histories and little to no upfront collateral (down payment). These "credits" were given by Congress to make home ownership possible for less fortunate people. At least that was the official line, in effect it was a handout to the poor and minorities. So let's take a look, on a macro level, at this nightmare: banks with little to no incentive to enforce underwriting standards, the nonsensical expectation that home values would continue to outpace inflation, a quasi-governmental agency that would purchase basically any loan and got EXTRA money for purchasing questionable loans AND political pressure to issue loans to people who did not have the ability to pay the loans back. Well...it does not take an MBA from the Wharton School of Business to know that this chain of events was a disaster waiting to happen.
Believe it or not, there was additional idiocy that added more fuel to this conflagration. We all know about "The Fed" but not many understand what the Federal Reserve does. The Federal Reserve is another shadowy quasi-governmental agency that manipulates the growth of the money supply with use of open market operations. Layman's terms...they set an interest rate on money that banks can borrow the Federal Reserve. For decades, the Fed has been tasked with controlling inflation. This process is quite simple. When inflation (growth of the money supply) increases or "heats up" the Fed sets a higher rate on the money that banks can borrow from them. When the economy slows down, they adjust the rate downward to encourage the banking system to borrow more money. It is simply supply and demand, when money is cheaper (lower rates) banks buy more money and the inverse hold true to form.
I talked about the savings habits of the greatest generation earlier in this article and it is relevant here. From the 1950s through the early 1990s banks had an ample supply of money sitting in reserve that was stable and not likely to be withdrawn. If a bank wanted to increase its reserves, it would advertise a higher CD rate, for example, and the old folks would take their money from Bank A that was earning 3.0% and move it to Bank B where they could earn 3.5%. This simple market dynamic died with the greatest generation. As I explained earlier, the Baby Boomers took this money and invested in equities or real estate. So once again, banks were facing diminishing deposits to fund their loan activity. Enter "The Fed". Banks began to realize that they could just go to the Federal Reserve and borrow money.
In theory, facing increasing demand for money The Federal Reserve could simply increase the interest rate on these loans (Federal Funds rate) and the banks would borrow less money. This did not happen. The Federal Funds rate is critical barometer of the nation's economic health. When the Fed lowers rates that means that Fed believes that the economy is slowing down. When the Fed increases the rate it sends up the evil red flag of inflation and adds cost to all future loans. A hike in the Federal Funds rate means less profits for banks and highly leveraged corporations. Due to the importance of the Federal Funds rate, it has become politicized. While the Federal Reserve acts independently from elected government officially, politicians from both sides have been known to pressure the Fed's decisions on the Federal Funds rate. For example, let's "imagine" that a President and his party have been in control of government for the last four years and are seeking reelection. The economy seems to be doing well and the ruling partys' approval ratings are high. In fact, the economy is doing "too" well and there are signs of inflation. In a vacuum, the Federal Reserve would raise interest rates to curb inflation. This would send the stock market plunging and potentially harm the ruling partys' grip on power. Rather than risk being replaced by the new President, the Chairman of the Federal Reserve makes the decision to keep rates unchanged. The ruling party stays in power and under the surface those inflationary pressures continue.
Back the main story...so again, we have banks that are in need of money. They have two main sources of money; consumers or the Fed. From the early 80s until 2007 the stock market was churning out consistent 7-9% returns. The American investor had grown used to these returns. With this being true, few Americans were interested in no-risk investment vehicles. In other words, the supply of money that banks had available was low. In Macroeconomics 101, banks would have raised the interest rate on their CDs and savings accounts to encourage American consumers to save money. But because of the artificially low cost of money that banks could get from the Fed, they got their money there and left their CD rates unchanged. Not surprisingly, the consumers refused to deposit their money into CDs that were earning 2-4%. That money was either spent or invested into mutual funds or rental homes.
The following is a hypothetical example to lend some life into this discussion...
March 19, 1996
John Jones is a 51 year old middle manager for Ford Motor Company. He earns 110,000 annually and he is a disciplined spender. His family lives comfortably and he has $1500 a month in discretionary money that he can choose to spend, invest or save. John wants to retire at age 60 and travel. He has a sizable 401k and has done very well in the stock market. He started investing about 8 years ago and his portfolio has doubled over the last four years. John reads Mutual Funds Magazine and loves his Janus Funds. He recently read an article in Forbes that talked about people his age starting to move into safe investments as they neared retirement. He seems to think this is a good idea. He has almost no savings account and carries only enough to pay the bills in the checking account, most of his excess money is sent to his favorite mutual funds. Last year, his portfolio returned 17%. So, he begins to check into his local banks and notices that his bank is paying 2.5% on a 3 year CD with a minimum deposit of $10k. He thinks to himself "Wow, I can send $1000 at a time to my Janus funds, take it out anytime and probably earn 10% at worst". John understands that there are risks in the stock market and would be happy to buy a CD if it paid 4.75% but try as he might, he can't find a bank who will pay that. He wonders out loud to his wife "Who in the hell saves money in bank when they pay such a terrible rate of return". She says "I can't believe that my Dad had $200k in CDs when he died, if he had followed your advice and moved that money into the Janus Funds he would have left us a million instead of 200 grand". John "I wonder where banks get the money to make loans? I don't know anyone who buys CDs or uses savings accounts".
John was right. No one saved money, at least not into traditional savings devices. Banks were awash in damn near free money from the Fed and had ZERO incentive to raise the rates on their deposits. For nearly two decades Americans laughed at the notion of savings accounts or CDs and dumped their money into the stock market. Or instead of investing their money into the market, they bought boats, cars, computers, etc. Hell, John Jones was making 17% a year on his portfolio and it was looking like he would be able to retire in four years, so what was the harm in buying his dream car for $40k? His portfolio was earning that every six months!! You could replay this same scenario in 2005 by substituting mutual funds with the "equity" John had in his primary residence.
The trend of American consumer savings rates has been a direct inverse of the stock market and housing prices. In 1985, Americans saved 10% of their incomes. By 2005, Americans spent more than they made. It marked the first time since the Great Depression that Americans, as a whole, spent more than they made. The same was true in 2006 and 2007. Americans literally quit saving money. Why save money when the stock market is great, home values are exploding and banks pay terrible returns on risk-free savings devices?
Guess what America? The bill just showed up and we are fucking broke.
The real cause for the current economic situation was an orgy of spending by the American consumer. Were there outside forces that helped create the right conditions? Of course. But blaming political leaders or The Federal Reserve for this economic disaster is no different than blaming the "assault rifle" for a school massacre. Just because you have the rifle and ammunition does not mean that you should go to school and start plucking kids off. We have to take responsibility for our collective mistake and stop looking to our government to save us from ourselves. What can we do, as Americans, to dig ourselves out of this shallow grave? From my vantage point there is only one solution...
START SAVING MONEY! Stop buying Blu-Rays for your lazy child and tell him to go play outside. Stop replacing your car because it has 60k miles and the wife wants something with more fucking airbags. Use your credit cards as target practice for your Mosin Nagant. Our banking system is taking BILLIONS from us, the taxpayers, to give them the necessary liquidity to provide loans to deserving businesses and individuals. If we collectively started saving money the health of the banking system would improve immediately. Our banking system is the backbone of our economy and if banks don't have money to lend...businesses close and you lose your job.
Sometimes the solution to a complex problem is plainly obvious. Our spending habits destroyed our banking system and made them dependent on a politically motivated and arguably incompetent Federal Reserve. The Fed did us no favors by allowing banks to have as much money as they wanted but that does not absolve us from guilt. You won't hear a politician say this because no one wants to hear it. We want to hear about stimulus packages, tax cuts and the evil transgressions of CEOs in the banking industry and that is what politicians will say because, above all else, they want to remain in office. We created the problem and we are the only ones who can solve it. We need to save money and get rid of the politicians who pressured banks into bad loans (Democrats) and who thumbscrewed the Fed into artificially low federal funds rates (Republicans). Then and only then, will we get back to work and wake up from this economic nightmare.
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