I got this email from my dad:
Ok, you are the trained expert on this. In 100 words or less please explain what the hell is going on with the market and what will be the final outcome. (ps: your inheritance just went down over [30%] in the last seven days!)
J. William Ambrosini CPA
My reply which I hope is wrong in the “you can’t get all the details right in a short essay” sense and not a “what the hell is he talking about” sense:
What the hell is going on?
Prices in houses have decreased a lot because we were in a housing bubble. This means a lot more people are delinquent and defaulting on their mortgages because credit ratings algorithms were attuned to an environment of ever-increasing home prices. This may have been prevented if banks didn’t move to score based credit ratings in the 90’s and if people with poor credit weren’t encouraged to buy homes… but who knows what would prevent asset bubbles.
What’s the effect?
First, in the banking sector, this newly discovered risk is spreading like ripples in a pond. Mortgages were repackaged as “mortgage backed securities” and sold and resold. This had the effect of spreading risk (a good thing) but it spread it in a way people can’t account for. We’re in a situation now where we know a lot of assets are worth less than we thought, because they have more risk than we thought, but we don’t know exactly which assets. People are nervous to buy anything related to mortgage assets, even good assets, because they’re afraid they might actually be bad. That’s why these assets are called “toxic”. Nobody wants to touch them. People don’t even want to touch banks that had positions in these types of assets (which are most banks).
Second, in the “real” economy the credit expansion caused by high house prices led to over-expansion of capital so now we have a lot of excess capacity. This isn’t covered as much in the press but I think its may be as much of a problem as the financial stuff. Basically, people were borrowing against the inflated value of their homes and consuming a lot. This extra consumption prompted businesses to increase capacity — to expand their business. But this extra consumption dried up when the house prices tanked and businesses are stuck with a lot more capacity than they need. This means investment that would have happened, even without the housing bubble induced consumption, won’t happen now.
What am I worried about?
I’m worried about the effect this all will have on the “real” economy. As banks struggle to get rid of these bad assets they’re reluctant to make normal loans to businesses. This makes it harder for companies to make payroll or to get loans in order to expand capacity. This is how the “paper” economy has an effect on the “real” economy and this is why this financial mess may cause a recession. Also, over capacity means businesses will have less demand for capital goods, there will be less investment and this may mean the recession will be protracted. The good news is that China and the world economy in general are expanding like gang-busters. This “over” capacity might not be.
What am I really worried about?
The government screwing things up worse. The great depression was really a bad recession that the government made much, much worse. Government made a lot of mistakes, but the biggest was in its attempts to control prices. President Hoover basically had a deal with big business to keep wages high at their current level. Because wages couldn’t drop as they needed to, unemployment was high (if you can’t reduce your employees wages, you have to fire them) and so aggregate demand was low (people didn’t have jobs so they weren’t keen to spend money). There’s two ways to deal with low aggregate demand: increase government expenditures and let prices/wages adjust back to the full employment level. Increasing government expenditure is a good short term solution but it has to be paid for eventually. Letting prices adjust, on the other hand is painful in the short run (the employed people have to live with wage decreases), but its the only solution that works in the long run. Eventually, prices have to adjust. During the depression, government didn’t let wages adjust down for nearly a decade and we had a depression for… you guessed it, nearly a decade.
Anyway, this is more than 100 words. But this is my sense of what’s happening. I expect a short recession as the banking sector reorganizes unless there’s lots of over-capacity. But if you see politicians making a lot of noise about controlling prices, we’re in a world of hurt.
J. William Ambrosini Jr.
PS – Short term movements in the stock market get the headlines but they convey no useful information. If stock prices represent discounted future cash flows, I find it inconceivable that future cash flows will be 30% less than they were a month ago (before the 30% decrease in stock prices). Even if we have Depression 2.0, I can’t imagine future profits will take that big of a hit even in discounted terms. In other words, my inheritance took no such hit!
Just a tad over 100 words… by the way, a point similar to the one I made about over-capacity was made by Prof. Phelps the other day (via The Economist).