Monday, February 4, 2008

economic lacunae

Over the weekend, I was browsing about on the Internet reading blogs by self-identified conservatives. While I am quite certain that what I am about to say applies all across the political spectrum, it was these conservative bloggers that brought it to my attention. It would appear that many, otherwise well educated Americans, lack a clear understanding of how our present day capitalist economy functions.

The primary misunderstanding seems to be lodged in the assumption that what is good for individuals and families is always good for the overall economy, and vise versa, what is bad for individuals and families is always bad for the overall economy. Certainly, many times that is true, but not always.

In many posts and comments I ran across this weekend, the writers blamed our current economic down turn (and possible recession) on Americans spending too much and getting too deeply into debt. Yet, when we look at the remedy being offered by President Bush to provide "economic stimulus," the solution offered is putting more money into the hands of people to spend; not to save, not to pay off existing debts, but to spend on new purchases. Notice also that the response of the Federal Reserve to the economic down turn is to reduce interest rates. Reducing interest rates encourages borrowing, and discourages traditional saving (although it may help encourage investment in the stock market). This is because President Bush, his economic advisers, and the Chair of the Federal Reserve understand that our economy lives or dies on consumption [even the consumption of goods made in other countries].

While the U.S. still does have a substantial goods producing economic sector, its importance in our economy today has declined in comparison to our service sector, where goods and services are sold. Back in the 1940's it was said "As General Motors goes, so goes the nation." Today it would probably be more apropos to say "As Walmart goes, so goes the nation."

I suppose that it is easy to confuse one specific economic problem -- the melt down of the subprime lending market -- with the overall economic process. Certainly the large number of defaults by subprime borrowers who were severely over-extended has contributed to current economic down-turn. However, it is how those defaults impact consumption through cutbacks in housing construction, purchases of construction goods, and workforce layoffs that is crucial.

From the standpoint of the individual or family, cutting back on expenditures and paying down debts is rational and sensible. Saving, may or may not be rational from an individual depending upon the relationship between interest rates and the cost of living. But for the economy as a whole, rebounding from recession depends upon expanding consumer demand for new products and services.

As presently constituted, our economy depends upon continuous growth in production of goods and services, which requires continuous growth in consumption. The expansion of credit in the United States has been one major means by which our economy has produced growth in consumption. This has obvious negative consequences for individuals and families whose debt grows to unsustainable proportions. Moreover, as our current economic downturn evidences, in the long run, growth cannot be sustained on credit.

The economic history of capitalism has been a cyclical history of booms and busts. After the Great Depression of the 1930's governments, including the U.S. government, became more involved with the economy to moderate the devastating impacts of the bust periods. Nonetheless, down-turns are inevitably built into to the our economic system, they are not the "fault" of the individuals and families who borrowed beyond their means, since that is exactly what is required to create the boom periods. This is one of the internal inconsistencies or contradictions of capitalism. To remove it, means to modify the economic structure in significant ways.

It is interesting to me, that one of the primary beneficiaries of our economic system has recently suggested exactly this, that our economic system requires modification. Last week Bill Gates, speaking to the World Economic Forum in Davos, Switzerland, said:

"We have to find a way to make the aspects of capitalism that serve
wealthier people serve poorer people as well. I like to call this idea creative
capitalism." He [Gates] also called for making changes to capitalism so that corporations and governments devote more time and money to doing work that "eases the world's inequities" - and bringing science and technology to everyone. ("World's Richest Man Criticizes Capitalism")
Ideas worthy of further consideration.


Panhandle Poet said...

Wow! Where to start --

Debt. There are two basic kinds of debt. Consumer debt and business debt. Consumer debt is rarely good although occasionally necessary to acquire the means to better oneself -- such as basic transportation and other necessities. One drain on our economy is the tremendous amount of interest paid on consumer debt. That interest covers several costs. 1) The time value of the money itself. 2) The operating expenses of the lender (which portion re-enters the economy through a multiplier effect) and 3) Bad debt risk (the chance that the aggregate loans issued of that specific type will not be repaid).

Business debt on the other hand is generally of three types 1) acquisition cost of the business itself or 2) investment in capital purchases to accomodate growth or 3) purchase of inventory (or manufacture of goods). For any of these reasons the debt is expected to be self-servicing. That is, the amount borrowed is for something that will generate additional net revenue above the debt service. Any of these reasons are considered acceptable. Borrowing for normal operating expenses is a sign that a business is in trouble.

Yes, consumption does drive our economy. However, debt siphons off funds that could be used for consumption because of the cost of that credit. That cost as outlined above, increases the overall cost of goods and services within the economy.

Where do funds come from for investing in businesses? They come from saving. For the average "consumer" to truly experience the benefits of capitalism, he must do as those who currently benefit from capitalism. He must invest in the economy. A consumer expenditure is not an investment. Investment assumes risk. Yes, the individuals who failed to repay their "sub-prime" loans lost, but in reality, they assumed a debt beyond their ability to pay. The investors who bought securities based on packages of these subprime loans did so hoping to reap a windfall profit on the investment. Such windfalls are associated with risk. The greater the risk, the greater the potential reward. It is a case of buyer beware. Most investors in sub-prime mortgage instruments fully understood the risk they were assuming. They were willing to accept that risk because their "feeling" was that the economy would continue to "boom" for the period in which they intended to hold those securities. The sub-prime lenders didn't cause the collapse of that market, it was people defaulting on their loans that caused the collapse. Those defaults were the result of over-extension of their personal credit. They borrowed more than they could repay in the event of a "glitch" in their personal economic situation.

We do not live in a purely capitalist economy. Government regulation and intervention long-ago modified the U.S. economic system to something hybridized.

All economic systems depend upon growth in consumption. This growth can come from expanding or new markets, from increased expendable wealth in the hands of existing markets, and from population growth. A portion of the economic instability in the world today is the result of the rapid growth in emerging economies such as India and China. That growth is creating a change in the flow of wealth around the globe. It is changing investment patterns and it is changing consumption patterns. The break-up of the Soviet Union and the re-emergence of independent states in eastern Europe and Asia has futher fueled instability. Each of these countries is seeking to obtain a piece of the world economy. The result is competition and market turmoil that will take many years to settle. Turmoil isn't a bad thing. It creates opportunity -- in a capitalist economy.

Much of government regulation adds burden to economic activity. Such burden creates a dragging effect. Governments are inefficient users of wealth. Putting wealth back in the hands of individuals is the most efficient method for providing economic stimulus. One of the beauties of our system of government is that individuals have the freedom to choose how they spend that money. The issue I take with the stimulus package is that it is a one-time "refund" of my money. I would rather see permanent tax cuts. The result would actually be a greater stimulus than the rebate.

The Soviet Union collapsed for many reasons, one of which is the tremendous economic inertia created through state control. Creativity and initiative are stymied under such a system. The reason so much of the technology that provides the promise of taking the world into the "next level" is created right here in the U.S. is because in spite of the attempts of many, we still have tremendous freedoms to be creative and to derive personal benefit from such creativity. Free market capitalism is the only system that takes the weaknesses of individual greed and turns it into a greater good.

Sue said...

I quite agree that consumer debt is a "drain" on the economy in the long run. Yet, it is quite obvious that the profit of thousands of businesses depend (and have depended) upon consumers assuming debt. If this were not so, there would not be thousands of businesses that encourage such debt. Obviously, the large banks and credit card companies make their profit (with of course the risks you mention) from consumer debt. Additionally, each retail outlet (whether bricks-and-mortar, catalog or internet), restaurant, hotel, supermarket, gas station, clearly sees some advantage to encouraging the use of credit -- why else would they be willing to pay the fees charged by the major credit card companies? The wide spread availability and use of consumer credit has to be driven by benefit or profit to business (as well as to consumer).

Yes, business growth and expansion depend upon investment, and investment does come from savings. And the personal savings rate is declining (it has dropped from 10.8% in 1983 to 1.4% in 2003). But business investment in this country has never depended upon the saving of the masses. In 2001 84 percent of all the stocks and mutual funds in America were owned by the top 10 percent of the population. The bottom 50 percent owned only 1 percent. Moreover, historical studies show that stock and mutual fund ownership was less well distributed 50 years ago than it is now -- largely due to changing pension programs. So the failure of working and lower middle class people to save impacts them far more than it impacts the availability of funds for business investment.

I certainly do not disagree with you over the negative aspects of consumer debt. But consumer debt exists to the degree that it does because it has served to create profit for many sectors of American business. Had investors not seen profit in it (after weighing the risks) there would not have been an expansion of debt. For people to borrow, some one must lend. Ultimately it is the people with the money to lend who control the flow of credit, not the debtors. The only power that debtors have is to say "I can't buy if you don't give me credit."

Panhandle Poet said...

You said, 'The only power that debtors have is to say "I can't buy if you don't give me credit."'

I have one big disagreement with what you said, Sue. Consumers have the power to say, "I WILL NOT buy on credit." Debt certainly has played a role in the economic growth of the country. Debt is the only mechanism by which money is created. It is STILL the consumer's responsibility to say, "I WILL NOT buy on credit." We have such an "instant gratification" based society that most people have lost the will to discipline themselves and their spending habits. Blaming business, or government, or credit companies or anyone other than the consumer himself for consumer debt is a "victim" mentality. Individuals are, and should be, responsible for their own decisions.

Most businesses make the decision to accept credit cards because it is a means by which they are assured of receiving "good" money for the goods or services rendered. It is often preferrable to the risk of a bad check. The fees charged by credit card companies are a cost of doing business that is factored into the price that you pay for those goods and services. If it was legal to do so, most businesses would add those fees to the cost of the item for anyone paying with credit. Instead, you find some businesses that offer a cash discount. What does that tell you about the price of the good/service? That it has been marked up enough to cover those fees.

As individuals, we are better at deciding how to spend our money than is the government. The collectivist/socialist, government-controlled economic attitude has sunk more than one ship. The growth of the Chinese economy today is due to the growth of capitalistic sectors that have been allowed to flourish. It IS NOT due to state control. It is due to an easing of state control. It isn't due to credit. It is due to the personal initiative of individuals willing to take financial risk by investing in a business.

You said, "Obviously, the large banks and credit card companies make their profit (with of course the risks you mention) from consumer debt."

Credit card companies make their profit from the fees charged to merchants for facilitating the transaction. The debt is held by banks -- not the credit card company (meaning Master Card, VISA, American Express, etc.). Bank lending is a function of deposits. Without deposit growth there can be no lending growth. Bank profit is derived from the Net of income less expenses. Expenses to a bank include operating expenses, cost of funds (what they pay to depositors) and bad debt expense. The reason interest rates on credit cards is so high is that they are high risk loans and come with many defaults.

There are two types of credit card users. 1) Those that use them for convenience who typically pay the balance at the end of each month and who incur little or no interest expense, and 2) those who use them to finance purchases who pay interest rates that often exceed 20%. That high interest rate is because a large portion of those borrowers default on their payments. When you look at the growth in credit card use in this country you must differentiate between these two groups. Businesses also use credit cards for purchases. They, almost without exception, fall into the first type of user.

"Keeping up with the Joneses" is no excuse to incur debt. A new television, clothes, dining out, bigger/better vehicles, etc. are not legitimate uses of credit unless it will be paid at month end. Replacing a "modern necessity" such as the refrigerator or washing machine through the use of a moderate amount of credit is a good use of credit. Buying a new car because our old one is showing a little wear is not. I won't buy a new vehicle unless I can pay cash for it. Driving it off of the lot costs around 30% of its value! Used vehicles however present a mathematical/risk model that must be considered. At some point, a vehicle costs more to maintain than it does to replace. A purchase decision should be based on overall cost/value -- NOT "can I make the monthly payment on my income?"

Consumer credit -- they type that is used to buy "desires" - not needs - and that is paid off over extended periods at extreme rates of interest is a DRAG on the economy. All of us pay for that misuse of credit in the higher prices that we pay for goods and services -- including interest rates on legitimate borrowing.

Sue said...

I quite agree that consumers have the power to not use credit, but that does not translate into the power to not buy on credit, since without credit many people simply are not buying. That is the issue, from the point of view of those who sell goods and services.

The consumer always has the power to consume less than producers wish for them to consume. Whether the producer is a producer of credit or a producer of goods and other services. As a person who has no major credit cards (no Visa, no MC, no AmEx, no Discover), no gas credit cards, and no department store credit cards, who chose to buy a house that was paid off in less than 10 years, who drives a 9 year old vehicle which replaced an 18 year old vehicle only after it completely fell apart, and only uses credit for items that either enhance the value of my business/profession activity (and can be amortized) or my home value, I'm fully aware of the ability of consumers to cut back on their consumption and their use of credit -- in our household if we don't have cash we don't buy it.

The consumer has control over the lower limit of their credit -- but they do not control the upper limit of their credit. That is controlled by the lender. And the only motivation for lenders to extend more credit, which many lenders knowlingly extend beyond what the borrower can reasonably handle, is because it generates profit in the economy.

I'm only asking for a balanced view here. We can't just say that the problem is all the fault of the consumers who don't know their own limits. Lenders, and sellers of goods and services, who benefit from the extension of credit, are a serious part of the equation. We have to examine carefully why our economy depends so heavily on consumer credit. To say that it is all the consumers responsibility to refuse credit, when clearly huge segements of our economy are based on getting people to borrow money, is short sighted.

Panhandle Poet said...

I spent 8 years in the lending business. I spent another year working directly with bankers and their technology needs. Credit limits are set based on repayment records -- not because the banker (who extends the credit) wishes that individual to purchase more televisions or CD's or meals at Applebee's.

From a business standpoint, offering credit cards as a business is a function of risk/reward. I will take more risk if the potential reward is great. The precarious position of much of the financial sector is a result of taking on too much risk. An economic downturn will be felt first in the housing sector and then in the financial sector. There was no conscious decision on any individual's part to create the house of credit cards (pun intended) that our economy is inhabiting. It is a function of risk and reward. As long as people spend more than they can afford (use credit unwisely) there will be someone willing to accept the risk of extending that credit. That is capitalism. If it isn't done legally, it will be done in back alleys. The responsibility for incurring too much debt is solely on the shoulders of the individual who incurs that debt. Period.

It's like the robber who kills a convenience store clerk during the commission of a robbery. That robber is the criminal -- not the store that sold him the gun, or knife, or baseball bat, or whatever he used to kill the clerk. Not the business who fired him because he was lazy and wouldn't work. Not the educational system who failed him because he wouldn't behave in class and instead disrupted the classroom so that it was more difficult for others to learn. He was the criminal. He is responsible for his acts. The consumer is (should be) responsible for their acts of incurring credit.

[One of the causes of the credit crisis is the ease of declaring bankruptcy.]

Your statement, "We can't just say that the problem is all the fault of the consumers who don't know their own limits." -- elitism? That is something commonly heard from the left. It reminds me of Feudalism. The Lord of the Castle knows what is best for his serfs. Perhaps my response is a bit harsh, but you hit upon a pet peeve of mine. I don't like someone else telling me what is best for me. I prefer to decide that for myself. I assume (perhaps unwisely) that most people feel the same way.

Sue said...

PHP, we're probably going to have to agree to disagree. I see much of value in your perspective. It is important to emphasize individual responsibility. But I don't think the analogy with the robber who murders is appropriate. The robber provides nothing of value to society through any of his/her actions. The person who uses credit, on the other hand does provide something of value, demand for products and services -- money circulates, going from the banks and credit card companies to the merchants and employees to the producers and their employees.

As for the bankrupcy laws, I believe that the tightening of those laws at the beginning of 2007 that has contributed to the timing of this crisis--something that I predicted (to my friends) in January of 2007. One of the changes introduced at that time, was that lenders should require borrowers to make larger minimum payments than in the past. My prediction was that as borrowers had to put more of their income into paying for past purchases, they would have less money to put into new purchases, and this would contribute (not be the only cause) to a decline in consumer spending. I predicted that the brunt of that cut back would be felt by Christmas of 2007. The record of consumer spending certainly has followed my prediction. Whether or not the tightening of credit terms contributed to that are not is certainly open to interpretation.

Well I'm going to take a break for a few days for some surgery. Look forward to more thoughts from you and others!