The Curse of Reverse Banking

Banking is the great octane booster of the engines of economy. It can make many people feel rich. Albert deposits $100 in the First National Bank. Bertrand borrows $100 from the First National Bank and deposits the funds in the Second National Bank. Clyde borrows $100 from the Second National Bank ... and so on ad infinitum. Everyone has $100 in their bank accounts at the same time! There is a lot more spendable funds now than if Albert had just kept his $100 under the mattress. A whole lot more. Whee!

This sort of dementia has been going on for a couple hundred years and has reached a fevered pitch in the last ten or so. How could this go on so long without it all crashing down like the house of cards that it is? That is the marvel of economic growth. As long as the economy, and consequently income, keeps growing in the aggregate, there will be plenty of funds to keep all those plates spinning.

When banking goes into reverse though, it is deadly. Sufficient losses on loans cause banks to become unprofitable. Unprofitable banks have to pull the loss out of their equity and shrink lending, because loans cannot exceed a regulated ratio of bank equity. Roughly $10 of lending has to be cut for every $1 of losses. When lending is cut, borrowers have to pay back loans (if they can) instead of rolling them over. When they can't pay the loans back, the banks have further losses, and must restrict lending even more.

It gets worse. When borrowers have to pay back loans they have to cut other spending. If their income is falling, this causes their spending to fall disproportionately. One person's spending is another's income, so income tends to fall. When income falls, debt becomes harder to pay back, and many borrowers default, causing more loan losses for banks, and more restrictions on lending.

Around and around this destruction goes, and where it stops nobody knows. The entire World's economy is wildly indebted. Households, businesses, and governments have never been so in debt as they are now. What goes up, must come down. The bottom could be shockingly low.

Households at the Edge

According to a recent survey, many people would find it impossible to raise just $2000 in 30 days from any source - savings, credit, family, friends, etc. - in a pinch. The table below is extracted from the article, which is well worth reading.




The results are shocking to say the least, especially for the USA - supposedly the "richest country in the world." $2000 is not a lot of money when one aspires to a middle-class lifestyle; it could represent the cost of car repair, a home repair, a minor medical problem, and so forth.
These sorts of things crop up continually.

Mexico is no great surprise, but the fact that the UK, Germany, and the USA (all supposed major economic powers) rate worse than Argentina - a country with serious issues in its struggle to remain prosperous and civilised - should be cause for concern. This survey, if accurate, indicates that not only are half of UK, German, and US households there essentially broke, but most of the other half is so frayed financially they are in no position to help out poorer friends and relations; or perhaps simply socially support networks have collapsed. In either case (and both could be true) the situation is terrible.

This is not the sort of economic information we would like to see near the beginning of this Depression - and yes, we are still early on in this thing. Faced with falling income and no standby resources to fall back on, it is clear that more and more supposedly 'middle class' households are going to sink into financial ruin merely from routine financial stresses.

Our advice to our readers is simple: make sure you are living well below your means; that your net worth is rising and not falling; that you have ample financial resources (savings, lines of credit, willing friends or family) to draw upon should the need arise. This is serious stuff - it may require you to drop many of the trappings of middle class life in order to prevent ruin.

There are ample horror stories out there about people who discovered 'middle class poverty' by not changing their spending habits in the face of income loss. Typically they expect "something is going to happen" to fix their deteriorating situation: a new job; selling the house; etc. But that "something" never happens.

More and more, what were for many once reasonable expectations - say, getting a full-time job - are going to be as likely as having a winning lottery ticket. In a nutshell, this is why getting through the Depression is going to be about survival. Don't delude yourself; ignore the blather on the telly; get real about what is happening.

House Prices, Property Taxes, and Rent

Today we present a case study of a sleepy little town on the Pacific Coast of North America somewhere between Powell River and Portland. We have changed the name to Prosperity Harbour to protect the innocent. This town is fairly average; its heyday being some decades in the past.

Being an older place, the houses tend to be on the small side with plenty of cottages, each having less than 1000 square feet of floor space. As of today, the asking price on these little, older cottages ranges from $90,000 to $180,000. Prices have only sagged a bit since the onset of the Depression thanks to generous mortgage programmes from the Government.

Property taxes here are modest, averaging about 1% annually of the market value of the houses. Rents in Prosperity Harbour are low for a place on the West Coast. A typical two bedroom house rents for $600 per month.

The gross rental yields tend to range from 5 to 6%. After allowing 1% for taxes, 2.5% for maintenance, and .5% for insurance the net yield works out to only 1 to 2%.

Until recently, landlords were banking on appreciation to make up for the lack of yield. The last two years have been disappointing in that department, to say the least. Furthermore, there is no hope of raising rents or even maintaining them anytime in the foreseeable future. A great wave of rental construction completions has been hitting the market: luxury duplexes; low-income projects; warehouse district renovations; and everything in between - all begun at the peak of the recent housing mania. The major property management companies have even entered a price war as their efforts to whittle down their swelling rental listing portfolios become desperate. Even with asking rents down 1/3 or more from their peak two years ago, vacancies go begging.

Prosperity Harbor is not losing population. What is shrinking is the number of households. Or put differently, the increase in household formation - a fact of life in North America since the European settlement began - has gone into reverse, here as elsewhere. Unemployed and underemployed persons are doubling up and making do with more cramped conditions.

What hope is there for Prosperity Harbor's landlords? None. As long as incomes continue to fall, there will be less and less money available for rent. Property taxes will not fall. As assessed property values decline, rates will rise in order to maintain public expenditures. Even if a frenzy of cutting the public sector hits Prosperity Harbor's voters, it will only serve to shrink the incomes of the local public servants - furthering the vicious cycle of declining incomes.

In a word, Prosperity Harbor's landlords are f****d. This goes for the landlords who rent to themselves as well, a.k.a. homeowners. Housing here is a terrible, terrible investment and will be remain so until prices come in line to a sane multiple of rents - meaning those old cottages need to be selling for something like $9,000 to $18,000 - a mere one tenth the current prices!

A Depression Trajectory

As a sort of follow-up to yesterday's post, we will muse a bit on how much world GDP decline to expect to this Depression.

One assumption that we are making is that over the next twenty years or so, fossil fuels will become too expensive to use very much as... well, fuel. The world is not going to run out of oil, gas, or high quality coal - but their fuel use will mostly be limited to its highest ends (i.e., not for mass private cars, heat, or electricity). In the post-fuel hydrocarbon era, much of the remaining supply will be used for non-fuel uses such as fertiliser, plastics, and specialty chemicals.

Its a rather uncertain thing modelling collapse, but it is not unreasonable to say that hydrocarbon production may decline 90% or so in the next 20 years. That may seem outrageous, but many people like ourselves who make a study of this matter are arriving at similar conclusions. Consider this recent post at The Oil Drum. It's a bit technical, but Figure 3 is worth a thousand words.

As every schoolchild knows, or at least ought to know, the industrial economy grows or shrinks with the supply of fuel. If fuel production declines 90%, the economy will fall by a similar amount. There will be efficiency, nuclear power, solar power, hydropower, and many other ways to mitigate the loss of energy available to society - hopefully enough to keep things civilised. And once Civilisation has weaned itself off fossil fuel, economic growth just may well resume from a new, low base and at a slower rate.

We believe an energy-intensive economy such as the USA's will experience roughly a 90% decline over the next 20 years. At the end of the Depression, per-capita income is likely to be in the neighborhood of $5,000 a year in current dollars.

We suggest the Reader consider what life might be like for them on such an income, or a bit more or less - depending on their skill level. Also to consider what sort of means they would have to produce any income in a world where most people can afford very little beyond the basics of food and shelter.

It will be very difficult to hope that investment capital will produce much income. Which industries will even survive this depression? Virtually all bonds are sure to default, including government ones - either directly or through inflation. Successful investors will likely be the active, hands-on sort.

To earn income will require being involved with a surviving industry, such as agriculture. Otherwise you will need to become entrepreneurial, and hard-working. Though challenging, the changes ahead are manageable - as long as you keep a positive outlook.

Too Many Obligations, Too Few Resources

Within the OECD nations, at all levels of society - from the household, to business, to government - obligations have been piling up for years: debts, pensions, social programmes - to name a few. Clearly, these obligations can only be met with continual economic growth. But what happens when anticipated growth fails to materialise?

This question is hardly academic. Virtually everyone and every institution is struggling with the fact of a less than expected actual income slamming into financial obligations. The general consensus is that this is a crisis, a mere interruption of the norm of perpetual growth. Once the crisis is passed, like a fever, economic health (a.k.a. growth) will return.

Our opinion departs from the general consensus. We expect growth to become the interruption in the general economic routine. It will become even more difficult for individuals or enterprises to amass wealth. The present uncertainty of employment and profit will continue and be normal.

In such an environment the notion of taking on any obligations is questionable. There will be an enormous cultural lag for the realisation of this however. Expect to see a lot of bad decisions to be made over the coming years: investments made with the expectation of a return to a prosperity that never comes.

Economic actors - everyone, that is - need to learn the new rules of economic life in a world turned upside down. We don't know them - no one does - but we could hazard a few guesses: you must live on half (or less) of your income; much of what comes in is not true income but a windfall and must be treated as such; never borrow money; investments must be recovered from cash flow in a very short time frame - perhaps three or four years for low-risk endeavours, perhaps one or two years for risky ones; all investments are riskier than they used to be.

At present, society is following a set of economic rules completely at variance with our guesses of the new rules. The transition to new rules will nevertheless be made, no matter how impossible it seems at the moment.

Will the Depression Make Everyone Poor?

If the World finds itself a good deal poorer in the coming years it will not be because the Depression made it thus. The Depression is only revealing the fact that everyone is poorer than they thought they were.

This is an important distinction that is lost on almost everyone. The Depression is happening because incomes are declining. Incomes are declining because the productive capacity of society is not as large as people imagined it to be.

Allow us to present a simple metaphor: Suppose you owned an apartment building. Suppose further you had two tenants: your hairdresser, and your stockbroker. Now suppose that instead of fixing the soft spot in the roof and the crack in the foundation, you took the rent and spent half of it on expensive haircuts and the other half on penny stocks. Then comes the day that the rain came in through the roof and through the foundation.

No problem, you say, as you've been creating a rainy day fund with your stockbroker by investing in penny stocks. Oops! The stock market crashed. Uh oh. Well, you'll just have to do all the work yourself, and get money for supplies by using the rent money, skipping the haircuts and further stock purchases.

Now the bad situation gets worse: because your stockbroker isn't making the commissions (largely on account of you) she once was, she is getting behind on the rent. So too your hairdresser - you were his best client - is also getting behind. This means you can't buy the supplies... so the rain will just keep pouring in.

We hope this metaphor isn't too obscure. It really does describe to an extent the pickle the world's economy is in. There are a complexity of reasons why capital and spending has gotten grossly misallocated for a long time before the consequences were revealed. It is well past the scope of this little post, but we plan to touch on some of it in the coming months.

The Reality of Peak Minerals

An idea which is gaining traction in the mainstream is Peak Oil, the inevitable maximum level of world oil production. The idea of limits to growth is not a happy one for most, so we will sidestep the argument of whether or not scarcity of energy can be overcome with technology. Instead, we merely point to the facts: all major oil producers have peaked, and indeed world oil production (excluding ethanol, tarsands, and other such silliness) peaked in 2005.

But what of other minerals, the stuff that oil rigs and cellphones are made of? Their futures are no different from that of oil. In fact, many minerals have already peaked: the fertilisers potash and phosphate rock both peaked in 1989; industrial metals lead and cadmium peaked in 1986 and 1989 respectively;... and we hear rumblings that peak copper has recently been reached.

If peak minerals were to have occurred absent peak oil, the increasing scarcity of minerals might not have been as bad. However, the world is facing both increasingly-difficult-to-mine minerals, and increasingly-difficult-to-drill oil. Quite simply, this means that the prices of anything that requires oil and minerals will be going up in price - if not nominally (i.e. increased purchase price), in any case in terms of affordability (i.e. lowered personal income).

It seems to us that this is just about everything. Although some may say that improved technology will help alleviate the pressures of scarcity on supply and cost, we respectfully disagree. The pressures of scarcity will be made even more painful with the 2007 Depression. Falling incomes will make one poorer, inflation will burn up the purchasing power of what money one gets, and one's stuff will be more costly to buy... one will be feeling triplely poorer.