No Silver Lining

A perverse meme is circulating in the news media and blogosphere that some good can come out of house price declines, mortgage defaults, and mortgage restructurings.

Charles Hugh Smith discusses Why a 35% Decline in Housing Values Would Be Good for the Nation. Smith, an otherwise competent commentator, does state the obvious: people have been spending too much on housing and to spend less on that will help households and consequently, the economy in other areas. However he neglects to mention the enormous economic catastrophe that will result from having a huge part of the US National balance sheet permanently wiped out. The US financial sector, as healthy economic agents, cannot survive the permanent impairment of mortgage assets that would result. Bank equity - which forms the basis of banks ability to lend, and even just hold deposits, would be wiped out.

As a matter of fact, it is already wiped out de facto - the FDIC and other regulators just keep banks going in the hopes that a recovery in housing prices will make most of the mortgages legitimate investments again. A further decline to lasting low prices will make that charade simply the legitimisation of a zombie banking system a la Japan.

In a Wall Street Journal editorial on 'walking away' masquerading as an article, the author states:

People's increasing willingness to abandon their own piece of America illustrates a paradoxical change wrought by the housing bust: Even as it tarnishes the near-sacred image of home ownership, it might be clearing the way for an economic recovery.

and:

For the 4.8 million U.S. households that data provider LPS Applied Analytics estimates haven't paid their mortgages in at least three months, the added cash flow could amount to about $5 billion a month -- an injection that in the long term could be worth more than the tax breaks in the Obama administration's economic-stimulus package.

"It's a stealth stimulus," says Christopher Thornberg of Beacon Economics, a consulting firm specializing in real estate and the California economy. "The quicker these people shed their debts, the faster the economy is going to heal and move forward again."

Unfortunately, less money flowing out of the pockets of consumers as debtors means less money flowing into the pockets of citizens as creditors (e.g. the proverbial little old ladies who rely on savings income). It is a bogus calculus which could in any way construe the process as 'healing'.

If "shedding debts" means defaulting (as the article seems to imply), then citizens as taxpayers will feel the suck of money coming out of their wallets as Uncle Sam through the FDIC has to make depositors whole. And, as mentioned above, having a walking-dead banking system is not going to help recovery.

On the whole, the intellectual basis of the perspective of this 'article' is entirely flawed. We suspect it is simply another in a long series of efforts by the Ministry of Truth to put a positive spin on the ongoing havoc caused by the Depression.

Not that this flawed intellectual notion doesn't get the support of some heavy guns. Nobel-prize winning Joseph Stiglitz is quoted in Bloomberg as saying a new kind of bankruptcy needs to be created to let mortgage holders write down their mortgage to a market level and keep it! Either Mr. Stiglitz knows better and is dissembling, or he is the one suffering from bankruptcy - intellectual bankruptcy.

There is a serious moral hazard issue here. Dysfunctional economic units must be allowed to suffer the consequences of poor decisions. Stiglitz's proposal is yet another bailout - this time a bailout for credulous, housing-bubble participants on the borrowing side.

We do not approve of bailouts for housing-bubble participants on the lending side, either. But two wrongs do not make a right. The more poor decision-makers are coddled through bailouts, the more society at large is harmed by resources being diverted to the thieving, hapless and stupid; and the less resources are available to be used by the Intelligent who were wise enough not to get involved in the housing bubble, and who are truly the World's only hope of economic progress.

US Households: Unhappy Speculators

The economist Hyman Minsky divided financing techniques into three categories: Ponzi finance - where principal and interest on debt cannot be paid out of earnings but only ever more borrowing; Speculative finance - where interest on debt can be paid out of earnings but principal must be rolled over; and Hedge finance where both principal and interest on debt can be paid out of earnings.

From 1952 to 2007 the ratio of debt to income for US households rose from about .35 (hedge financing) to about 1.3 (speculative financing). Even two years into the Depression, the ratio has only declined a bit.

In times of economic contraction - especially when a major asset bubble bursts (i.e., housing), speculative financing units run into two significant problems. Routine debt service becomes more burdensome, and more critically, the ability to refinance becomes often impossibly difficult.

Consider the case of otherwise solvent households with exotic interest-only mortgages with impending punitive resets. The reset payments are unsupportable, and yet there is typically no way to roll the mortgage into a conventional mortgage as the value of the collateral is typically less than the mortgage balance. The underwater position also almost always prevents a sale to terminate the mortgage since that will require bringing too much money to the table.

Barring a sudden and extremely improbable surge in house values, these households will be ruined by the trap. Even many households with fixed rate mortgages will find those unsupportable in the face of income loss, and have no non-bankrupting exit strategy due to their underwater position. Another trap is facing households with sudden rate hikes on large credit card balances.

The distribution of the pain of the speculative unwind will not fall evenly on US households. A substantial number - perhaps 1/4 - have little to no debt and at least adequate resources. Another substantial number - also perhaps 1/4 - have no debt because of too-low income and too-few resources.

This puts the burden of the pain squarely on the roughly 1/2 who have substantial debts. We suspect that most of these households' net worth will be wiped out, creating ever more cascading failure throughout the economy. The end state will be a poorer USA, but one where debt revulsion is so strong, households will once again be Hedge financial units.

The Dubai Gambit

Although we just wrote about Dubai and its impressive level of debt - not to mention its impressive malinvestment of its resources - the Emirate has made a manoeuvre which we didn't even think of: declaring the debt of Dubai World not backed by government guarantee. From the BBC:

"[Creditors] think Dubai World is part of the government, which is not correct," said finance minister Abdulrahman al-Saleh. "Creditors need to take part of the responsibility for their decision to lend to the companies."

Clever, very clever; it seems to us that Dubai is looking to have its cake and eat it too, after a manner of speaking. They got their theme parks and little islands, and now the investors can go stick it wherever they'd prefer the pain. And if those investors attempt to foreclose on the assets of Dubai World, they just might run into the little problem that said parks and islands are property of the Dubai government, or perhaps the Abu Dhabi government; in other words, foreclosure is not happening, because we really don't think an UAE court would care to strip a sovereign government of its assets. Certainly not for foreigners, and the latest incident with the Swiss banning minarets will likely not help the situation.

A thought arises from the move, which we give the same title as this post: the Dubai Gambit. We'll put it in the general terms for starters. A nation's Government spawns this enterprise (we'll use the U.S. term of Government-Sponsored Enterprise, or GSE, with apologies for such Amero-centrism), and lets it just toddle along, doing its thing. As a GSE, it would seem to investors that the GSE enjoys an implicit Government guarantee; the Government made it, so why wouldn't it keep it going if times were tough? So, investors cheerfully pile into the debt of this GSE, because from their perspective it's just as good of debt as sovereign debt.

But surprise! It doesn't say anything anywhere in the GSE's charter (or what have you) about a Government guarantee. That means the Government, at its fickle discretion, can either help out the GSE in times of trouble, or not. The average investor, being apparently rather dim-witted when it came to reading fine print, was speculating much harder than he or she thought; the money he or she plopped down for the GSE's debt might never come home from the front lines of the Free Market. It's a messy place, we hear, and casualties can be heavy.

Bad times come along, and the GSE gets into some serious trouble. Investors start thinking "Boy, I be sure glad that thar GSE's got some sort of gum'ment guarantee or some such. I's real smaaart," and patiently sit on the deck of their double-wide trailer waiting for the cheque from the Government to make them whole. Grandma Kettle's rocking chair creaks as she loads up the shotgun to take aim at a stray dog; the hole in the roof gets a little bigger; no Government cheque comes in.

That's because the Dubai Gambit was brought into play; the Government decided the GSE was not, in fact, going to enjoy a bailout. In the real world, this would probably happen when such a GSE was in such horrible shape, that the Government would have risked its own credit rating to support the malinvestment of the investors, and the GSE's own malinvestments. GSE debt goes from being 'as good as Government' to 'someone has to do something about this!' overnight, as the bonds go belly-up. Investors are left footing the bill for someone else's good time, and the Government comes out, theoretically, smelling like a rose, at least to the credit markets.

As this meltdown of the GSE is underway, the Government finally steps in, but not in the way the investors were expected. Instead of providing a backstop for the full value of the GSE debt, the Government starts Agency X, with the explicit goal of winding down the GSE's debt. With a pre-packaged bankruptcy agreement - and a sufficiently... agreeable... court system - Agency X gets to cherry-pick the good assets of the GSE, and leave the GSE with all of its liabilities. Investors in the failed GSE would get Agency bonds worth pennies on the dollar of their original GSE debt, and the Government gets to have at least something for its efforts.

We fully expect Dubai to do this manoeuvre, or at least something like it. If it seems far-fetched to you, dear Reader, please consider the shenanigans surrounding the General Motors bankruptcy fiasco in the United States. The 'old' GM went into bankruptcy, gave its few good assets to the 'new' GM (owned by the U.S. Government, the Crown in Right of Canada, and a few other favoured parties), and then left its legacy of toxic waste dumps (or, 'factories,' as they are charmingly misnomered) and other such massive liabilities upone the shoulders of now wiped-out investors; the 'new' GM is in the clear. This, in civilised countries, is typically considered unlawful conveyance, but since the Federal Government was involved, such trivialities were easily brushed aside.

The Dubai Gambit is, at its core, entirely designed to have the Government - any Government - protect its credit rating at all costs. Dubai seems to be very much conscious of that factor, as why else would the Emirate have explicitly withdrew any implicit Government guarantee? Dubai World et al. is a mess financially, and it would probably bring down the Government if it tried to back the enterprise's debt for its full value. At pennies on the dollar, as it were, Dubai might be able to convince the UAE central bank, or Abu Dhabi, to bankroll a resolution of the fiasco; Dubai keeps its sovereign credit rating, the UAE and Abu Dhabi look like heroes, and investors in Dubai World don't feel quite as raped as they otherwise would have.

The question is, if Dubai makes this Gambit work, and to paraphrase Tom Lehrer, who's next?

October Credit Card Collapse Report

It has been a while since we provided an update to the story of the great credit-card pay-down. According to Federal Reserve data on US household revolving debt, consumer revolving loan (mostly credit cards) balances have declined 9.17% from year-end 2008 through August. This represents an annual rate of - 14%.

Given the high credit card delinquency rates lenders are suffering (5% at last report), much of this balance decline can probably be chalked up to charge-offs. This implies households are not (contrary to popular opinion) actually paying down their debts to any great degree. In the aggregate, non-defaulting households are actually only gradually reducing their debt level. Since we have direct knowledge that at least some people really are paying down their debts furiously, this means others are getting in deeper.

The tenacity of the credit card balances could offer alternate interpretations. It is possible that household finances are in OK shape, and that people are confident about their prospects for the future. On the other hand, it could be that many, many people are desperate for funds to pay the bills, and thus borrowing (instead of cutting spending) in the face of declining income.

Since we opine that we are in a Depression - one of the defining characteristics of which is declining income, we favour the second interpretation. If true, this bodes very ill for the profligate households, and not so good for the rest of us in the months ahead.

Mass Unemployment + Heavy Debts = Ruin

In the USA, household debt as a percentage of household income is at an all-time high. At the same time, for most households, income is falling - making the debts more onerous. For a significant minority, long-term unemployment or underemployment means income has collapsed and the debt burden is overwhelming - usually resulting in default and bankruptcy.

We have been reading many 'horror stories' about people who had good jobs, but lost them and were unable to replace them, and then drowned in their debts. These people are no longer at the fringes of society, but just another form of 'normal'.

We are beginning to see the human side of this Depression as a series of millions of little catastrophes. Lives that were until recently lived more or less conforming to the typical American Consumer Lifestyle: House, Car, Stuff - complete with mortgage, car loan, and credit card balances. Then income loss leads to wipe out: getting behind on bills, letting them go, and then the repo men take it all away.

It's hard to guess how many will follow this path, but we suspect about half the population. It's going to create a very different America. Luckily for the powers-that-be, most will probably just blame themselves.

Imagining a Better Future

Seeing how we are writing here about the Depression - which may last a very long time and turn out to be a dramatic economic collapse - we feel it important to state once again we are confident that the future can actually improve for anyone who is prepared for it.

The most important preparation is to be optimistic in the sense we mean it: making the best out of every situation. At its most trite: when life hands you lemons, make lemonade. Loss can be liberating if you find new fields in which to apply yourself.

Of course it is also important to avoid certain traps that will stifle your ability to survive and prosper in the coming years. The biggest trap is the notion that things will go back the way they were. This even applies to a lot of notions of 'prosperity', 'growth' and so forth. More specifically it applies to notions people have about what is worth investing in: a career, real estate, the stock market. Most of the systems that have worked to make people better off in the past are breaking down, and will not deliver the goods going forward.

So what do you invest in? Try to invest as much as possible in yourself, your skills, your tools, things you have control over which will help you produce income or reduce expenditures. You must take full responsibility for your income, and for living within your means.

The biggest shock the world is facing is that the era of an ever-growing stream of material goods and services is coming to an end, and will become an shrinking stream for quite some time. Happily, your quality of life is not measured by how much stuff you can buy. But you have to focus with ruthless efficiency on managing your income and expenses or you will find yourself a Depression victim.

To have a better future, you must also avoid having a worse future. However, for many with debts, children, or other substantial obligations the future may be unavoidably worse before it gets better. In any case, try to identify your weaknesses with some cold honesty, and shore them up.

The route to prosperity is simple in theory: live within your means (no matter how meagre) and profitably invest the surplus. In practice this can be extremely challenging, but it is achievable.

A New Rule for Profit in a Declining Economy

Whatever you might be hearing, reading, or wishing to believe to the contrary, the world economy is still declining. Looking ahead to 'the recovery' is premature. A practical question arises to those who wish to better themselves financially: How can one make sure one is better off tomorrow than today?

In a growing economy, it pays to take risks. For example, if you can borrow money at a low cost, you can invest the funds in an instrument that makes more and profit off the 'spread'. In a shrinking economy, this strategy typically no longer works. Lenders are not inclined to lend, and few investments yield positive returns.

In a shrinking economy it pays to destroy risk. For example, if you have debts - pay them off. You have a guaranteed return in avoided costs. Likewise, seek to reduce operating leverage in business, even if it means giving up work so that you don't have to take on additional costs (such as buying new equipment, or hiring employees).

This will be a tough lesson to learn. It runs counter to the experience of the last 60 years. Recessions may present buying opportunities, but a Depression - at least at the beginning - is a time to hunker down.

It is very important to measure your income and outgo and ensure the former is larger than the latter. If you economise and create safe, secure savings, your net worth will rise. At some point in the future it will be time to consider more aggressive investment strategies, but that time has not yet come.

Credit Card Collapse Report

With today's post we are introducing what we expect to be a recurring report on consumer credit in the USA.

On May 7, the Federal Reserve issued its monthly report on consumer credit. Going beyond the massaged, 'seasonally adjusted' figures, there are some impressive numbers. Apparently in the first quarter of 2009, revolving credit balances - mostly credit cards - fell $60.4 billion, approximately 6%.

This means that not only are people not taking on additional credit card debt, they are paying it off at a rapid rate. If this should continue as a trend, and there are at least two reasons to expect that it will, it will have a serious dampening effect on consumer and business spending.

The first reason to expect the credit card paydown to continue is that credit card issuers are cutting credit lines right and left. Even good customers who have always paid on time are finding letters in the mail informing them their lines have been reduced or their accounts closed altogether.

The second reason is the debtors themselves are feeling less inclined to be debtors. When one's income is declining or even just less certain, all debts become onerous.

It should also be mentioned that part of the decline in debt outstanding is due to writeoffs by lending institutions. These writeoffs also erode the lenders' capacity to issue new loans.

Punishment by Debt-Based Money

Debt-backed money evolved to facilitate economic growth in response to the braking effect of precious metal money and its inherently inelastic supply. Unfortunately during a depression, debt-backed money is destroyed as old loans are paid off or defaulted upon and new ones do not take their place, and thus can be even more restrictive to economic activity than precious metal money which is not destroyed. National Governments' and Central Banks' current furious pace of borrowing is an effort to replace private debts with public ones and keep the money supply from shrinking.

Will this public debt binge work? Only if the expanding public sector can engender sustainable growth. As we suggested in previous posts, there is a range of optimum government spending above which is too much, and below which is too little. Another factor is the quality of that spending. Government spending can be considered to be quality when it provides services that are actually useful (for example electric power) in contradistinction to wastes of resources (such as luggage inspection).

Yet another factor is whether any further consistent economic growth is possible at all. If it is not, and there are many reasons it may not be, then having debt-based money will be especially ruinous. Debt is a magnifier of both profits and losses. Now that humanity finds itself on the right-hand side of Peak Just-About-Everything, private debts are increasingly being realised to be more untenable than previously imagined, and servicing public debt will exact an increasingly heavy toll on an chronically shrinking economy. This toll will likely exceed the imagined benefit of maintaining the debt-based money supply.

Growth in Household Debt: Paused or Ended?

In the United States, the last 60 years have been marked by the continuous expansion of household debt: mortgages, car loans, student loans, credit cards, and so forth. In the fourth quarter of last year, this party came to an end. In spite of Federal Government and Federal Reserve efforts to expand lending, more loans were paid off than taken on.

We believe this is not the result of the masses coming to their senses, but a constriction imposed by wounded banks and finance companies. If the current economic troubles were merely a 'recession', when banks were inclined to lend again, as they must sooner or later if they wished to stay in business, the populace would borrow willingly. We wish it were otherwise, but the consumer culture is very deeply embedded in the American psyche.

If this Depression turns out to be as truly nasty as we expect it might, substantial banking capital will be lost - and in spite of all the bailouts, it will be many, many years before banks and finance companies are in any position to expand lending. In this environment, as it was in the Great Depression, a culture of thrift and debt-aversion will arise out of survivor bias.

We recently asked an elderly friend how her parents coped with the Great Depression, and what they brought out of it. The answer was simple: they were very frugal; and they paid for everything with cash. These habits remained with them for the rest of their lives.

So, to answer the title's question: If the economy is in a recession, paused; if in a depression, ended.

A Brief Lesson in Debt

Hyman Minsky (1919-1996) was a rather obscure economist who came up with an excellent theory of debt which seems especially appropriate to current events. In brief, he divided borrowers into three categories: the hedge borrower, who can make loan payments easily out of income and extinguish the principal; the speculative borrower who can make interest payments more or less easily out of income, but cannot repay the principal except by rolling over the debt; and finally the Ponzi borrower whose income does not cover even the interest on debts, and therefore needs an ever expanding supply of credit to service loan payments.

A clear example of the hedge borrower is the homeowner who takes on a traditional fixed mortgage, the payments of which are a fairly small part of his or her income. An example of the speculative borrower is the house buyer who takes out the interest-only mortgage hoping to sell the house at a profit. The ponzi mortgage borrower takes out the reverse amortisation mortgage, hoping the house will appreciate fast enough that he or she can refinance at a higher amount.

In the housing bubble bust of the last two years or so, most of the borrowers in the Ponzi category have already lost their houses. Most of the borrowers in the speculative category are 'underwater', and many have 'walked away'. An increasing number of mortgages in the hedge category are going delinquent due to falling incomes and rising unemployment. It is not pretty, and the situation will probably get worse. We expect, on the other side of this Depression, that hardly anyone will ever want to buy a house with a mortgage again.

Of course Minsky's model applies not only to mortgage borrowers, but to the banks that lend to them. Banks are completely dependent on continuously rolling over their entire debt structure. This is why they are the first to feel the strain of a credit crisis.

As things are currently unfolding, central banks and governments are stepping up to fund banks who need their debts rolled over. Banks are not as generous to their borrowers, and are mostly calling in risky loans, and mostly not expanding safe loans. This is hurting a great many businesses who rely on speculative finance, and will cause a great many to go under. We suspect a lot of individual borrowers who are getting their credit cards cancelled will also be forced into bankruptcy.

If the Depression continues to unfold along these lines, most speculative finance units (as Minsky would call them) will be euthanised. Exceptions will be made for banks, insurance companies, and public utilities. The consequences will be very dramatic: tens of millions of failed businesses and hundreds of millions, if not billions of downwardly mobile citizens.

We doubt this this process can be arrested until it is spent. If you are a borrower and you cannot pay your debts out of your income (and these days incomes are not so reliable), you will need to liquidate assets or default. The end result is that you will become poorer. So-called 'rescue plans' will be of little help. If you are able to service your debts - congratulations! - you will be fortunate enough to experience the down-not-so-much that is the new up.

Another Sign for the Bottom

We like to keep ahead of popular trends in society. For instance, a few years ago the typical American citizen was a debt-addicted consumer: they borrowed, borrowed, borrowed, so he or she could spend, spend, spend. We saw that, and tried to go the other direction: keep debt within easily-manageable amounts.

Fast forwards to today, and people are fretting about their McMansion, their big-screen plasma TV, and their automobiles; all were bought with credit, and all are pretty expensive when one doesn't have a job. The average 'consumers' are only just beginning to realise just how unsustainable their lifestyle once was.

However, it's going to take a quite awhile to obliterate unsustainable 'common knowledge.' 'Common knowledge' holds that everyone can own their own home, their own car, and live in the suburban paradise. 'Everyone' knows that one should pay for as much as possible with credit; it's so much more convenient that way.

We are on the fringe when we write this, but we feel it is true: consumerism is dead; the 'every family in their own home' fantasy is dead; there will be no chicken in every pot and car in every garage. Buying a house with no-or-little money down is a bygone memory, no matter what any bank may say or advertise.

Frankly, we know we're a Cassandra, screaming the bleak truth toward disbelieving ears. However, if one day, you should read on the front page of USA Today that, not only is buying a home with credit is a terrible idea, owning a home is a terrible idea, the worst is over. Simply put, when what we write today becomes the mainstream knowledge of the future, the bottom of the 2007 Depression has been found. When that happens... buy stocks! Buy apartment buildings! Buy everything that can generate a profit! Buy, buy, buy!

Increase in Savings Rate Explained

Fortune Magazine just published an article bemoaning the lack of consumer spending and (what is to the author) a paradox of increasing savings rates. Mr. Colvin, the author, apparently does not get out much, because anyone with eyes to see can tell you why savings rates are increasing.

People are 'saving' only because they are paying off their debts. They are not paying off their debts because they want to, but because they can no longer refinance their debts with home equity loans, low-rate promotional cash advances, or even just plain juggling their balances between credit lines. Banks are relentlessly cutting lending. Credit lines are cut and new loans are harder to get. In order to pay off their debts, people must cut their spending on whatever they would have bought if they didn't have to pay off their debts. Consumption declines, 'savings' increases, end of story.

The dimness represented here by Mr. Colvin and other writers in the leading financial publications is disconcerting. If the investing class continues to be as misinformed in the Depression as it was during the Mania beforehand, recovery will be very far off indeed.

The Problem of Financing the US Federal Debt

There are countless misconceptions about where the money comes from to finance the US Federal Debt. One reads constantly in the financial press something like "the U.S. must have a sound fiscal policy, or the Chinese [or Japanese, or Arabs, etc.] will not fund the deficit." This is actually just silly.

Foreign trade partners have money to invest in US Government debt because they run trade surpluses with the USA. Debt is bought with funds left over after they have bought whatever they might want (if anything) that the USA has to sell them. The amount of debt they buy is incidental to their trading activities. Internal US policy (interest rates, inflation rates) has little impact on the process.

For a while it was a great deal for citizens of the USA. They got to buy stuff from abroad, and when the money was recycled back to the Federal Government, they got to spend it again! Things are changing, though. Foreign trade surpluses with the US are crashing. This is because foreign trade is crashing (see a previous post).

The U.S. Federal Government (and indeed any national government that has been running chronic trade deficits) will be losing a critical source of funding in the years ahead as international trade declines. It is highly unlikely that interest rates will be raised to attract funds as this would exacerbate the economic contraction. Instead, the loss of recycled trade deficits will be made up for by just that much more 'printing'.

As we have been hinting darkly, the USA is coming to the point where its economy simply cannot service the debt load it has placed upon itself. Given the way policy has been going lately, the outcome will be the quasi-default of runaway inflation.

What is Poor?

As one of the biggest shopping day of the year dawns, we look out the window and -- to quote the archetypal priest -- we think of those less fortunate. No, dear Reader, we don't mean those who couldn't buy their family a new plasma TV. We refer to those in the world are inconceivably poor: they cannot even afford proper nourishment.

For example, take Haiti. 80% of Haitians live on $2 or less a day -- making them part of the 2.4 billion or so who live on the same budget. Mind you, Reader, than isn't $2 for food a day, that's just $2 a day. They are so poor they are eating baked mud, potentially ingesting various toxins or parasites. This mud they eat is euphemistically referred to as a cookie.

Mmmm, cookies.

We have no ethical axe to grind, one way or the other. We merely feel greatly irked at people who worry when they cannot blow large amounts of money on the holidaze. For instance, a worker at a recently-reopened cookie manufacturer in Ohio said, after getting a $1,500 gift card, 'I can give my kids a Christmas.'

Really? No kidding. We can see a couple ounces of gold dancing in our eyes if someone handed us $1,500. A person in Haiti would have probably screamed for joy, since they could then have eaten on $5 a day for about a year... but this person instead saw Wal-Mart, or possibly Toys-R-Us.

No one in the West quite understands what it truly means to be poor. We certainly don't, and we don't want to, either. The poor of Haiti have little-to-no hope of improving their financial situation, because they cannot even afford to live hand-to-mouth. In the West, one still has the potential to improve one's finances, even in this Depression. If one gets a windfall, like the worker and her $1,500, one must think long and hard about spending it wisely. Use it for a lasting improvement in one's living conditions: pay down debt; shore up investments; buy some precious metals. To fritter away a windfall, time and time again, launches one on the road to perfect understanding of just how poor the average Haitian really is.

What is Deflation?

There is, at present, a raging debate in the blogosphere and elsewhere as to whether the economy has entered a period of inflation or deflation. The conflict is not helped by the fact that there are no generally accepted definitions of these two concepts. We will attempt to create a definition that will provide a framework for analysis of various viewpoints.

First of all, the most useful definition of inflation and deflation would explain them as two sides of the same proverbial coin. A naive definition would call inflation, rising prices; and deflation, falling prices. Unfortunately in the real world, the prices for all sorts of things rise and fall continuously for a wide variety of reasons. Many analysts attempt to reduce their definitions to narrow, easily observed phenomena, i.e. official defined money supplies, or indices of consumer prices. Much of the contention arises over what is being observed.

Inflation and deflation could be said to be something that is hard to define but, like pornography, we know it when we see it. In that spirit, we define deflation as pervasive, structural falling of costs as measured by the currency across a broad range of economic activity; and inflation as its inverse.

By pervasive, we mean costs therefore do not just refer to retail prices, but also asset prices, wholesale prices, producer prices, and most critically wages and rents (including profits and interest). By structural, we mean that economic activity is inherently complex. Making money has many costs embedded within it, and what one pays out axiomatically ends up as many multiple others' income. This aggregation of costs, wages, interest, and so forth we call the structure.

Is deflation happening in the 2007 Depression? What costs have fallen so far? Obviously, the cost of many securities, houses, and commodities. Not so obviously, the cost of interest on national debts (with some notable exceptions, such as Iceland), and corporate profits. What about costs that are rising? The U.S. minimum wage went up in 2008 by 12 percent, and in 2009 will be going up a further 11 per cent; U.S. Postal first class stamps; and, as a personal example, our water and sewer utility service.

The picture is once again, conflicting trends. Over time, one of these trends will emerge the 'winner'. In the mean time, falling prices of certain things might be called 'deflationary', but that is very conjectural. For example, if the price of a commodity falls so much that it is unprofitable to produce it, the fall will simply be what is known as a price spike down. The price will then have to rise again, if people want to continue using the item. This is hardly deflationary.

Likewise, incomes will likely soon be shown to be falling, and some may call that evidence of deflation, but it might just be people becoming poorer. If what people want to buy does not also become more affordable, then there is no deflation.

It is our opinion that the 2007 Depression will probably not be deflationary. Two significant factors are at work to ensure that outcome. First, it is the stated objective of monetary authorities everywhere to prevent deflation. Second, many costs (such as minimum wages or social security benefits) are fixed by law, and even more costs, contractually over long periods of time.

It is also our opinion that the 2007 Depression will probably be, overall, strongly inflationary, if not even hyperinflationary. We believe that the overhang of money, and money-like securities (bonds, CDs, money market funds, etc.) from the bubble years combined with central bank efforts to prevent deflation will create a surplus of currency chasing a quantity of goods and services which is declining due to contracting production. In other words, when more money chases fewer goods, the outcome is inflation, not deflation.

Peasant Virtues

As our income has fallen, we have been trying to rediscover the skills our ancestors used to manage their financial affairs. We break the skills into three sets: Industry, Frugality, and Thrift.

Industry is not here referring to factories and mines, but the idea of doing things for one's self. Hungry? Don't run to McBurger Kong, but make a meal for yourself. Cost of fresh food got you down? Grow some. The basic principle here is what economists call import substitution. Instead of importing goods and services into your household and exporting money, you substitute the fruits of your own labour (sometimes literally) for what you would buy from others.

Industry is also about figuring out what you can do to make extra money, on the side - if you still have a job, or as self-employment. Lots of things always need doing. If you can't figure out what to do to make money, keep busy around the home - chances are there are many worthwhile projects. Also, you may teach yourself some marketable skills.

Frugality is all about enjoying what you have as long as possible before you replace it. And when you do replace it, do that as inexpensively as possible. Let's suppose you have an article of clothing, say a sweat-shirt, and it's getting a little ratty on the collar and cuffs. Does it still keep you warm? Then keep it! You might say, "But it's shabby." Listen: a new one costs money (even if you make it yourself), and this one is free. Any money you spend is infinitely more money than not spending money. A new thing is not infinitely better than an old, shabby but serviceable thing. When you spend money to replace something which still works, you are being irrational. It's OK to be irrational now and then, but don't try to pretend that you are being rational by coming up with reasons that the new thing is better.

When it comes time to replace something, go first to rummage sales and thrift stores. Often you can find very good quality things at minuscule prices. Frugality is also about finding which stores get you the best prices, finding the best deals, conserving energy, and repairing things as cost effectively as possible.

Thrift has two components. The first is to look at money coming in as something to be saved, not spent. This is, for inhabitants of the developed world, counter-cultural. One hears countless messages to spend from family, friends, coworkers, employers, salespeople, and marketing. If your financial situation is not so good, the more you save the faster it will improve.

The second component of thrift, which answers the question of where the best place for most people to put their savings, is: Never, ever borrow money. People have gotten very lax on this in recent decades, and the results have been catastrophic. If you are fortunate enough not to have burned by your debts so far in the Depression, don't take any more chances. When all your debts are paid, you may then delve into the joys of learning to invest your savings. On this last point we must insist that you learn to manage your own affairs, and not leave the decisions to 'experts'. The experts have done very badly lately.

Preventing Deflation Won't Stop the Depression

The world's monetary authorities are, at present, desperately trying to stop "deflation." Deflation is a complex and controversial topic, but suffice it to say deflation is the perception of falling prices. The theory behind central bank actions is that when prices are perceived to be falling, one becomes reluctant to invest or even spend on consumables, when just waiting will get one a better deal.

Obviously, stock and commodity prices have fallen dramatically in the last few months. Most real estate has been falling for a couple years now. Consumer prices are beginning to fall as well. Can this process be stopped? Actually, yes. Central banks can ensure that the money supply rises fast enough to devalue the money in one's pocket, making assets, goods and services again an attractive use of that money.

Can arresting deflation stop the 2008 Depression? No, it cannot. Depressions are a self-reinforcing process of declining income. Wages have been falling in purchasing power for decades. Households responded at first by sending more of the population into the workforce to support the household. Families with a single 'breadwinner' are now quite rare. Lately, workers have taken to eliminating savings, borrowing against the value of their homes, as well as taking on increasing amounts of consumer credit in an attempt to fund their spending. This is, of course, not sustainable. In fact, defaulting consumer debt will be a serious drag on the world economy for quite some time. A further drag is rising unemployment, and over all personal income in decline.

At this point, the economy will not recover until several things happen: the losses from bad investments are recognised; failing undertakings have been liquidated; savings rates return to healthy levels; employment and the purchasing power of wages begins to rise. Current government policies are not promoting any of these conditions. If anything, the policies are working against the first two conditions.

It is possible that we are witnessing an effort to 're-inflate the bubble.' Perhaps if the public sees that their houses and investments have stopped falling in value, they will pull out their metaphorical charge cards and dig themselves even deeper into debt. Leaving that central banker fantasy aside, we believe that conventional economic theory is incorrect. The current decline in prices is a symptom of economic contraction, a destruction of purchasing power. Alleviating the symptom will not cure the disease. Denominating prices in a debased currency will do nothing to help the current situation, and even risks igniting an economy-destroying hyperinflation.

Two Macro Trends of the 2008 Depression

We have been careful to avoid detailed or specific predictions of what is going to happen during the 2008 Depression. Certain symptoms, like the housing price and tax receipt collapses, are 'baked into the cake.' In this post, we will look at some macro-scaled trends of this Depression, and what shapes they may take in coming years.

The first trend is a monetary crisis. This Depression, like every other, involves economic contraction. This was brought about by too many people and organisations assuming more debt than they could feasibly service. As these debtors inevitably began to default, the world economy began to contract. This process will continue until all untenable debt world-wide has defaulted or been renegotiated.

This unstoppable contraction is putting considerable pressure on all monetary systems. The world-wide paper money experiment is unable to cope in its present form with this force, and is in a state of crisis. Central bankers are aligning their respective policies to inflate the money supply in an attempt to combat the economic contraction. They may succeed in creating consumer price inflation, but they will not be successful in arresting the ongoing contraction.

This phase of the 2008 Depression does not necessarily spell the end of the paper money experiment, but it guarantees at least one large and unpredictable shift in policy. Whether this will cause rising consumer prices or falling consumer prices is unimportant to the macro trend. Suffice it to say that money as it is known today will be rapidly changing in the near future.

The second trend, which will serve to reinforce the contraction of the world economy, is that of increasing energy scarcity. Peak oil, long considered a crackpot theory, is indeed a reality: production of light sweet crude oil, the most potent and versatile natural energy source, peaked in 2004 and has begun an irreversible decline. There is no way to reverse this trend... but we will save more detailed discussion for a later post.

As energy becomes increasingly scarce, the world economy will increasingly contract. What energy is available will be increasingly diverted towards high-value-added processes. The world economy has hit the wall of falling energy availability, and will be forced to adapt to the new energy reality.

These two macro trends -- monetary crisis and energy scarcity -- are ones to be very aware of in the coming years. The 2008 Depression will make working against these trends ruinous. It would be wise to avoid institutions and investments which ignore these trends, or simply assume these trends will be managed without ill effect. If one recognises these trends are not temporary, one can plan more effectively for the future.

Ingredients for the 2008 Depression

'Why is this happening?' is a question that will defy a rational explanation. Our previous post suggested because the Depression is an unstoppable force, but that is hardly satisfying to the inquiring intellect. What are the ingredients that were thrown into the economic pot that triggered this Depression? There has been a bit of speculation on this subject, and as the Depression becomes increasingly self-evident, the attempts to rationalise it will become abundant, and politically motivated. One can never know for sure, but we shall offer our opinion of what the ingredients have been, both in this post and future ones.

Here is today's list: falling real median wages in the USA; too much debt just about everywhere; a speculative mania in housing in most countries; a speculative mania in housing -related investment securities; a speculative mania in securities backed by consumer debt; a speculative mania in exotic investment vehicles such as bond insurance and credit default swaps; a speculative mania in companies which separate speculators from their money such as mutual funds and hedge funds; corruption and mismanagement in financial institutions, their auditors, and their regulators. To this we could add some factors that are probably be at work: fiat (i.e. "paper") money; resource depletion issues; consumption of previously-formed capital, including social capital.

Every item in this list has quite a story behind it, and though they may seem abstract, their effects are most definitely present in your life. In future posts we will touch upon all these ingredients (and more). If you deem any to require expedited discussion, please leave a comment.