Monday, April 14, 2008

Economic Predicament (April 2008)

If It's Not One Thing, It’s . . .

. . . three or four things to make a real economic mess. What has caused the economic predicament we face today? Politicians are all pointing fingers, blaming the "Sub Prime Mortgage Fiasco," or the bursting of the housing bubble, or the falling dollar. It may be instructive to understand how these economic scenarios blow up from time to time.

The 'Great Depression' was variously blamed on Hoover/Rockefeller for not maintaining liquidity in the financial markets when runs started at banks. Others pin the fault on the Congress for the Smoot Hawley Tariff act, which raised our tariffs to protect American jobs, but set off a wave of retaliatory tariffs by other countries that decimated our exports. Often the stock market bubble of the 20's, where stocks were bought with only 10% margin, is fingered as the problem. The truth is, I think, that none of these events by themselves caused the Great Depression, but rather a 'perfect storm' where all these events happened in the same time period. Of course the record 'Grapes of Wrath' drought in the Midwest and plains states in the early 30's exacerbated and prolonged the depression.

This is true of other recessions too. In the 70's, the stock market also ended a record run-up at the end of the 60's, plus the Vietnam War was a huge financial drain. Inflation started rising rapidly, and was likely accelerated by Nixon's Wage and Price controls in the early 70's. Those factors were then aggravated by the increase in oil prices by the oil cartels, as well as the strategy of the Federal Reserve to cut interest rates to head off a recession. The result was 'stagflation' and the death of Savings and Loan companies, salvaged by the RTC.

There were mild recessions too. The late 80's had a brush with the junk bond collapse, compounded somewhat by the stock run-up in the Reagan years. But there were not enough negative whirlwinds to create a major recession. Housing hit some bumps in the early 90's, but again the national economics wasn't impacted by other forces, and in fact the increase in globalization and computerization propped up prosperity.

We were hit very hard in 2000-2002, when Greenspan finally broke the back of stock market’s 'irrational exuberance' which was then soon followed by 9/11. The era came to an end, impoverishing many nouveau-riche millionaires and decimating portfolios. It was the effect of these events happening together that produced the severe economic downturn, which in turn created huge unemployment.

Today we can see the bond market, which had become enamored of 'collateralized debt obligations' which were foisted on the investing public. This created another liquidity crises, and the stock market dropped as companies and individuals found they had committed to more debt than they could handle. The housing market, buoyed by speculators collapsed and now almost every region has a surfeit of excess housing inventory.

Will it get better? Yes, but maybe not right away . . . if there are other set-backs, we could face worse times. For example, if there is a string of
Municipal bond defaults, due to the overwhelming unfunded pension liabilities. Or even a severe earthquake along the California coast, or the overthrow of the Saudi Kingdom or other Middle Eastern political shift which interrupts the world’s oil supply. The economy can withstand one or two of these setbacks and recover quickly as it did in the 80's and 90's. However, if there are three or four of these storms which occur in the same period of time, we could see our economic situation seriously worsen.

The problem is that it is impossible to figure out the timing. It is a mathematical certainty that municipalities are not going to be able to pay the pensions they have promised to the baby boomers and beyond. Scientists agree that a major earthquake in California is inevitable. But no one knows when.

For each of us personally, we can protect ourselves from these outcomes by keeping a diversified portfolio. Treasury bonds are the stalwart buffer against deflation. If we encounter rising inflation and associated high interest rates, a long-term mortgage is our best protection. We will eventually see the dawn of prosperity again, and maintaining a diversified stock portfolio is what allows prudent investors to participate in long term growth.

So, even if it's not one thing, but three or four bad things that make a perfect storm, it's not a good idea to jump ship.

Bert Whitehead, MBA, JD

No comments: