Monday, May 3, 2010

Present Economic Picture

Perhaps it is time to comment on the global economy again which is weathering what can best be described mostly as a global slump brought on be an excess of bad credit creation in various forms around the world.  The dominant forms are the mortgages packaged up in the USA and the chunks of sovereign debt that need to be reconstructed in the Euro Zone.

The horror stories and fear mongering has been unending with the usual predictions of catastrophe.

So let us make a couple of things a little clearer.  The money lent foolishly has been long spent and the borrowers will likely never repay these loans or at least they will take all the time they need.  The inflationary effect of all this money has long since been felt and is presently in the system.  The folks who have a problem are the lenders who made these loans.  That is why governments have been effectively printing money to make up these losses for the banks themselves.

At the same time the banks are bringing their reserve ratios back in line before governments force them to.  This also contracts their capacity to over lend even with all the new money given them.  Everyone has sobered up and reckless loans are been cleaned up.

In the meantime in the USA, underwater borrowers are either properly restructuring or dumping properties they can no longer carry shoving the liability back onto the banks.  This has the effect of increasing personal cash flow and allows liquidation of any other debt.  The result is a rapid improvement of personal balance sheets and the beginnings of rising consumer confidence.  We can expect surprises.

The banks are discovering a long forgotten lesson.  A house is a lousy investment if it is based solely on its natural earning capacity.  In fact on a cash flow basis a house is normally worth less than its replacement value before the land component is factored in.

The only thing that has sustained the myth has been the fact that rising prices for underlying land has provided all the gains.  That is no different than rising stock prices been their own justification without recourse to earnings.

Now that that music has ended nastily the price structure is busily deflating to around the original value of a first mortgage reflecting the unwillingness of the banks to book a real loss.  Again by selling a property at a cash loss the bank loses at least ten times the cash loss in lending capacity and is forced to shrink the portfolio some more.  The bank has a powerful disincentive to accept losing sales.  Thus present price structure appears stable while foreclosure inventories continue to expand merrily along. 

My point is that the American consumer is extracting himself from the vicious bank deals he was sold into by the simple expedient of handing the problem back to the banking industry and in the process liberating his income.

This pool of rising income will bring him back into the housing market as prices reset and any encouragement is provided.  It could be sped up but that appears too much to ask for.

If the VAT tax can be implemented then the playing field will be leveled with our trading partners and the USA can in fact race to full employment as the manufacturing sector re-expands.

Questions that we need to understand and answer.

1                    Will inflation kick in with all this bail out money?

No!  The banking industry is contracting and all that money is merely offsetting the damage caused by the sub prime lending binge.  Amazingly, it appears to be happening in an orderly manner.

2                    Will the stimulus money actually stimulate the economy/

Not likely.  What will stimulate the economy is the progressive liberation of underwater borrowers from high monthly payments.  There is presently plenty of pent up energy industry demand alone to super charge the economy. Tie that into renewed consumer spending and we have a flat out economy developing over the next few months.

3                    What will help the banks?

Rapid growth resolves a lot of bad deals.  They still have to peddle a lot of real estate and absorb hefty losses, but the consumer is about to re enter the market because of attractive prices.  This can all be cleaned up in two years if folks get excited.

4                    What about the price of oil?

Prepare for rationing.  The government will need to control access to available fuel shortly and may slap an import tax on non North American oil.  I certainly would. The economy cannot operate with prices in excess of $100.00 per barrel so we are not going to.

5                    What about the rest of the world?

Who cares?  They will sort out their situations a lot easier than we can. Our first and present priority is to get this financial house in order.  Do that and options will open up.

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