Saturday, April 18, 2009

Impact of Government Economic Stimulus on Consumers

Q:  Given that the consumer is already under debt duress, does the government's massive stimulus program to stave off the recession create new consumer burdens?  In other words, does government's current expenditure policies make it harder for the consumer to repay his debt?

Yes, the government's spending program does, indeed, create new consumer burdens; however, it is possible that the stimulus program will better enable consumers to lower their debt.  Of course, for the stimulus program to work, the expenditures have to be responsible and effective.  For the purpose of discussion, let us assume that the Obama administration will spend the money as effectively as possible.  With that set aside, let us look at the ramifications of this massive expenditure program.

Indeed, the consumer will see additional burdens in the years to come.  These burdens will come in one or many of the following forms:
  • Inflation
  • Lower dollar value
  • Higher taxes
  • Slower economic growth
Inflation, lower dollar value (as measured against other currencies), and higher taxes all have the same impact to the consumer:  Given a fixed paycheck, they take away from that paycheck's actual value.  Slower economic growth means, among other things, that it will be harder to argue for a pay raise to offset the hit on the paycheck's value erosion.

First, let's put things in perspective.

The Bush administration came into the office under unusual economic circumstances:  It inherited the largest budget surplus ever.  Driven ideologically, the Bush administration proceeded with one tax cut after another while creating new expenditure obligations and entitlement programs.  This was the only administration in history to push for tax cuts while waging wars.  Not surprisingly, the end result after eight years was the biggest budget deficit in history.  

Deregulation is a longer historic arc which began in the 1980s.  As regulatory bodies were weakened, financial crises became more common:  The Savings and Loans failings of the 1980s, Long Term Capital Management in the 1990s, Enron in early 2000s, and the collapse of the financial industry in 2008.   Recent profit reporting by various financial houses are also suspect.  In essence, it is difficult to tell who has clean books and real profits any more.

These set the backdrops in which the Obama Administration must operate, thereby framing the problems that they have to deal with and the limited solution set.  One point is worth making:  I am not indicating that deregulation or tax cuts are necessarily good or bad; I am only indicating that as they were implemented, they had certain, unpleasant and unfortunate ramifications. 

The Bush Administration handed a  self-amplifying double whammy to the Obama Administration:  A financial crisis and a failing economy.  As the financial crisis deepened, credit became harder to get.  As credit became harder to get, the economy suffered more.  And the ever increasing suffering economy further exacerbated the financial crisis.  The Obama administration had to stop the financial crisis and boost the economy simultaneously, and do so at a time when America already had a record budget deficit.  The solution that the administration chose was to pump liquidity into the financial sector (keeping zombie banks alive) and massively increase government spending (with the goal of creating jobs, albeit this is questionable) while having limited latitude to raise taxes.

As any consumer knows, when you spend more than you earn, you burn up your savings.  If you do not have any savings, you get deeper into debt.  In the US, we are getting deeper into debt, and we are financing this debt through foreign borrowing.  To keep the foreign money coming in, the US will have to increase interest rates to keep US bonds an interesting buy.  The interest rate hike will hit every consumer by making borrowing more expensive and forcing a higher portion of the consumers' incomes to be allocated towards servicing debt.

Of course, the US will have to pay back the debt.  It can do so in an honest way, by keeping inflation in check, or the expedient way, by inflating its way out of debt.  Printing money is the perfect inflation creation mechanism:  By increasing the money supply at a faster rate than economic growth, the US will simply lower its debt obligation by effectively transferring wealth from the debtors to itself.  

However, inflation will have other unkind effects, one of which is the devaluation of the dollar against foreign currencies.  Because US is a net importer, the devaluation of the dollar means that foreign goods - the kind that we consume voraciously - will become more expensive.  This erodes from the dollars purchasing power and will make the average consumer poorer.  

At some point, inflation will have to be brought in check and some realistic portion of the debt will have to be paid back.   This will mean a further elevation of interest rates - and taxes, both of which again put pressure on the consumer.

So, the outlook for the consumer is grim.  However, this outlook is far less grim than the alternative where the financial crisis and economic downturn viscous circle would completely collapse the world economy and create a long-term, worldwide depression.  

There is no easy way out and the consumer will have long-term pain.  The path that we are currently on seems to be the least painful path, but keep in mind that we made a key assumption:   The Obama administration will spend the money as effectively as possible.  The wrong policies, or poor implementation of the right policies, will drag us down even further.

Monday, April 6, 2009

Why Did Lenders Lend, and Why Do They Keep Lending

A series of thoughtful questions were posed to me on private email.  I have captured the essence of those questions and my answers here:

Q:  Why did the lenders overextend borrowers in the past Decade?
This has been a hot discussion topic in mainstream media.  It is hard to understand the rationale of lenders, be they mortgage companies or credit card issues.  The answer to this puzzle seems to be that the financial wizardly wisdom of the past decade was that high-risk loans could be collateralized and packaged (into collateralized debt obligations) so that the overall risk would be lower than the risk of any individual loan.  Add in rating agencies that were - for lack of better terms - sleep at the wheel, bonuses affiliated with selling debt and debt-backed securities, and the false sense of security that credit default swaps (insurance policies for CDOs), to create a perfect storm of reckless behavior by lenders that encouraged reckless behavior by borrowers.  Once the house of cards fell apart, the tipping point being Lehman Brother's bankruptcy, the wheels of the wheeling and dealing debt market came off.
Q:  Why do lenders continue to overextend borrowers through credit card debts?

Credit card companies are (comparatively) actively turning away customers, increasing their borrowing rates, or lowering the credit limits of their most risky customers.  American Express is a case in point.  As a result, we may see lower credit card debt levels in the ensuing months; however, credit card limits are preset.  Other than active intervention by financial institutions mentioned previously, there is nothing to stop consumers from borrowing until they reach their credit limits.
Q:  Will higher debt interest rate obligations further reduce consumption?

Absolutely.  Lower consumption will occur either because a higher percentage of disposable income will become allocated to servicing debt or because the consumer becomes insolvent.  In either case, this bodes poorly for US' short-term economic growth.