Saturday, December 27, 2008

"The Perfect Storm" and other lame excuses

During the past few months, executives from virtually every kind of company - from autos, to tech equipment, to financials - have invoked the "we've been hit by a perfect storm" excuse as to why they are underperforming recently provided expectations. The beauty of the perfect storm excuse is that it deflects accountability.

No doubt, there is some truth to the fact that a confluence of factors have come together to negatively impact their business. The questions are "why is it a surprise" and "is this really as bad as it gets".

The confluence of factors often provided: deleveraging, consumer recession/demand collapse, lameduck presidency, housing collapse, stock market collapse, credit market collapse sure sounds like a perfect storm!

Other than the lameduck presidency, upon which I place virtually nil weighting for our present circumstance, these factors are all correlated. However, what our "blameless" business executives don't realize is that the perfect storm is not today, it was the boom times that were the perfect storm. Instead of calling it the Perfect Storm, I'm going to refer to it as the Suckers' Rally of 2004-2007.

Let's take a look at the Suckers' Rally, who is to blame, and why it was so damnable.

Congress is owed a huge dollop of blame, as is the Fed, borrowers, and all the usual sensationalist suspects. Everyone caused it. But especially the Fed. If we can agree that we went through a credit orgy, we have to point fingers most directly at the fathers of currency and credit: The Federal Reserve of the United States.

Let's step back and think about what it means to take on debt?

Debt is basically the process of taking from your future to spend or invest today. Conversely, saving is the process of taking from today to set aside for spending or investing in the future. That's what most people do not think about: debt is taking from your future. It ought to be a fairly attractive purchase or investment to entice you to take from your own future.

Our government encourages taking on debt in many, many more ways than savings, despite some nice things like 401-Ks and IRAs. One of its primary methods for encouraging borrowing is the tax deductibility of mortgage interest for individuals and the tax deductibility of all forms of interest for corporations (I first talked about this in a frighteningly prescient post in August of 2006). The Fed, through its Fed Funds and Discount rates also has provided a remarkably subsidized borrowing rate for much of the past two decades and has strongly encouraged banks to increase their leverage ratios until very recently.

In fact, while the Fed has increased the Fed Funds rate to something close to reasonable a couple of times, I cannot think of a time since the late 80s when the Fed has offered anything close to a punitive rate. You'd think, in order to offset some of the excesses that will obviously be created during times of cheap and easy money, it would need to occasionally offer a punitive rate. The Fed, however, seems quite one-sided in its price of money equation. This is obviously stupid as it basically is the equivalent of driving by only utilizing a balance of speeding and occasional short bursts of shifting to neutral before putting your foot back on the gas, but never using the brakes. Seems like just a matter of time before something gets out of hand. Most people would recognize that quickly.

Not our Fed, it seems.

These factors combined to create a huge increase in credit in the economy. As a percentage of GDP, credit nationally is about 360% and growing (page 13 in the presentation or this link), which is off the charts compared to history (at the peak of the Great Depression, largely because GDP declined by 46%, it reached 250% or so). Historically, 200% was high. Mind you, GDP is about $14 trillion per year (but shrinking). Therefore, every 100% decrease in credit as a percentage of GDP means contracting credit by $14 trillion dollars (or an entire year's economic output). Scary, but I digress.

Frankly, my personal belief is that the availability of inappropriately easy, unnaturally cheap credit is to blame for virtually every problem that ails us right now. The implication of this huge boom in readily available, subsidized credit was to create a spending orgy. We just took and took from our future to spend more and more in the here and now.

Businesses took these spending signals in exactly the way we should expect them to: they expanded capacity to meet the new "demand" not realizing that it was not sustainable demand. Rather, it was the future’s demand being brought forward to today – we can only take from the future for so long, so that type of “demand” is inherently limited in its ultimate scope and sustainability. That means that the capacity expansion of American business over the last decade was in response to a false signal: an unsustainable spending boom.

We saw this expansion in obvious areas like housing, but also in things like a huge boom in retail shopping outlets, an explosion in eating out (which is a more expensive way to deliver calories than cooking in), a huge boom in new car purchases, a huge boom in luxury goods "demand", a huge boom in leisure travel, etc., etc. Each of these booms leads down the supply chain to explosions of "demand" for inputs like steel (and thusly iron ore and coal), power, oil, timber, labor, etc., etc. Businesses sized up to serve this “demand”.

Just imagine what this means: Virtually everything in our society expanded to meet a demand that was inherently temporary. What a giant, giant period of malinvestment caused directly by the policies of our Federal Reserve and governmental leaders!! The frightening corollary to this is that because recent demand was taken from the future, the future's demand will now be "falsely" lower than it otherwise would have been, perhaps mistakenly sending the opposite signal. The implications for fallow capacity are scary.

In any case, I think there are a lot of fingers that ought to be pointed, but none more directly than at the Fed. Sadly, they’ve caused the problem yet we’ve also charged them with fixing the problem.

The "solution" to our unnatural explosion in credit that's being proposed? More credit! Our government has decided to replace all of the vanishing private sector borrowings (i.e., deleveraging) with public sector borrowings (i.e., levering up!).

I suppose the best analogy is taking a heroin addict to a meth clinic, but without any real supervision or understanding of the impact on the otherside.

A horrorshow of inflation seems like a virtually certainty to me, but only after a period of deleveraging caused deflation. Helicopter Ben has all but guaranteed a classic Helicopter Drop of cash. He is Charlie Munger's Man With a Hammer (to the man with a hammer, every problem looks like a nail). Deflation is Bernanke's nail. He has trained his entire life for this moment. I assure you he will not stop swinging his hammer until the nail's head has disappeared into the wood and the wood has a permanent hammer imprint pounded firmly into it.

Going back to the beginning of this post: why is it a surprise? and is this as bad as it gets?

The answer to the former is that while it's not a surprise to me, I think it is perfectly reasonable that most businesspeople were hoodwinked into believing false demand signals. The incentives for believing it are too powerful and the ability to recognize and dodge it is too rare.

As to the latter, I'm afraid not. We are not even remotely dealing with the root cause of this problem: too much leverage. Instead, we are adding new borrowed money to replace the bad borrowings of the past. The issue with these new borrowings (financed by We The People) is that the only credible way to pay them off will be the printing press. The problems that come with a massive inflation will be new and fun...

No comments: