Q3 ’02:   Consumption Exhaustion and The Case for Deflation

Policy makers in the West, particularly in the U.S., no longer think of their constituents as “citizens.” Rather they are “consumers.” This point was imbedded in my consciousness in the days immediately after 9/11 when President Bush’s advice to the people of New York was to “get out there and shop.” Of course the intent was to not let the terrorists disrupt our lives, but the emphasis on shopping as the appropriate response to such a heinous act reveals the underlying vision of what people are and what their function is in society. And herein lies a central issue that I see nowhere on the policy radar or in the public debate. Economic considerations have become the all and everything for politicians and policymakers. (“It’s the economy, stupid.”) Furthermore, the prevailing economic mindset is grounded in a machine model of society which considers people to be “consumers” and utilizes any and every method to prod, manipulate and stimulate consumers to consume and thereby “grow” the economy with disregard, even contemptuous disregard, for community, philosophy, values, culture, environment, morality and religion. Indeed, it is canon in the WTO that these higher values are impediments to economic liberalization and to the realization of a global marketplace, and therefore to be overcome by “science based” considerations and rules. Notions of what passes for “science based” in the WTO are defined and interpreted by corporate lawyers and economists according to the agendas of their corporate constituents and have little to do with the philosophy of science, which is a discipline for discovering truth. “Corporate science” is the term that has been coined for these exercises in propaganda and policy manipulation. For an excellent review of the problems with the WTO and globalization, and potential solutions, see Tina Rosenberg’s article, “The Free Trade Fix” in the August 18^th edition of The New York Times Magazine.

The fundamental problem with the machine model of society is that people are not consumption machines, although we have seen that they can be fooled for quite a long time on this issue. People are human “beings.” They do have legitimate economic needs and desires and will respond to economic stimuli, sometimes even to their own detriment, but they also have personal, social and spiritual needs that reach far beyond the economic sphere. In recent decades, especially during the 90’s, global fiscal and monetary manipulations and a compliant, cheerleading, sensationalist corporate press created an illusion of vastly expanding and easily obtained riches for everyone, whereas the reality is that even in America the average working person has been losing ground for the past 30 years. The relentless drumbeat of economic utopia entranced virtually all of humanity, causing rich and poor, elite and the masses alike to forsake a balanced, community based, spiritually grounded and morally healthy life in order to pursue “easy” riches, simultaneously generating great frustration and even murderous rage in those left out. The resulting every-man-for-himself, get-all-you-can-get, gold rush mentality generated unparalleled excesses. (See Extraordinary Popular Delusions and the Madness of Crowds by Charles MacKay.) As the crowning example of historic excess, the specter of corporate chieftains being paid tens and even hundreds of millions in bonuses, forgiven loans and severance after they have devastated the corporations under their command, and having the gall to actually accept the money, is enough to turn the stomach of any honest person, and to create rage among those whose livelihoods were terminated and retirements ruined by these gilded criminals.

So what does all of this have to do with investments? Well, unfortunately, everything. The success or failure of any investment strategy is dependent on markets, and markets are manifestations of collective psychology. The central point of this piece is that recent decades have seen the manipulation of collective psychology to a fever pitch of enthusiasm for easy riches, resulting is historic distortions and excesses in every sector of the economy as well as in fiscal policy (fantasy budget projections), monetary policy (unsustainable expansion of money and credit), corporate valuations (way down and still grossly overvalued), corporate governance (nonexistent), accounting standards (fraudulent), elite values (corrupted) etc, etc. But now the bubble has burst.

The daily revelations of criminal behavior, betrayals of public trust and moral depravity among the leaders of economic utopia, including our President and Vice-President; the seemingly endless bankruptcy, restructuring and layoff announcements, and the destruction of investment portfolios and pension assets are taking their toll. The elite are beginning to express their concern over the failure of the economy to respond to stimuli (tax cut and unprecedented easing of interest rates), and the rank and file are realizing that they have been suckered. The consequnces to collective psychology are discouragement, mistrust and depression. There will be lots of ups and downs along the way but the correction of past excesses is not going to be accomplished by a few hastily passed “reform” measures and the jailing of a few criminal executives. Like withdrawal from a drug addiction, it is going to be a long and difficult process and will not be over until we have been sufficiently humbled to honestly confront the issues that got us here. We’ll know we are close when the collective assumption is that we will never recover.

When I think about how we got to our current situation I am reminded of the wisdom of the great William Shakespeare, “Oh, what tangled web we weave, when first we practice to deceive.” Policy makers on both sides of the aisle have been complicit in a decades-long deception and manipulation which has seen the deliberate destruction of value and savings through a policy of “controlled inflation.” This policy has turned “citizens” into “consumers,” and in the process impoverished pensioners and others on fixed incomes, effecting a gradual and massive shift of wealth from the working and middle classes to the very rich.

It has been clear for quite some time that the driver of the current phase of economic “expansion” is the consumer. We have global overcapacity in every other sector and as the developing world brings on ever more capacity and as technology increasingly infiltrates every sector, this overcapacity is only going to increase. So the hopes of continued expansion lie with the consumer. But what is happening to the consumer? As we have seen above, the consumer is getting hammered. Many are losing their jobs, their retirements and their trust, and those who haven’t lost these things are experiencing growing anxiety about them. The cost of living, particularly housing, is crushing many and the stress of keeping up is taking its toll on almost everyone. New York City had all-time record family homeless before 9/11. Now the city is overwhelmed with homeless families and has started to house these unfortunates in a former jail that was no longer deemed fit for inmates. See “Jail Reopens as a Shelter for Families,” NY Times, August 12th, 2002. I personally know two families anchored by honest, hard working parents that, for various reasons, cannot afford the high cost of housing and have been itinerant (read “homeless”) for over a year. In my entire 54 years I have never known a working family that couldn’t afford a place to live, until now.

The recent strength of the consumer as an economic force has been largely driven by the downward manipulation of mortgage rates and the massive extension of easy credit. This phenomenon is reaching the end of its run, and even now, despite continued easing of rates and endless creative financing schemes, including “interest only” mortgages, home sales have been falling off. The huge move into housing by marginal buyers and refinancing, often for 100% or more of market value, at the top of the cycle is going to result in a wave of defaults, personal bankruptcies, bank failures and big losses for Agency bondholders and other mortgage investors. The prevailing wisdom, perhaps better called faith, is that the government will bail out any problems in the Agencies. The vast majority of mortgage investors, including banks, insurance companies and even most hedge funds, do not hedge their investments in Agency bonds, relying on the “implicit” government guarantee to bail them out if there is trouble. Perhaps they will be lucky, but as I see it this is nothing less than gambling. If, in a crisis, the government has to choose between defending the dollar and Treasury-direct obligations or supporting Agency paper there is no question that the Agencies are going to be left to fend for themselves. For further reading on this issue see “No Shelter,” by Newsday columnist James Pinkerton and “Mortgage Myopia” in the July 20^th issue of The Economist.

It is my contention that on a financial as well as psychological basis, we have reached a point of “consumption exhaustion.” On every level, personal, corporate and government, the U.S. is deep in debt. We are simply too overextended and the problem areas are stacking up. People in general have run themselves to ground in an effort to stay on the economic utopia merry-go-round and the last wave of buyers has hopped on in the housing bubble. But increasingly people are falling off, being left behind, and/or seeing the handwriting on the wall. The party is over and they didn’t get in, or else they got in for awhile and subsequently lost all their gains in the stock market sell-off. Now what are they going to do?

Just this week I saw the first of what I expect will be many articles, books and debates that look into the relationship of materialism and happiness. The conclusion by economist John Easterlin from USC – we don’t get happier as our wealth increases and our possessions grow. Not that economic wellbeing doesn’t factor into happiness, but our wants keep expanding along with increasing means so we tend not to experience greater happiness with the expansion of wealth and possessions. A review of Easterlin’s paper, “Why Rising Incomes Make Us No Happier” can be found on the Royal Economic Society website.

According to the RES reviewer, Easterlin opines that we might begin to look more seriously at alternatives to the pursuit of ever more material consumption, “perhaps to enjoy family, friends, and relatives; to get to know our neighbors; to participate in community, national and international affairs; to engage in music and the arts, philosophical contemplation or religious pursuits; to pursue athletic activities; to develop our learning through continuing education; or simply to commune with nature. Whether these things would make us happier is not sure, but it does seem that they would make for a fuller, better-rounded and more meaningful life for most of us.” For those interested in looking deeper into this issue, Easterlin’s paper, “Income and Happiness: Towards a Unified Theory” is published in the July 2001 issue of Economic Journal. Also, there is a new release entitled The High Price of Materialism by Tim Kasser.

As this theme gets more airtime I predict that we will see the development of a trend away from materialism and eventually a tidal shift in the attitudes and aspirations of the masses toward endless consumption. The continuous strain to keep up the payments on ever more, bigger and better possessions will increasingly be seen as futile and growing numbers will give up on it. Awareness will start to dawn, as it already is, that there are other things in life worth pursuing. Family, community and spiritual needs that have long been neglected will become increasingly attractive as the illusion of economic utopia fades. Pressure will build for more balanced, people-friendly and sustainable ways of living. “Consumers” will gradually be transformed back into “citizens.” Grass roots political activity will soar and this activity will likely not be centrist. Under pressure from hard times it will likely swing hard to the left, although there is the danger that demagogues will seize the opportunity and cause a swing hard right. Ironically, as the surge of corporate bankruptcies grows into a tidal wave and individual investors and pension plans take huge losses on their stock and bond holdings, consumers simultaneously forced into bankruptcy will be greeted by new laws, courtesy of the banking and credit card lobby, making it much more difficult for them to escape their obligations to these same corporations that have defaulted on their obligations. Historically this will probably be seen as the high water mark of corruption in America, and it will surely be a rallying point for public outrage and big political changes.

In light of the above it is my opinion that deflation is inevitable and that falling housing prices will likely be the final blow that brings it on, possibly triggered by war with Iraq or other geopolitical disruptions or terrorist activities, economic contagion from the Far East or South America, or simply by the sheer weight of aggregate debt. Of course deflation and all the fallout that will come with it is not going to happen overnight. In particular the Fed and the Administration will do everything in their power to forestall any disruptions to the economy going into the 2004 presidential election. Whether they have enough ammunition to hold back the tide that long remains to be seen. There will be many twists and turns along the way, most of them unpredictable. But it is coming.

Until the last month or two the long held mainstream consensus opinion was that deflation is simply not possible in the U.S. But just last week the venerable Bank Credit Analyst began to sound the alarm on deflation. The BCA calls for relaxing economic policies if economic activity slows further, noting that “inflation is now close to zero in the U.S. and Europe and it is worrisome that the global economy is showing signs of stumbling, undermined by the excesses of the late 1990’s and the resulting meltdown in equity and corporate bond prices.”

Following is a summary of what deflation really means, particularly for a leveraged economy, company or investor, and what might trigger it, also from the Bank Credit Analyst: “Deflation becomes a dangerous force when it undermines the ability of individuals and companies to service their debt. Deflation can cause declines in nominal incomes and in asset prices, but the nominal value of debt does not change. This may result in forced selling of assets in order to make debt payments, unleashing a vicious spiral of falling incomes, imploding asset prices and even greater real debt burdens…Debt deflationary dynamics could perhaps unfold even if aggregate price levels did not decline. For example, a major drop in house prices could be the trigger (italics mine) for serious problems given that home mortgages accounted for almost three-quarters of the increase in household sector debt during the past five years. A broad-based fall in home prices would be a more potent force than lower equity prices in terms of undermining consumer balance sheets.”

The BCA goes on to say that Fed policy has been correct to date and calls for continued easing if economic activity continues to slow. Let’s hope that we can “muddle through” (the current buzzword) but the Fed will soon run out of interest rate bullets leaving the printing of money as its remaining weapon, which in the long run will create even more problems and won’t alter the final outcome. We would be far better off to bite the bullet, manage the inevitable write-down and start over than to resort to desperate measures. But modern politicians are not known for holding to the high road regardless of personal cost. One should never underestimate the capabilities of Washington policymakers for manipulating, masking and delaying the inevitable. And we should not completely write off the possibility of political heroism, but I suspect that when deflation starts taking hold we will see some unwise policy decisions that will bring unfortunate consequences.

Governments on all levels are already under tremendous financial pressure so I wouldn’t expect much support from government as the crisis grows. The projected surpluses from the 90’s bubble have vaporized and deficits are soaring. The federal government reported a $127 billion surplus for fiscal 2001 but this is a number that could only come from Washington (or I suppose from any number of large corporations). According to Michael Granoff and Stephen Zeff, “Fiscal Shell Games, Government Style,” Los Angeles Times, August 18, 2002, if unfunded pension liabilities and related benefits are factored in, the federal government actually ran a $515 billion deficit for 2001 – a $650 billion claimed/reality spread! If this is not fraud, what is? Also, reflecting the fiscal strain on the state and local levels, defaults are on the rise in the Muni marketplace. See “So You Think Munis Are Safe?” by Dean Foust in the August 5^th edition of Businessweek. I predict that within two years we will pass $500 billion in reported federal deficits and soon be looking back wistfully at $500 billion deficits. What will Washington be able to do under such constraints? Decades of fiscal mismanagement, monetary manipulations and financial engineering to fine tolerances have left little if any room to maneuver. Long gone are the days of keeping reserves for a rainy day. Like the Wizard of Oz our political and corporate leaders are being exposed for the frauds that they are. Once the leadership has lost the confidence of the people, due to the faith-based nature of our fractional reserve system (which isn’t even fractional any more), we are going to have to hit rock bottom and see some major political changes before confidence will be restored.

On could argue that sound policy changes could allow us to manage our way to a healthy, sustainable economy. I would agree, but the problem with this argument is that it requires leadership. We don’t have any of that. Our leaders “lead” by following the polls, manipulating the press, seeking personal and partisan advantage, and pandering to the lowest common denominator. We don’t have the kind of noble, visionary, self-sacrificing leadership that would be required to manage a challenge of this magnitude. We are going to have to go through this adjustment the hard way. In the end, if we can hold on to our basic democratic principles, we will be leaner, meaner, stronger and healthier, but it’s going to be painful in the interim, and in my opinion, we ain’t seen nothin’ yet.

For a compelling multi-faceted development of the case for deflation I strongly recommend that the reader purchase and read Robert Prechter’s recent publication Conquer the Crash. Robert Barker’s review, entitled “Lend Half an Ear to This Doomsayer,” is in the July 22^nd issue of Businessweek. One of many interesting points made in Prechter’s book is the stunningly poor track record of economists at major turning points in economic activity. Citing annual surveys conducted by the Wall Street Journal he notes that 52 of 54 economists were bullish for 2000, 53 of 54 bullish for 2001 and a unanimous 55 of 55 bullish for 2002. Remarkable consistency. I would keep an eye on this group. When you see 55 thumbs down on the economy, it’s time to buy.

Note: Where possible links have been provided to articles referenced. If no link is provided, the article is not readily available in electronic format or must be purchased to be viewed. In the case of books the link provided is to Barnes and Noble.

Copyright 2002 Cuddehe Capital Management, Inc.