The Credit Crunch is Only a Symptom

Summary

The conventional wisdom seems to be that there is only one problem..- "the credit squeeze, sub prime crisis, the - if it wasn’t for these lousy bankers we'd all be OK problem".....this is not really true. The credit crisis is really a symptom rather than the underlying disease. The underlying problem is that the USA does not have the productive capacity to support current levels of consumption.

With the action of the European central governments, the credit crisis has eased and this will probably lead to short term rises in the stock market. Over the longer term fundamentals will re-assert themselves and I expect to see a drawn out recession and lower stock market levels in the US.

What I Mean to Say Is…..

The deal out of the EU over the weekend is pretty incredible. Essentially as I understand it all bank debt up to 5 years guaranteed by the respective governments.

Which of course means, at least in theory, that the bank credit crisis in Europe is over. Suddenly there is no reason at all for banks in the specified countries (Group of 7 less UK I believe) not to lend to each other, and this gives them funds that they can on-lend to others and therefore very significantly reduces the pressures on the US banks as well.

The plunge in the stock market has been caused by two factors:
(1) The credit crisis. The lack of available loanable funds has driven banks and corporations close to, or in some cases into, bankruptcy. As the situation worsened the probability of further bankruptcies increased – as a result (stating the obvious here) the future value of expected earnings fell - and therefore stock prices followed. If the supply of loanable funds recovers, this problem simply disappears and the so of course, if this were the only issue, the stock market should shoot right back up to its previous highs.
(2) Economic fundamentals. Many U.S. corporations are struggling because they are simply unable to find markets for their goods. The near bankruptcy of GM, for example, has nothing (or at least very little) to do with the credit squeeze, simply their revenues do not support their ongoing expenses. As more and more companies have seen falls in their earnings results this has led to a decrease in stock values – as market stock valuations are of course based on expected future streams of earnings and dividends. This second problem is not fixed, at least not directly, by an increase in the availability of loanable funds.

Over the next few days the initial and rapidly drafted statements of the G7 will probably be revised, there will be squabbling and quibbling about exactly what was meant and who will get the loan guarantees. But regardless, the credit crisis has eased – at least partially reversing the first cause cited above of the market decline. As a result I expect to see dramatic rises (even after today’s huge move) in the market over the next few days - of course with very significant volatility.

However, over the longer term the fundamental problem is that a large part of US aggregate demand for goods and services has been lost, and is unlikely to come back in the near future.

Consumer expenditure has been the driver of aggregate demand in recent years in the US. Aggregate demand also includes, corporate investment in productive capacity, government expenditure and exports. However, corporate investment demand is itself driven by current and future estimates of consumption. Government expenditures are also affected, as strong consumption expenditures result in greater levels of income and corporate profits, leading to greater tax revenues, and therefore a greater willingness of government to expand their expenditures as well.

Consumption expenditures have in turn been driven by increases in asset prices, mainly real estate, but also stock prices (the Dow rising from around 8000 at the end of 2002 to 14,000 at the end of 2007).

This filtered through in two ways. Firstly as asset prices rose, individuals and corporations felt wealthier and spent a portion of their increase in net worth, either by dipping into cash savings, or by borrowing. Secondly Wall Street generated huge phantom profits (40% of corporate US profits in recent years according to an Economist article) relying on continuously increasing real estate prices, and passed on these profits to their employees and shareholders – who also increased their consumption expenditures.

This created a temporary upward feedback cycle. Asset prices rises caused increases in consumption expenditures, resulting in increases in incomes and wealth and further willingness to purchase assets (equities and real estate) and so further pushing up asset prices.

The important point is that this was sustainable only as long as asset prices were rising. Individuals were spending at levels that they could only maintain as long as the values of their stock and property continued to rise. In many cases we know that sub prime borrowers could in fact only maintain loan payments as long as prices continued to rise. The moment that prices stopped rising therefore, demand had to fall, and that in turn lead to a reverse feedback cycle of falls in asset prices and further falls in demand. In other words there was no stable equilibrium at the top. Either asset prices were rising with high demand, or falling with low demand – which is were we are now.

When asset prices ceased to rise and started back down, suddenly collateral did not cover loan values, banks started to be squeezed, and this has of course caused the credit crunch.

Asset prices are not increasing anymore, and the recent extraordinary Wall Street profits, it turns out, also came largely from the speculative bubble in property prices, and now that this is gone we, will not see these levels of profit again in the foreseeable future. As a result, the situation is continuing to worsen as more and more people find that they have run out of scrapings at the bottom of their barrels of cash and credit. In short a huge chunk has been taken out of demand with no immediate prospect of coming back.

In addition, the illusion of profitability of the financial sector resulted in a huge diversion of capital and human capital to what in retrospect turns out to have been a largely unproductive sector for the last several years.

In summary, our current situation is an economy with considerably reduced demand levels and a large amount of our resources invested in the financial industry which is likely to see severely reduced profitability.

As a result, after the brief exuberance that the markets and the economy will certainly experience as a result of the easing of the credit crisis, I believe we will suffer a protracted period of a severe recession, reduced corporate earnings and lower stock prices.