If you are expecting a quick recovery from the market problems that began in 2000 and have brought both losses and great volatility, don’t count on it! Those financial firms selling securities would have you believe otherwise. Without security sales, their income is zip, a big zero!
So what will really happen?
First, the government will have to stabilize the credit markets. This could easily take several years because foreclosures will be spread out in time. Even though home prices may be less than mortgage values, people do not decide to abandon a home on quick notice. They have to carefully consider their alternatives including whether the housing market will recover and the desirability to move to a different location. This is extra tough when people can’t qualify for new mortgage because their credit rating was destroyed by abandoning a mortgage.
It can’t be long before credit card defaults hit the banks really hard thereby aggravating the situation. The top six credit card companies hold $639 billion credit card debt. Then there are $365 billion securities backed by that debt. These are bundled into groups of credit-card receivables and sold to investors, insurers and hedge funds which likely find their way into other derivatives. It’s the mortgage problem all over again because about 30% of credit card debts are from low-credit-score people. Business Week (10/20/08) predicts that this is the next big blowup ahead.
In the meantime, people should develop a better appreciation for the fact that they should be saving. The decline of savings started two decades ago from 9% national savings rate to minus numbers today. Failure to increase savings rates is surprising because of the large number of baby boomers who are starting to reach retirement age and the long-term trend of industry to go from pension plans to savings plans.
As a consequence of saving too little, incurring large debts and losing conventional pensions, people will have to save more—lots more and start quickly.
When the savings rate finally increases to the extent necessary, much of the resulting investment would help the stock market. It would also bring back some of the national debt from overseas, thereby strengthening the dollar and reducing the cost of imports. But this will take years, not days or months and will be softened by slower business growth.
By necessity, many are going to have to retire much later. This is good news if they still have updated skills and the physical capability, but they will face a difficult labor market. On the one hand, demographics show there will be proportionately fewer young people entering the work force. That would bode well for seniors trying to retain jobs. On the other hand businesses will be facing many difficulties. This is likely to be overwhelming for a number of years.
Businesses will have lower volume when consumerism declines—as it must with increased savings! At the same time, employers will also face higher taxes, at least at the state and local level if not at the federal level. Heavy industries will face costly capital improvements for environmental and energy reasons. All of these things put pressure on labor as well as encourage businesses to look abroad for less expensive sources of materials and components–if not total assembly. Lower market volumes mean less need for commercial real estate, so there will be trimming there as well.
Another new impediment is put on businesses that offer pensions when the stock market falls and shows definite signs of slower growth. As an example, suppose that a pension trust’s securities fall 10%. Then the company has to either come up with 10% more funds (think of a huge number) to add to the trust. If the forecasted growth rate for their securities in the trust drops only 1% point, they will need about 15% additional assets in the trust. Firms like General Motors and Ford are already reeling from pension promises that are beyond their capability to fund. This is also likely true for government pension promises—only more so because most government pensions have cost-of-living-adjustments which require higher reserves than fixed pensions of private enterprise.
Another consideration is that the cost of government itself will go up. More regulation and health insurance administration will add significant government employment. Many government employees enjoy automatic cost-of-living adjustments to their paychecks. And government employees on the average make more than the average employee in the private sector. If the business share of higher government costs goes up, the product costs go up thereby aggravating inflation.
Some people think that higher corporate taxes reduce will reduce personal taxes. Not so, higher corporate taxes are simply passed on as higher product costs so that everyone pays—just as with a national sales tax.
The net result of reduced consumerism, increased savings and higher taxes will take some time to evolve before business earnings stabilize at a lower level. When that happens, stock price-to-earnings ratios likely will seek lower values than the historical norms for decades. That’s because of at least two factors: (1) People have got to make up a large part of the savings shortages of the last two decades or face poverty in retirement, and that will take many years of cumulative effort. (2) The outlook for growth will be tempered by the consequences of an aging population that has a much different budget distribution than that of the youth. Consumerism is a disease of youth. Lower price-to-earnings ratios combined with lower earnings do not bode well for the stock market for a very long time.
An aging population brings lower national income, more government outlays for entitlements, and a disproportionate increase in the need for services, particularly medical related services. The service industry does not have as great a multiplication factor for support jobs as does manufacturing. Further, it means a significant increase in the number of retired people to the number of workers. In a couple of decades the number of retirees will be one retiree for every two workers compared to one retiree for every three workers today. By itself, that means a 50% increase in individual workers’ burdens and even more with more people on government welfare.
The part of the economy that will continue growing is the government, but it is the least productive part of the service industry. It has virtually no productivity gain. Politicians are reluctant to propose cuts in government payrolls, in part because they are part of it, but also because government workers probably constitute at least 20% of the voting public. Benefits for government workers grow disproportionately as well. Government pensions most often have cost-of-living adjustments, i.e., COLAs, and savings plans too. 80% of private sector employees do not have pensions at all, and virtually none have COLA pensions. The number of government employees with pensions is fast approaching the number of people in the private sector that have pensions. That’s because of the double whammy of the private sector reducing the number of pensions while the government’s size is increasing.
The changes from these effects do not occur in days or months. They take years to evolve. To recoup the lost savings of the past twenty years in the next twenty years would require more than a 20% reduction in consumption. This implies savings rates comparable to that only achieved in World War II when most things you could buy were rationed and little else was available. Further, virtually everyone worked and provided income for the family during the war. Saving was politically correct and even school children saved stamps to accumulate savings bonds.
No, don’t look for any rapid improvement in the stock market. There may be spurts as occasional good news is highlighted to improve the economy, but the long-term effects described above will dominate the economy for several decades. There is no quick fix for our past savings deficiencies, record borrowings, unstoppable government growth, automatic entitlement growth and inevitable demographic creep to an aging population with greater demand for services, not hard products.
At the same time, even though stock prices will seek a lower level and grow more slowly in real terms, stocks may still be one of the better hedges against inflation. Inflation will increase the apparent earnings and business assets. Since we are living in a world of ever increasing prices, everything is relative. Inflation is very hard on fixed-income investments because the real value of the principal goes down. Owning a house with a mortgage may be one of the best investments since the value of equity increases disproportionately as the price escalates with inflation and the relative value of the debt goes down. Of course this assumes that we are willing to sell our houses later on, go into smaller homes and invest the savings in something that’s liquid so we can spend it.
As bleak as the picture is as painted above, it can get worse. One of the ways to solve part of the debt problem is for the government to let inflation increase above what we consider to be acceptable levels today. That has happened to numerous other countries and our own as well. Inflation is particularly hard on retirees who are trying to live on fixed incomes. It’s not so bad for government retirees that get a kick upward every year.
It was very poor public policy to pressure lenders to make loans to people who could not afford them. The resulting boom in housing prices made it seem that a home was a great investment and worth some speculation—even by those who could not afford the payments, much less all of the other costs of home ownership. People started to consider their home as their primary retirement resource even though a house is about as illiquid as an investment can be and has negative interest. Further this policy exacerbated the lack of mobility of our work force and made people look furtively for new jobs only close to their homes.
But some good came from the resulting crash. My view is that this mortgage crisis has kick-started us on a better path in the long run. It’s better in that less consumption eventually will help provide more for the aging population and less of a burden on our children than continuing this economic madness for many more years. We’re all going to be poorer, but less poor than we would be otherwise. We may still live more comfortably than most other nations. Hopefully the troubles we suffer in the meantime will bring more economically savvy politicians into office. Perhaps they will reduce government growth and entitlements that otherwise will be an unbearable tax burden on future generations.
