Tuesday, December 02, 2008

The Economic Crisis: Transfusion of Continued Anemia?

We interrupt this "Best of" series to comment upon the economic crisis, a subject in which my qualifications are dismal, both by education and personal example. Yet something as abstract as the economy lends itself to intellectual curiosity, which fosters an instant education (in as much depth as the mind wishes to seek). So here's a Q and A with myself.

1) What is the economy?

2) This question cannot be answered with any certainty, but it has to do with the amount of imaginary money changing hands at any time. Capital overcomes its scarcity by leveraging about 10%--how much capital is usually required on a loan. The economy has something to do with how cash is converted to loans which are converted to derivatives which arrive in portfolios, and as we have recently seen, can be easily overvalued. The economy is an engine driven not by need but by consumption, a measure of human self-indulgence that has long exceeded simple survival--say since 4000 B.C.

Once real things are turned into commodities, they become phantoms of the future, leveraged by limited capital in real time. Loans are the lifeblood of the economy, loans are what allow us to spend ten times what we earn. Without loans a dentist can't open an office, even a donut franchise likely needs financing. To understand the beginning of the economy, you must understand that it is more concerned with leverage and collateral than cash, and that the values placed upon items in the future supersedes any present worth. Investors try to control the future, not the present. And businesses, in their need for loans, live off the future as well. The economy is a wonderful invention that allows us to live above our means on the basis of a credit culture--credit being the money accorded you for certain considerations that by no means equal a cash equivalent.

The economy is the arterial structure of the body politic; the blood flow is the flow of money available through credit arrangements. If credit contracts, the flow of money contracts accordingly, and all the organs of business suffer. Many things can be applied to this metaphor; in our present case it's anemia, a lack of sufficient red blood cells to oxygenate the organs, in a word, a lack of credit-- where more money changes hands than really changes hands, or, imaginary money from the future is promised by both parties.

In this metaphor, arteriosclerosis could be likened to encroachment of regulations, taxes, benefits, bribes, protectionism and other things that inhibit the flow of money. And cancer could destroy a single organ, say one large bank. Inflammatory diseases like arteritis might be likened to unstable political situations like wars and revolutions, affecting the blood flow spasmodically. But these are not the current problem.

For one organ to fail, like WaMu, would not indict the health of the body economy, but multiple organ failure, as in WaMu, Freddie Mac, Fannie Mae, Lehman Brothers and Goldman Sachs, points to a systemic cause.

To pursue our metaphor further, the cause of the present decrease of blood flow to the economy is that some investors in bone marrow (say mortgage derivatives, or pools of home loans) gave too much credit to stem cells who had not decided to be red blood cells yet, and many of them failed in the process (failure to fulfill a mortgage). Suddenly the investors said, "Oh my God! These potential red blood cells are worthless" (as in poorly secured mortgage derivatives); "now I have to hoard all the real red blood cells I have, and my God! There are not enough to meet the obligations I owe to other organs to keep them oxygenated."

As the blood supply decreases, all the organs suffer, because the bone marrow monitors (banks) and the stem cells (desperate home buyers) failed; the former by overestimating the future supply of money or blood flow, the latter by overpromising their futures ability to fulfill the contract.

2) OK, Doctor, we got your metaphor. So you say the economy can be likened to a blood flow of credit?

2) Exactly

3) How can this blood flow be increased?

3) We could wait for the bone marrow to recover gradually. The banks would have to pay for their losses in mortgage derivatives and wait to recover sufficient capital to extend credit again. Or we could do a bone marrow transplant, have the government buy up all the bad mortgages and free the banks to lend again.

4) That's not how the government is approaching it.

4) No, they are calling for a wholesale transfusion. They believe the anemia is too dangerous to rely upon a natural recovery, and that major organs are already in danger. They wish to bypass the actual cause of the crisis and inject blood upstream, else the body could go into shock--a mechanism to preserve the major organs at the expense of less valuable ones.

5) Why would that be so bad?

5) We don't, in truth, know that it would be. I don't know the exact figures on mortgage defaults, but we have already committed, with the bailout and Obama's promises, 1.3 trillion to a transfusion. Yet no one knows what this will do or where exactly to put the money. If that amount could cover the bad mortgages, it seems easy to say, why not put the money where the problem began? That has a nice symmetry to it. Unfortunately, as I said, the experts think things have gone too far for that to help much.

6) Gone too far?

6) The ripple effect of overvaluation of bad mortgages has already put other larger organs at risk, so the argument goes.

7) Do you think it's gone too far?

7) I do, but in my simplistic thinking I wonder why a transfusion instead of a bone marrow transplant? If buying up bad mortgages is possible it would straighten out the banks' books in a hurry. Here's an estimate for next year's mortgages:

"As recently as September research and consulting firm iEmergent was predicting that total mortgage originations in 2009 would be $1.53. Now it has lowered it estimate to $1.3 trillion at best."

1.3 trillion for one year, total? If the sub-prime rate of foreclosure reaches 20%, I doubt the government rescue for them would exceed the new mortgages generated in the year to come. Would it actually be cheaper to aid the mortgages? If so, it doesn't seem a bad alternative, but I don't have the figures.

8) So would you inject money into bad mortgages?

8) How do we know that wouldn't extend the bubble that burst? If we allow a buyer with a mortgage on a $600,000 house to reduce his payments to correspond to a $300,000 house, aren't we extending his credit? And if we do so, can we rely upon him to start spending again? Confidence is a big part of this. On the other hand, do we say, "Eat it, it's too late, there's help needed upstream because the banks are bigger and thus more important than you." But are they? If homeowners were bailed out, however unfair that is (it is no more unfair than choosing banks to bail out), would it get the economy running again? More likely they'd be grateful but gun shy when it came to new purchases. Banks, on the other hand, make their money off of credit. So a direct transfusion to them might lube the economy more efficiently.

9) If there were a causative agent in this scenario, what would it be?

9) Greed, pure and simple. The bankers and buyers of bone marrow futures all erred.

!0) So you agree with the transfusion?

10) My natural instincts say no; in a previous blog I opposed the bailout. Japan went through this in the nineties, however, and hindsight now seems to suggest that their balanced budget and tax increases backfired and extended the crisis. Likewise it has been shown that FDR didn't spend enough early on to turn the economy around, it was too much "a little here, a little there." So I now halfheartedly endorse the experiment of a transfusion; if it fails we will have to taste the pain of a depression anyway. If it succeeds, the accumulated debt can be managed over time given a healthier economy.

Thine in speculation,

C. E. Chaffin


  1. Our country indeed needs a transfusion. A transfusion of wind, solar and other sources of cheap clean energy. Not enough credit is being given to the high gas prices this past year and it's serious damage it did to our economy and society. A record number of homes and jobs have been lost as a direct result.Most families broke the budget at the pump alone. The high cost of fuel affected production and shipping of every consumer product & was passed on to us at the checkout. Electric companies have huge rate hikes. And, while we are doing the happy dance around the lower prices at the pumps OPEC is announcing cuts to manipulate the prices upward again.We can't take another year like this past. There is a wonderful new book out about the energy crisis and what it would take for America to become energy independent.This book is profoundly informative and our country needs to become more informed and move forward with becoming energy independent. Green technology would not only provide clean cheap energy it would create millions of badly needed new jobs. The Book is called The Manhattan Project of 2009 Energy Independence NOW by Jeff Wilson. I highly recommend this book if you are distressed about our economy, would like to see new jobs created and see our country become energy independent.

  2. Fascinating synchronicity CE! You must read the following thread. Using your analogy, the patient may in fact be dead. I would urge you to read the comments too as there are some very astute ones made.

    This addresses the great mystery of why we have not (yet) seen massive inflation as a result of hyper-aggressive money creation by the Fed. Mandatory reading.



  3. It's class war CE. Our economy versus their economy: the financial (wall street) economy versus the real (main street) economy. Wall Street is the pathogen. The body (politic) has been 'tricked' into defending the pathogen and killing the host. Early signs are that Obama plans to continue this ass-backwards regimen. Remember young George Bailey in 'It's a Wonderful Life' intercepting the wrong prescription. Well there's a new doctor at the White House and he plans to continue the same regimne plus he's keeping the pharmacist, Bernanke. We're screwed.



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