Monday, October 6, 2008

The Financial Crisis Isn't Going Away

I'm obviously no expert in finance. I'm just an observer. But I strongly believe that being on the outside is necessary to spot when things are going wrong. Those on the inside get a view of the situation with too many details and possibilities, enough so that they aren't able to see the forest for the trees. This I think is what happened during the tech bubble. And I see it happening again.

I believe this financial crisis is multiple decades in the making, and will take a decade to sort itself out. I don't see anyone talking about what I believe is the key problem in the system: the wage stagnation of the vast majority of Americans. There's been quite a bit made of the growing income gap between the top 1% of Americans, and the remaining 99%, over the previous decade. This is, I believe, extremely unhealthy. I don't know what the situation was before then. My bet would be that the years preceding the actual increase of the income gap would have gone into prep work. In other words, the groundwork for the acceleratng income gap would have been laid down. The problem has in other words been created by both Democrats and Republicans.

Would the consumer be at fault? I think the consumer acted as would be sensible given the circumstances. Cost reduction and easy credit had made up for the loss of income for the vast majority of Americans. Moving jobs and factories overseas made it easier to keep a healthy supply of cheap goods coming in. So it was possible to squeeze through on falling wages. At the same time in the name of making housing more accessible to home buyers, easy financing was created. After all, in the absence of growing wages, it would be impossible for businesses to make money off consumers. I believe this would have been especially true of the mortgage industry. Easy credit was an incentive to make bad investment decisions, which everyone did. These investments led to asset inflation. Which led to further credit. And at some point the cycle had to break.

So, what's in store for us? Nothing good, I fear. Basically, housing costs have far outstripped income for many. The only real fix for this problem is to bring housing costs back in line with income. There are two ways this could happen, and both are going to be incredibly painful. You can either let house values drop. Or you can let incomes catch up. The result of dropping housing prices is already evident. And this doesn't seem to be working at all. Bringing up consumer incomes is also a long term solution. What, after all, are you going to do to bring up their income? Increasing income in this manner is going to lead to increasing inflation. So, everything will become more expensive to match the prices of homes. Not a pretty scenario.

What of the bailout plan that's been proposed? Say the government buys $700 billion of bad debt. What we're doing basically is setting up an entity to absorb losses in the housing market, an entity for which taxpayers are taking responsibility. So we're insuring ourselves. But how is that debt going to be repaid? Consumers don't have the income to support the houses they're in. There's nothing here that tells me how we're going to fix the housing situation. Say a house forecloses. We take a loss on the $700B. That foreclosure affects the values of other surrounding houses. And we have affected debt that formerly wasn't bad, debt that's presumably still in the hands of financial companies. Have we solved anything if this scenario, which I think is quite likely, comes to pass?