Rebuilding US wealth,
means we must Stop Digging!
Financialisation, Malinvestment & Over-consumption have destroyed wealth
by Michael Hampton, AKA Dr.Bubb | October 14, 2008

"If you want to get out of a hole, the first thing you need to do is to stop digging."


There is a serious limitation built into traditional measures of economics. We focus on growth in national consumption, rather than growth in actual wealth. When our leaders embrace measures that encourage unbridled consumption and unhealthy growth-for-growth's-sake, they may be doing so, at the expense of the future wealth of their own country.

We appear to be headed into a crack-up, bringing enormous economic and financial pain to American, and some other countries too. More understanding, and enlightened leadership from policy makers will be needed to traverse the coming crisis quickly, and get to a stage where America is once again building wealth, rather than taking desperate and misguided efforts which help it to melt away. I fear that day that Americans wake up, and start taking sensible long term measures is still many years away, and may lie on the other side of a long recession, or even a depression. But maybe if enough people see the light of logic sooner, some badly-needed progress can be made BEFORE we suffer all the measure of pain which seems to be headed our way.

This article assumes the country will get past the current severe financial crisis, and the American banking system will get back on its feet, and lending money again to corporate America. Then, America will be facing the problem that many jobs have been lost permanently, and they will not becoming back. The new president will be facing the challenge of how to help create new jobs in the right sectors, that will help build real wealth in the long term, and not just the broad spectrum of consumption, which is all that GNP measures. In short, our leaders will need some vision and a plan. They cannot just leave the issue of growth to free markets. Wehave already seen how dangerous that approach can be. The challenge of conceptualising "good growth" is what this article addresses.

A core problem for America is an economy which became over financialised, with profits of that sector being the largest single greatest source of profits for the US economy. The trouble is that once this sector becomes too large (and it was over 30% of total US profits in 2006), it is no longer the servant of the economy, helping growth in other sectors. Instead it aims to become the master. When this happens the financial sector becomes parasitic.

Financial companies rely upon claiming a commission, or a spread from transactions that they assist. But the sector can easily become blind to the essence of those transactions that they help to foster. Even worse, at times the financial sector can aim to encourage transactions, even loss-making investments, for the sole purpose of extracting their spread. We have been living in such a stage. In the last few years we have seen: speculative excess on steroids, mal-investment and massive over-consumption, All done in the name of a free economy seeking growth. Now we are stuck with a toxic economy, loaded with debt, and highly vulnerable to the two opposing forces.

Standing at the gates of our future like Cerberus and Orthus, are twin scorges. They are deleveraging and peak oil. Freedom of choice, has not built the sort of economy that Americans would choose to have when entering a period of stress and volatility. First, this year, we saw rising oil. When oil pushed through $100 on its way to $146, many Americans found they could barely afford to drive to work. Then, as oil prices eased, a second problem hit: massive and rapid deleveraging, as banks called in their loans, and refused to lend money. The credit crunch brought a "cardiac arrest", as Warren Buffet put it. Businesses started laying off people, and the stock market plummetted at it became clear that the US was headed into a recession, and perhaps even a severe and long recession.

To cure this lending freeze, global banks are co-operating, to pour massive credit into the system. A great reflation may be on the way, and that could allow the US to get its lenders back in the business of lending money, but if the economic growth gets back on track, the risk of rising oil prices remains. Most people are now focussed on the downside, and are forgetting the recent pain of high oil prices. If I thought this reflation would fail, then I would have written a different article. But the massive global effort to get money back into the banking system before the economy breaks look set to succeed, after a rocky start. Failure is not an option, the weekend huddles and the massing of global politicians confirms this. But lower libor rates, and banks lending again will not be the end of the stress in our fragile economy. We need to focus on the other extreme, while we are working to escape from the risk of a deflationary collapse.

The pain the US felt at $150 crude and $4.00 gasoline prices, is nothing compared to what will come if oil hits $400 and gasoline moves up above $10.00- levels that knowledgeable observers like oil insider Matt Simmons find highly plausible. We need not have driven into such a dangerous cul de sac. Better leadership could have taken the country elsewhere towards a different future, and it still can. Unfortunately, we are rapidly running out of time. We must start making the right choices, if we are going to avoid sliding into the a vicious downwards cycle.

How we got here - Unrestrained growth and a Housing Boom

The following chart appeared in the New Your Times a few weeks ago, in an article entitled, "As Safe as Tiny Houses." To me, it spoke volumes about the mess which is the US economy:

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Over the 24 year period of 1982 to 2006, the average new single family home rose in size from 1,500 sf to 2,250 sf - that's an increase of 50%. Now at first look this may seem to be a good thing. Americans have more space to carry out the drama of their day-to-day lives. What's wrong with that? Isn't that a sign of increasing wealth? To some it may have seemed to be a good thing, and to a few it may even still seem that this chart shows that Americans are making progress. But let's think of this in a different way. Homes which are 50% larger in space, by necessity have a larger footprint. They need larger lots, there will be more space from one driveway to another, and they will cost more to heat in the winter and more to cool in the summer.

So the chart is also depicting suburban sprawl, and a rising dependence on cheap energy. The chart tells us that Americans will need to drive further to reach their McMansions, exposing them more heavily to rising gasoline prices, and they will also face higher heating and cooling bills, even before a rise in energy prices is factored in. In short, they are in a weak postion to face a continuing rise in Oil prices. Now some are seeking to counteract a part of that vulnerability to oil prices, by getting Americans into smaller cars, or by convincing them to buy expensive hybrid vehicles. That change may help to some degree, but such small changes do not address the structural problem of the American "living arrangement." Too many Americans live in big homes scattered around the sprawling suburbs. Something like 50% of Americans are stuck in homes in the suburbs. They were complacent about the resulting oil dependency when prices were cheap, but now that they have seen them leap to moderately high, with the potential for becoming very high, many are beginning to worry about these long commutes by automobile. And so they should.

At Ground Zero of the Subprime Crisis, there's a "Stranded Suburb"

Let's consider Stockton, California, which has been called the "ground zero" of the subprime crisis. Something like one-quarter of the homes there are in foreclosure. How did this come about, why is Stockton so much worse than other parts of California? Well there are not many high paying jobs in Stockton. It is mainly a residential community. So those who live in large homes there, cannot afford to do so if they work at the local Walmart or McDonalds. They are likely commuting long distances to jobs located in major cities nearby- cities like San Francisco, San Diego, or San Jose. Each of these cities is about 80 miles away. So many Stockton residents are facing commutes of perhaps one to one and a half hours each way. This may have seemed sensible when gasoline prices were near $1.00 or even $2.00 per gallon. But at $4.00 per gallon it can be economic ѕυιcιdє, especially for someone who stretched to get into an expensive new home, taking a subprime loan whose lower payments are about to reset after the first 2-3 years. Now they are facing expensive interest rates resets, at a time when their home values are plummetting. And they are stuck in a financial vise-grip made much worse by higher oil prices, and compounded commuting costs.

I blame Alan Greenspan, and Fed policy makers, who sought to escape the recession that was emerging from a popping of the dotcom bubble in 2001, by creating another one in housing. Greenspan's Fed took interest rates down to 1.25% in 2003, and this touched off a huge wave of speculation in housing. Unfortunately, this came at a time when Basle 2 banking regulations made it expensive for banks to use their balance sheets to hold housing loans, while making it easy for them to bag risk-free profits by securitising mortgage loans and passing them on the unwary investors.

The Wall Street greed machine found the temptation too great. These investors in mortgage securities did not truly know how to assess the credit risk. As the underlying mortgage collateral got sliced and diced, it became more and more complex. And so they came to rely on the risk models of the rating agencies. Only those agencies had never before tracked the default of such complex securities through a severe cyclical downturn. They only had ten years of bull market data to look at. So they established appropriate legal disclaimers (to minimize their own risk of being sued) and began to slap triple A ratings on the securities, collecting huge fees from the investment banks. The banks loved it, and the economy grew, with the financial sector's share of profits growing and the easy money stimulating a building boom, adding more growth concentrated in the building sector. Many of the new homes were built more cheaply, and more affordably, on cheap virgin land, miles away from the working places of the home buyers. I now call these places, the Stocktons, the "stranded suburbs" of America. You cannot get to work without a car, andthat means you area hostage to oil prices. In the future, many of these homes will wind up abandoned, oras firewood, if oil prices continue their ascent towards my $400 target by 2012-2015.

We chose to let our addiction to oil grow

It didn't need to be this way: Europe raised taxes on Oil years ago, so gasoline is already in the range of $6 to $10 per gallon in some European countries. They use more public transport, which is far better developed, than in America, and drive smaller cars shorter distances. Their homes tend to be smaller and cheaper to heat. The result? Europeans use about one-third as much oil as Americans. In Hong Kong, where I live, we see an even greater extreme. People live ontop of each others, in high rises, typically within a short walk of mass transit links. In this living arrangement, many people can get to work without cars. In fact, many people do not own cars at all.

These examples need to be kept in mind as our leaders formulate the measures to try to get America (and the world) out of the deleveraging spiral. We cannot afford to go back into a pattern where money is pumped into the system, and it merely winds up temporarily propping up past mal-investments, or worse yet, creating more malinvestments, new types of "stranded" investments. If we are to spend injected money, it must be spent well.

It Matters how the Money is spent and invested

A basic banking concept, is to lend money only to finance projects which will generate cash flow to repay the loan. Lending purely against assets is very dangerous since the asset values will fall dramatically, it they are not generating sufficient cash flow. That is the problem with America's housing boom of 2000 to 2006, it added little to America's productivity and earnings power. This is why the debt became toxic, the loans had little chance of being paid back when they were made, except through sale of the underlying housing asset, and the values did not hold up.

If the money had been spent on toll bridges between large cities, or in building mass transit systems, which could get people off crowded highways, and using less foreign oil, there would have be a revenue stream to repay the debt, and the lenders would be getting their money on time.

The Bush Adnministration's initial idea of handing out tax rebates, and telling people to "go and spend them at Walmarts" was another example of a completely wrong policy. This added to debt, benefitted foreign countries who sell goods to Walmart, and added exactly nothing to productive capacity.

To rebuild US savings, people must spend less. If they spent 7 years worth of income in only 6 years, then Americans must spend 6 years of income in 7 years. That means a dramatic slowdown in spending, and for a long time. Investment in businesses that feed America consumption and borrowing habits will not be the place to be. If sound jobs are to be created, they will have to be in other sectors.

Eric Janszen at iTulip has spoken about his "Ka-Poom" concept - where America first faces a deflationary collapse, and then to avoid it, moves into a reflationary high-drive. That may well be where we are now, on the virge of a new round of investments, to try to pull the economy out of a recession. Janszen believes this will involve creating another boom in infrastructure spending. And I do think this is possible. However, it is essential that leaders, and the new president in particular, pay attention to America's exaggerated suburban living arrangement with its huge vulnerability to high oil prices.

Investing for the Future - a Future of Lower Oil Usage

Investments that are made are made with the twin objective of creating sound jobs, and of reducing America's consumption of imported oil will be the best ones.

Following is just a partial list of the types of investments and policy actions that should be encouraged:

+ Nuclear power plants, to expand electricity generation

+ Mass transit systems, especially where the increase in land values this will bring can be monetised or taxed and used to pay for the investments (this is what is done by Hong Kong's MTR). New lines can be built on top of existing highways, with the increase in land values from the mass transit line tapped to help pay for the system.

+ Changes in zoning laws, to allow mixed use property development along New Urbanist principles. This will cut down on driving distances and create communities permitting ease of walking rather than than the exitinmg system that wants to cater to "happy cars" left sitting in parking lots, as people walk huge distances from car to store. These could be much better designed and linked in with new mass transit,so many shoppers arrive without automobiles.

How will we pay for it? Part of the answer may be staring us in the face. The drop in oil may in fact create an opportunity, America could wake up, and understand that its long romance with the automobile has now become very destructive, and is now like an affair with a high spending lover, who keeps emptying out our wallets, and is doing little of value in return. To create the right incentives to downsize oil use, we should begin to tax gasoline at a higher rate, and also put a higher tax on gas-guzzling automobiles. The money so raised can be recycled back into projects (such as those above) that will reduce dependence on foreign oil.

The next few years will not be easy. America has become too dependent on foreign oil and on foreign capital. It has not helped that much of the foreign capital borrowed through complex financing arrangements, like mortgage-backed bonds, was wasted on building energy inefficient homes in the stranded suburbs. We must get both financing and spending right in the future. Dismantling an over-large investment banking industry is a good thing, fewer toxic financings will be done, and a smaller banking industry can once again become a servant to the larger economy, rather than its master. We certainly need more enlightened political leadership, some intelligent forward planning, and good policy, rather than unregulated and out-of-control markets. If American is going to spend tax payer money to create jobs, it had better do it in a way that will make the economy more productive (to provide a return on funds invested), and also less dependent on foreign oil.