Our economy is represented by flows of dollars through millions of transactions every day. When there are imbalances in our economy, that result in a reduction of the value or quantity of transactions, or when there are dollars that flow out of our system, this creates a dampening effect on our economy. It is similar to a circulatory system, where the entire system is affected when the coursing of blood is somehow constricted, or when a wound begins dropping down the blood pressure. If the constrictions or the blood loss is too great, the whole system fails. Our challenge is to find the constrictions and the wounds, and apply salves as quickly and as precisely targeted as possible.
To establish a sustainable economy, we need to understand the causal factors which created the imbalances, and to carefully construct a system which monitors and mitigates their possible occurrence. These imbalances are exacerbated by our generally unsustainable approach to resource intensive and extraction activities, as well as our own exuberant behaviors within our created economic realms.
Energy - The key imbalance that led to our current economic woes. In no time in the last thirty years have energy price increase such as we have seen not led to a recession, and now is no different. Individuals, households and businesses saw their energy expenditures for electricity, heating, cooling and transportation increase, drawing their economic resources away from other expenditures. It is this competition for expenditures that began to take economic flows away from alternative consumer expenditures. People started doing everything they could, from reducing trips, buying more efficient vehicles and trading off other expenditures.
This ratcheting up of energy expenditures on the part of households, and the resultant reduction in expenditures impacted not only consumer expenditures, but began to gnaw away at our overall economic vitality, which may have begun to erode the driving forces behind the housing boom.
Energy prices were driven up by increasing global demand for a non-renewable natural resource, which our economy had to suffer through. We were not able to do anything to address the price growth.
Housing Boom - The second key imbalance in our system was caused by a multi-year run up in housing prices that outstripped the underlying economic foundation for housing prices. We saw a significant reduction in credit standards for housing mortgages that created marked upward pressure on the part of buyers, which, coupled with normal growth associated with economic expansion, created a huge overhang in housing prices, and the bubble eventually burst.
When housing valuations turned around and began to drop, consumer sentiment switched along with a marked reduction in associated economic activity. Houses were no longer the piggy banks that they have been, and the impact on sentiment may even be more significant, along with reductions in the purchasing of furniture, appliances, etc. associated with home purchasing.
More recently, with the reduction in stock market valuations of certain banking and financial institutions, has caused those banks and financial institutions to tighten their credit standards while they strengthen their balances sheets by reducing the value of their loan making. This has created an additional factor further dampening sales in the housing market.
Financial Leverage - A third key imbalance in our economic system of late is the extraordinarily high levels of financial leverage on the balance sheets of our banking and financial institutions. This imbalance created a much higher exposure to rick that was not recognized until too late. Various financial instruments were created that have been very difficult to determine the level of risk carried by the holders of the instruments. These included credit default swaps and collateralized mortgages and other investments.
As the performance of these investment instruments began to erode, the various financial institutions began to revalue these investments as significantly lower values, requiring write downs. The losses and write downs caused stock valuations to fall precipitously for certain institutions with too much risk. These stock price drops and simultaneous downward adjustments in their balance sheets created a huge problem: these institutions needed to strengthen their balance sheets with capital, while their access to capital was drying up. Without government intervention, these imbalances due to the writing down of toxic assets lead to insolvency and potential bankruptcy.
In the absence of public intervention, private financial institutions are going to be rebuilding their balance sheets by among other measures, reducing their loans by increasing credit standards.
These three imbalances are the core sources of our economic meltdown today, driving fewer house sales, fewer automobile purchases, reduced overall consumer purchases, and constraints on commercial lending, capital purchases, growth and hiring. The development of solutions to this situation have to explicitly address the causal factors, targeting specific changes in behavior that are sought to pull our economy out. The solutions will be addressed in the next blog.
