July 22, 2022
This week in the world of economic reports we saw:
- Building permits (a proxy for future construction) dropped to their lowest level in nine months…
- Housing starts dropped to their lowest level in 14 months…
- The MBA Mortgage Market Index (a weekly report of mortgage applications of any kind) dropped to its lowest level since the year 2000!…
- Existing Home Sales dropped to their lowest level since June 2020…
- While the Average Mortgage Size upticked to $415K from $405K (But still well off the highs of $460K in March)…
- And Average Home prices reached their highest levels ever…
What do they all mean?
On the surface, it would appear that housing prices are approaching a blow-off to the upside, while rising interest rates are starting to cool the rest of the real estate market.
Does it have a deeper meaning?
The truth is, a lot of these numbers are irrelevant. Fake numbers on a magic white board.
I’ve been going back and forth in my head for a couple weeks about whether or not to write this update. I think during bear markets, like the one we’re in, a lot of investors don’t care about the next hot stock. Once they get past the initial pain, a lot prefer to understand what the hell is going on that’s causing the collapse.
For the past few weeks, I’ve been trying to use this space to explain some of that.
This week I’d like to explain a reality I believe goes one level deeper — about why our economy is in such trouble in the first place.
It’s because we’ve finally transitioned from a real economy to a fake one. Let’s take a look…
Real vs Fake Economies
To explain this, let’s start with some basics…
REAL economies produce value.
They produce products and offer services that make the lives of the people who buy them better.
That value is exchanged for money (which is only a representation of value — it’s basically worthless on its own) which gets paid back to those who participate in its creation. Who, in turn, return it to the economy (either by spending or saving/investing) which drives more value creation.
The more value gets added to an economy, the more it grows. The production of value is what drives growth in a real economy.
Fake (or financial) economies produce… nothing — only a smoke screen that looks like growth.
Financial economies are based on debt. The only thing they produce is higher prices by means of inflation, aka currency devaluation. By creating more “money” via credit.
But hold on a second, isn’t it true that capital is necessary for real economic growth? And doesn’t the “financial economy” provide that capital via debt?
It sure is… And they sure do. But there’s a distinction you have to understand.
Good Debt vs Bad Debt
Let’s call this distinction “good debt” vs “bad debt.”
Good debt is the loan you take out to add equipment to your factory, so you can produce more or better products. So you can hire more people to work for you producing those goods. The added value that this debt helps create is economic growth. It’s based on the desire to produce.
That’s good debt.
Bad debt is something entirely different.
Bed debt is the loan you take out so you can buy the shoes or the big screen TV or the car or the higher education you can’t otherwise afford. Bad debt is rooted in a consumption mentality and it explodes when that desire can’t be satisfied by available resources.
With me so far?
All debt has the potential to be inflationary. It really ought to be handled like a class 5 contagion. Because if it gets out of the lab and spreads uncontrolled through an economy, it can cause incredible damage.
Here’s how that works.
The entire banking system (the financial economy) is undergirded by something known as the “fractional reserve system.” It’s the ability to “safely” lend a percentage of the cash they have on deposit. That means whenever I make a loan based on the fractional reserve system, I’m effectively inflating the money supply.
That means as a bank operating under a 10% reserve requirement, for every $1 you have on deposit, you’ve got 90 cents you can pump back into the economy. Which, of course, has to be paid back with interest (more money) that has to come from someplace.
Analysts reference an equation referred to as the multiplier equation when estimating the impact of the reserve requirement on the economy as a whole. The equation provides an estimate for the amount of money created with the fractional reserve system and is calculated by multiplying the initial deposit by one divided by the reserve requirement. Using the example above, (a bank with $500 million on deposit and a 10% reserve requirement) the calculation is $500 million multiplied by one divided by 10%, or $5 billion.
The equation is a simplification… But it’s not wrong.
So if that makes debt what you might call a necessary evil, at what point does it go from good to bad? Let’s consider that…
All debt borrows from the future (it has to eventually be paid back with future earnings — plus interest).
When debt expands the production of real value in the future, it’s perfectly fine. Because that real, increased value gets spread back through the economy via people’s bank or investment accounts.
Price stability also occurs when the increase in the amount of money in the system is roughly in balance with the increased level of value it produces — when production and consumption balance. In a healthy, real economy, production drives growth.
Good debt grows economies.
Bad debt, on the other hand, is simply tapping into future earnings to pay for what you can’t afford today.
In some cases, “bad debt” is a necessity. Like when wages have fallen so far behind inflation that many people can’t even afford necessities anymore. When all that debt does is expand purchasing power, that’s when we’ve crossed the Rubicon into fake economy-land.
At that point it becomes bad debt — and bad debt becomes an addiction. Ultimately debt becomes the only thing that keeps the economy afloat.
And over the past 80 years, that’s the direction the US economy has been headed.
For a While the US Had a Booming REAL Economy
During the second World War, the government stepped in to regulate the economy in order to help in the war effort. Rations were placed on everything to support production for the war. And Americans all pitched in and did their part.
But by the time the war had ended, America was ready to start spending again. (It’s what happens when you lift any artificial cap — demand starts to soar.)
Industry retooled to producing homes, cars, appliances and every other kind of consumer good you can think of as quickly as it transitioned to producing bullets, bombs and tanks for the war. Jobs were plentiful.
Value was being created and consumed at a record pace. And real prosperity spread across the country for decades.
Driven by growing consumer demand, as well as the continuing expansion of the military-industrial complex as the Cold War ramped up, the United States reached new heights of prosperity in the years after World War II. Gross national product (GNP), which measured all goods and services produced, skyrocketed to $300 billion by 1950, compared to just $200 billion in 1940. By 1960, it had topped $500 billion, firmly establishing the United States as the richest and most powerful nation in the world.
But real economic growth has its limits. Eventually growth slows from the exponential curve we experienced in the 50s and 60s because any market can consume only so much — be it bombs or TV sets.
When natural growth slows, as it always does, new growth has to be driven by innovation. But innovation can take time. And when you’re used to explosive growth, slowdowns aren’t a welcome thing…
Especially when you’re a politician.
So if consumers weren’t going to spend to drive the economy, someone had to…
Pass the Guns and Butter
By the mid-1960s, President Johnson had undertaken massive amounts of spending on both social as well as military programs.
The Vietnam war was raging on and after nearly a decade of fighting, the United States had spent $168 billion on it — $1 trillion in today’s dollars.
His social programs, the Great Society and the War on Poverty… We’re still paying for many of them today.
Under Johnson, all the borrowed spending increased the national debt by 13%… (Not to beat up on President Johnson too much, every president since has increased the debt by at least 30%!)
It was the beginning of what was to become an endless trend in deficit government spending…
The Federal Deficit
…and bottomless debt.
Total Public Debt
By 1971, the number of dollars that had been created had put the world economy on edge, fearing that the US didn’t have enough gold to back up our obligations. So President Nixon closed the gold window making the US dollar 100% fiat. The party was just getting started.
All this spending led to inflationary pressures and as inflation started to spike in the 1970s, the real wages of the average American began their long trend down…
Inflation Adjusted Hourly Earnings (2021 dollars)
Even today you’re still not doing as well as your dad did in 1974.
Ordinarily, this kind of loss in purchasing power would slow consumption which, in turn, would tap the brakes on production. But something else happened just a few years earlier that made that rule of economics a quaint memory… more debt!!
There’s always been consumer credit. But consumer credit on demand is a somewhat more recent phenomenon.
…in the mid-1960s, two developments resulted in the formation of recognized credit card name brands. The California-based Bank of America—Visa’s predecessor—licensed its card across the country in 1966, followed, one year later, with four banks forming the California Bankcard Association, soon to be known as Master Charge. Over 11,000 banks had joined either one or both of these national credit systems by 1978. Sixty million Americans carried either a Visa or Master Charge card, and the spending charged to them almost equaled the amount placed on retailers’ cards. Just over half of all households had a bank credit card in 1986, and by 1998 that figure had increased to two-thirds. Average annual charges escalated from $885 to $3,753 through the 1980s, representing a leap that was twice as great as the rise in disposable income. By the early 1990s, the consequences of this trend became apparent: almost 16 percent of families had the same amount of credit card debt as their take-home earnings, and 8 percent had debt representing over twice the amount of their income.
That access to and use of consumer credit has continued nonstop ever since. And it’s created another nearly-$1 trillion in debt.
Consumer Credit
Today debt has outpaced production by such magnitude it’s likely we’ll never get even.
Of course there still is real growth in the economy… But when you factor in inflation on those numbers, it’s far from spectacular.
GDP vs. Real GDP
You Are Here…
For decades now the country and a large portion of its citizens have been financing much of their spending with debt.
While some of that spending does contribute to actual economic growth, the vast majority has been borrowed simply to pay for what we can’t afford… Like the government that currently owes over $439 Billion in interest alone on their outstanding debt.
At this point, the only way to maintain any kind of economic “growth” (i.e. manage our debt) is by taking on more debt.
The bottom line is we are eyeballs deep in an economy of fake prosperity with an inflated economy, stock market, and other real asset prices. But that doesn’t mean we’re all completely doomed.
A lot of smart people have written about the United States’ debt predicament.
Few, however, pose any actual solution to the problem.
That’s because there’s not a lot that can be done — at least not without causing a lot of pain to 99% of the population’s standard of living.
So while this situation is really bad, it’s not hopeless. First, because you’re now aware of the real state of the economy.
And second, because there are still areas of true potential value in the economy for the persistent investor.
While companies like Google, Apple and Facebook may have outgrown their “growth stock” glory, and while other pandemic darlings like Peloton and Zoom are busy figuring out their true valuations, there are companies out there that are still innovating and producing value. Undiscovered companies that are trading for downright cheap valuations, with potential to generate inflation-crushing returns.
A number of them are in our Streetlight Confidential portfolio.
Keep the faith and…
Make the trend your friend,
Bob Byrne
Editor, Streetlight Confidential