Armchair Economists

Yes, The Dow fell 777 points yesterday.

Yes, it was the biggest point-loss in history.

It was also only a 7% drop. The drop that triggered the Depression was closer to 25%, and Black Monday's was about 22%.  Funny how that  little statistic barely got reported in the mainstream media.

Seven percent is significant certainly, but not necessarily the harbinger of another Depression, or of a market spiraling out of control. The NYSE does have a tool in place to prevent the market from free falling: it's called a circuit breaker and had the market continued to plummet, trading would have been halted.

Doesn't it make you breathe just a little bit more easily to know that there actually are some balances to keep things from running away unchecked? And yet, that little failsafe mechanism has barely been mentioned in any of the news coverage either.

I blame the armchair economists. 

Specifically, the armchair economists who are whipping the country into an absolute frenzy based on insufficient (or incorrect) information and perfunctory analysis (at best). As it turns out, they are just as knowledgeable, and just as prone to gloom & doom hyperbole, as nuns teaching a Sex Ed class.

They're just as effective at teaching people how to make well-informed decisions, too.

I wrote a huge essay about all of this last night, but it was very long and I was getting very snarky near the end, so I've chosen instead to just hit you with some of the highlights. Bullet points after the jump:

• Parts of the economy are in trouble. I say parts because unless we're discussing the GDP,  there's really no such thing as "the economy." What we refer to as "the economy" is really a collection of eighteen or so different sectors, all of which have their own nuances and patterns. The entirety of the collective is not on the verge of collapse.


• The collapse of the mortgage industry, however, was inevitable. When the Clinton administration pushed for Fannie Mae & Freddie Mac to approve sub-prime loans in order to increase the number of minority home owners, they doomed us to facing an eventual day of reckoning. There's a reason that banks don't approve sub-prime loans, it's because they don't have faith that the loan requesters will have the means to repay them. And Banking 101 says when too many people default on their loans, banks fail. I'm sorry to break it to everyone, but it was actually the Democrats who caused this problem.


• The inevitable implosion of the mortgage industry was hastened along by what many call the shadow banking industry: finance companies, investment banks, and hedge funds that were able to fuel the credit boom since they have less regulation and more leverage than commercial banks.


• The Fed saw this coming; the mortgage industry has been falling apart at the seams since August of last year. Remember when interest rates were lowered? That was an attempt to cushion the market and stave off panic. Unfortunately, Bernanke (wrongly) assumed that the mortgage institutions were basically sound and that the problem was illiquidity. It's now obvious that the root problem was actually insolvency. Those two problems require vastly different solutions.


• Insolvency cannot be solved with more loans. Period. The only solution to insolvency is more capital. The only entity with deep enough, and patient enough, pockets to provide capital in this situation is the government.


• The assumption that almost everyone is making is that TARP calls for $700 billion in cash. It doesn't. What's really being discussed is a transfer of securities and assets potentially valued at $700 billion. The true cost to taxpayers is unlikely to be anywhere near $700 billion, because many of the acquired mortgages will be repaid.


• The cost of this bail-out is roughly equivalent to 6% of our GDP, which is not bad in terms of government bail-outs. in 1997, Japan poured an amount equivalent to 24% of its GDP into its own economy to stabilize it. From The Economist: When the loans to AIG and Bear Stearns assets are added in, the gross public backing so far approaches 6% of GDP, well above the 3.7% of the savings-and-loan bail-out in the late 1980s and early 1990s. That would still be much less than the average cost of resolving banking crises around the world in the past three decades, which a study by Luc Laeven and Fabian Valencia, of the IMF, puts at 16%.


• The Dow Jones Industrial Average (aka "The Dow") is used to gauge the performance of the industrial sector of our stock market. It is comprised of roughly 30 of the largest and most widely held public companies. Yes, only 30! Because of this, critics argue that the DJIA is not a very accurate representation of the overall market performance. Dow Jones therefore removes and replaces companies as it sees fit in order to keep the index current and relevant. AIG, for example, was removed from the DJIA the day after declaring bankruptcy. The DJIA is published by a private company and is only one of several indices used to evaluate the performance of the stock market.


• Unless you've sold your stocks and cashed in your 401k, you haven't actually lost any money due in the fluctuating stock market. Your bank balance hasn't changed. A quick look at your statements may show that the current value of your assets has dropped, but as long as you leave them alone they will recover.


• There is a difference between investors and speculators. If you want to maintain the value of your stock portfolio (and you don't have cash to burn in risky day trading) in this market, be an investor NOT a speculator. Investors are in it for the long haul.
  


• There is no difference between "Wall Street" and "Main Street." No matter how the media tries to spin it, this measure isn't about keeping rich people rich, it's about stabilizing one of the most important sectors of the economy. It is extremely short-sighted to suggest that mortgage companies just be allowed to fail, particularly when they're failing BECAUSE the government forced them to make decisions that went against sound financial sense. The resultant domino effect of doing nothing truly WOULD be disastrous.


• The current impasse on Capitol Hill has nothing to do with what's best for the country and everything to do with the fact that there's an election in a month. This measure (unfortunately) needs to pass, but the Democrats are too chicken shit to do so without a billion amendments to it and the Republicans are balking at all the crap being tacked on to the end of the bill. NOBODY wants to be decisive and risk precious votes.
  

I'm not an economist; what I am is an intelligent, resourceful person who started doing research as soon as the media started throwing around terms that she didn't fully understand. The information is out there, but we have to go searching for it. Sadly, panic is more profitable than reasoned analysis.

Be an informed consumer, and an informed voter.

Still have questions? Check out Morgan Stanley's free online financial dictionary for starters, and Forbes's Investopedia. Then get yourself a subscription to The Economist; it is, in my opinion, the single most balanced and informative periodical being published today.

Comments

[VT]

Hear, hear!

The Economist rocks. Thanks for taking the time to go over the salient points that I wish more people knew.

[JM]

Ah, a voice of reason in the darkness! /clap

[Tori]

Very nice, but I want to see the snarky one too.

[Adri]

Very well written, and full of good info and reason. Nice job.

[Greg Bratton]

Here is another news flash from my end of the world. I can tell you that luxury spending is only down 5%. It is the necessity spending that is cut in half right now. Wait even better these are the same percentages that we were down during the holidays this last year end.

And another thing. The Arm Programs that were put in place were crap to begin with. Most being offered at the time were being inflated by finance companies. At the time I was working in the mortgage industry and refused to write variable rate loans. In our list of finance companies we had 365 lenders constantly sending us information for these types of loans. I was the Marketing Manager at the time and can tell you these numbers in good faith.

The problem was that most consumers did not educate themselves about what they were getting themselves into. Also the loan officers that write these particular types of loans should be ashamed of themselves. They were the cause and the affect is our current mortgage crash.

Typical sales pitch "If you take this program you can pick your payment. If you fall a little behind you can pay only the interest for that month." Bull the balloon payment at the end of the loan is where they killed people. Along with the fact of a 2 year fixed interest with a variable after the fact. What this all means is in the long run people lost their homes due to agents collecting a better point range, in other words cashing in on peoples lively hood. Oh and wait theres more. How bout the fact that people went stated stated on their income and assets to get the inflated returns on their homes. And then the appraisals being paid for by the loan agents inflating the values of the homes. I have see in and waited and warned people for a few years now. This is what happens when the D.R.E. does not track the Loan Agents. The system was out of control long before all this happened and until some body of control steps in it will happen again.

I need to stop now as this is getting long. The point is that people got screwed because the companies got greedy and so did the agents. The agents and brokers have been rewarded for this type of behavior. They should lose their licenses and have to start paying them back.

[Tag]

This is a solid, well written piece. As always!

Economics; much like accounting, is very much an art form and not a science. This is something most do not realize because they assume since we are dealing with numbers it is a science. The reality is quite the opposite and is the reason why there are so many different valid methods of economic thought. Some better than others.

My immediate thoughts as quickly as I can! ;-)

- "The Economy" is referencing our economic system. The two principal components of all economic systems are natural resources and labor. They are of course only a part of an economic system. The financial market is a large part of our modern economic system, particularly in an age where we are moving into service based industries. I believe it makes up over a third of of our GDP.

- GDP simply shows the market value of the goods and services an economy produces. While this is an important measure of economic health it says little about what is important for sustained economic health or growth. It does not tell us how our quality of life is. I hate to bring it out as any business kid is sick of it but Maslow says the anchor of his triangle is the physical. How happy am I? How secure am I in the future? How is my health? Do I have access to clean water and fresh air or am I being poisoned by pollution?

- Quality of life is to me the most important part of any economy, especially this one.

- Our economy is in SERIOUS trouble but it is not merely limited to this "financial crisis." signs of this include...

- Unemployment is at 6.1% last year at this time it was at 4.7%. While not the double digits of the early 80s it has moved in the wrong direction and is at the unemployment level of the recession in 2003.

- 46 million Americans remain uninsured which makes up about 15% of us. That means 15% of us don't have access to private or public insurance.

- 12% (about 35 million people) of us are living below the poverty level; a statistic that is even more graphic when broken down by demographics such as 24% of African/Americans living below the poverty level.

- The U.S. debt is at $9 Trillion and is nearly the same percentage (about 65% of GDP) of GDP as 1996. In other words we all owe about$31,000. More importantly the deficit in 2007 was $167 Billion and was forecasted (prior to this bailout plan) to increase to $410 Billion in 2008.

I agree the government needs to bailout these chumps. I also believe we shouldn't march like Beetle Baily to the quickest trend. This is how the Patriot Act flew through which we are only beginning to now fathom the consequences.

The bottom line is that this is indeed ONE part of the economy. The world will not end if we put some time into constructing a bail out that not only addressed the financial issue but begins to address the more important economic issues we face as a nation. This is not just about taking care of some rich cats who created tools which created the illusion of wealth for the common citizen. In a true free market we would let them fall with their mistakes.

We are a Mixed Market though and the government not only has the right to fix this they owe it to the 3.7million people facing foreclosure annually to address the core issues surrounding.

In the end it must be about the greater good. This bailout; as necessary as it is, does little if anything for the greater good. Somehow there needs to be accountability for the architects of this financial markets mess. I agree with Greg that those agents and brokers should lose their license. Furthermore those that created and managed a system that rewards the behaviour these agents and brokers participated in should face a federal court judge.

I will stop now as I too am getting way long on this but I will say I am more than happy to bail out those mighty corporations; I do expect a 17% return on my investment though when they get back on thier feet.

:-)