Uncertainty, Uncertainty, Uncertainty

Well I think it’s safe to come out now. The threat of another depression has passed. Phew. Now comes the hard part. The odd thing about where we’ve just been is that in the depths of the last few months it was easier to act: thinking too far ahead was pointless and formulating proper reforms or corrective policies was just not appropriate. There was simply too much uncertainty.

“Without a fix for the banks we will absolutely be headed back into dangerous gambling soon, but this time without the resources to fix it. That way lies the road to depression.”

Now, from my point of view, uncertainty is the dominant theme in any economy. It is concern over the unknown that compels us to save and to form businesses that can undertake long term projects. Indeed from a theoretical perspective a business firm is simply a ‘hedge against uncertainty’ – as described by the economistBrian Loasby. Money is also such a hedge: we use money as a way to avoid having to barter and as a way to store value for future use. Money has no intrinsic value other than what it can be exchanged for, so keeping or setting aside a cash store in savings etc can be viewed either as a way to postpone current consumption for the future, or, alternatively, as a measure of the uncertainty we have about our ability to pay for future consumption.

So everywhere we look uncertainty affects the way we construct our economic lives.

I mention this because as we emerge from the storm of the past year one key factor seems to stand out: the dramatic drop in confidence, or conversely the dramatic increase in uncertainty, that has settled in on the economy.

This might appear odd in the context of the revival of the credit markets which is one of the clear signals that the storm is abating. It is true that the financial world has lost much of the panic feeling that gripped it over that past few quarters. Banks have been able to issue equity; spreads are returning to more normal levels; bank profits are rising; and capital ratios are not declining, but are fairly stable. None of this implies that the system is repaired, but it is on its way to recovery. The banks are back to having fun. We are left to clear up their mess. Confidence is creeping back on Wall Street. That’s not our issue just yet.

No. The uncertainty that has risen is on the consumer’s side of the economy. There has been an enormous shift in private savings. Looked at as the difference between private incomes and private expenditures, savings have gone through the roof. This implies an enormous contraction in consumption. And I mean enormous. Were it not for the extremely large increases in government spending we would most definitely be in the grips of a full depression at the moment. The contrast with the 1930’s is extraordinary: the rise in savings back then was less than our current shift. This means that we were on course for a worse depression than the Great Depression. It was, and still is, that bad.

I say ‘still is’ because the shift towards savings, which has been advocated by many of us for a very long time, has been so sudden, and violent, that it risks completely dampening the recovery. There is no doubt that we need to unwind the overhang of debt that we gorged on over the past few decades. One of the reasons I regularly harangue the Reagan/Bush era is that the economy was encouraged to rush into indebtedness in order to mask underlying weaknesses. The moment Reagan filled the country’s imagination with hazy visions of yesteryear he led it away from fixing its issues. Those rose tinted glasses created an illusion that prevented a proper understanding of long term problems then emerging. And so a very imbalanced economy was created: loss of long term competitiveness and growing foreign oil dependency were ignored; stagnating wages and rising health care costs were glossed over; and the fact that many people had to borrow to stave off a declining standard of living was seen as a sign of optimism about the future, rather than a sign of something going badly wrong.

The final nail in the Reagan/Bush coffin came when massive inflation in home prices was seen as a source of wealth rather than as a destabilizing social force. The prevailing, and hopelessly wrong, economic thinking that pervaded the whole Reagan/Bush era missed the danger of the real estate bubble precisely because it saw no bubble, just ‘exuberance’.

The consequent implosion, which contrary to the opinions of many in the media, was foreseen by many of us, has now manifested itself in the shift towards savings I mentioned earlier.

Uncertainty indeed abounds.

Couple the huge blow to confidence that a 30% to 40% drop in home prices has dealt, with a bleak long term employment outlook and it easy to see why consumers are saving at the rate they are. Who knows what could happen next?

The bad news is that the total debt level of the private sector is down only a couple of percentage points from its high back at the beginning of 2007. That implies we are likely to experience this rate of savings for a while longer as de-leveraging continues.

The conclusion I come to from all this is that the recovery will be long and very slow. Unemployment will stay high, and most likely increase over the next few months.

And the hard part is just beginning: we still have not dealt with the insanity of the banking system, which, if Goldman Sachs performance is anything to go by, is about to head straight back to the recent past and try to replicate its bad habits for huge private gains. There are no signs of lessons being learned there, just rampant opportunism safe in the knowledge that the taxpayers will pay the bill for the next catastrophe the banks heap on us all.

Plus the epic fiscal effort we have had to make to stave off total disaster has left us with a Federal deficit problem that will need urgent attention in the medium term.

Without a fix for the banks we will absolutely be headed back into dangerous gambling soon, but this time without the resources to fix it. That way lies the road to depression.

As I said: uncertainty, uncertainty, uncertainty.