Sunday, October 19, 2008

An economics question

Originally Posted by "Undead2" on CARM discussion forums:

"So a person in my shop is asking how this will affect him personally?

I gave the analogy about how when the price of oil goes up from Saudi, that means the price of corn goes up because farmers must pay more for the deisel in their tractors and that increase must be passed on to consumers, but he doesn't understand (and I am having trouble explaining) how the real estate market will affect him. He says he buys corn but is not buying a house any time soon..

Can you explain to both of us how this could balloon into another depression?

Thanks in advance"

Well, a recession/depression is inevitable, it's not a "this could happen if the government doesn't step in to ___________" scenario, as is being painted out by the bailout proponents. The only question we need to answer is how deep and long we intend to make this recession. The root causes of this economic downturn are:

- too much easy credit
- housing prices too high (speculative bubble driven by the easy credit)
- misallocation of resources to where they are less in demand (home construction, etc.)

Let's say the government chose to do no further harm to the economy than it has already done, and let collapsing banks fail naturally and so on. In this case, Joe Six-Pack is going to feel the crunch as follows:

- businesses will hunker down and try to weather the storm by cutting their expenditures
- one of the consequences of easy credit is that businesses across the board expand their outlays without necessarily increasing their revenues (they become more speculative on future revenue increases which may not materialize)
- as a result, jobs will become more scarce as businesses cut their outlays (labor is an outlay) - that is, unemployement is going to increase
- this will mean a general decline in wages which will
- effectively increase the cost of living
- in addition, to counteract the collapsing credit (which shrinks the size of the total pool of money in the country), the government will likely print more money which
- causes prices to rise, decreasing Joe Sixpack's standard of living even further

If Joe Sixpack holds a lot of debt, it is going to become increasingly difficult to meet the minimum payments as his wages decrease. And, since credit is tightening, his credit ceiling is lowering as well, meaning he can't pay it forward anymore. In short, if Joe Sixpack was living beyond his true means before, he will no longer be able to do so. In addition to the general decrease in the standard of living, Joe Sixpack is also stuck with high credit card payments which he cannot juggle away anymore, further decreasing his standard of living.

The bailout, however, will make every single one of these negatives that much greater. Its sole effect is to get the well-connected, big business interests in Wall St. off the hook for the insane credit practices they were engaging in. The bill will be marked up to you and I... adding that much more burden to us at the worst possible time. While we are all experiencing the pain of having to cut back to living within our means (and then some), taxes are going to be increased as foreign and domestic bondholders alike become increasingly nervous about the possibility of default on the astronomical US government debt.

Even worse, the bailout is going to attempt to perpetuate the very misallocation of resources that triggered the crisis in the first place. The goal is to try to price control home prices (to keep them high) so that the big boys on Wall St. who were asleep at the wheel can cut and run now that the game is up. But this will only perpetuate the problem by diverting resources to new home loans and home construction at a time when the market is drowning in homes!

In short, our political leaders intend to repeat every mistake that deepend and lengthened the Great Depression. All I can say is look out for yourself, don't trust anyone, especially the government, to look out for your welfare. Put your money where you know it is safe and get ready for a long, hard road over the next 5 to 10 years, depending on how bad these bailouts get.

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