Whether you are a student of economics or not, it can be important to know something about wealth. Wealth is accumulated value and all wealth is subjective. You may say feel some things are not subjective (i.e. gold) but the value of gold is dictated by what people are will to pay for it, and we have seen gold go from very high levels to very low levels. Money of course is subject to changes in its valuation and if you are familiar with history, there are many examples, such as the German Wiemar Republic, where money became essentially worthless in a very short time.
The world creates a certain amount of real goods each year (crops, ores, oil, lumber etc.) that can be said to increase the amount of wealth. These basic products are then turned into manufactured goods and value is added to them creating more wealth. Of course the third stage are the services provided to deliver these goods to the market as well as other services.
As nations develop, they usually start as producers of real goods, commodities, which they sell to more developed nations that turn these items into manufactured goods of some sort and provide services. Of course, some commodities require very little intervention to be marketed while others require quite a bit.
The reason all wealth is subjective is because ultimately the value of anything is dictated by demand. It wasn't very long ago that housing in some parts of this country demanded prices that were double what they can be sold for today. In a dollar denominated system, they have lost 50% of their wealth. Of course, if you own one of those houses, you own exactly the same thing you owned previously, and if you don't have a mortgage, you may actually be better off since it is likely your property taxes may be adjusted, but you would feel poorer.
By the same token, the prices we pay for many other items have also decreased as demand has withered and producers are forced to discount items in order to move them. The big danger here is potential deflation. Now the problem with deflation in a credit driven economy is that it leads to debt exceeding perceived value. If I have a $500,000 mortgage on a $750,000 I perceive that I'm doing OK. If the value of that house drops to $400,000, I am now paying the bank more than I believe I should. It makes better economic sense (depending on how you feel about your credit score) to simply walk away and let the bank have the house. Of course doing that makes the loss real, and you may very well feel that over time the value of your house will recover, but that is a gamble of sorts and requires a certain faith in the economy, or at least a belief that inflation will return.
So what is the natural outcome of an economic downturn, where wealth is lost? With or without Government intervention, prices will drop to a point at which demand is restored. Once demand is restored, the economy will stop contracting, and having eliminated the excesses that led to the downturn, it will start to grow once again. How fast it grows depends on many things, but clearly, as demand grows, employment will grow, helping to increase demand further at some rate.
In the bubble years, we had tremendous demand that was based on credit secured by housing wealth and to some extent loose credit policies that encouraged consumer spending. In fact our economy became dependant on consumer spending, and to a large extent the rest of the world is dependant upon our economy being successful. When we saw the housing wealth decline, that spending declined with it.
Now it would seem that in many parts of this country, housing has neared a bottom. However, because of the reduction in demand, we have greatly increased the number of unemployed individuals and reduced their income. Further, even if housing has stabilized (and it may still decline some more) it is not going to suddenly jump in value (at least not everywhere) so that wealth and associated credit needs to be discounted from the market for some time.
An additional factor is that many Americans have now been scared into saving. They have also been scared into safe investments. These investments simply do not create monetary wealth very quickly.
What does this mean? In a very simplistic way it means that the new American economy is going to be smaller than it was. This can be computed simply enough if you make some basic assumptions. For argument's sake, lets assume the amount of disposable income overall remains stable. This plus credit becomes the amount available to spend. Now credit spending unrelated to housing is down from 2008 levels but very close to 2007 levels. However, housing values in this country are down significantly. Ignoring primary mortgages for now, in the 2004 to 2007 period, there was a tremendous amount of refinancing done in order to tap equity. For a while the number of refinancing averaged over 800,000 a month. Currently more refinancing are done to lower interest rates and the numbers were below 200,000 a month. The implications of this should be apparent, consumer spending will increase/decrease year over year based on the following formula, d-s+c+m to d1-s1+c1+m1 where d and d1 equal discretionary income 12 months apart, s and s1 equal savings for those same two points in time c and c1 represent consumer credit and m and m1 equal cash out refinancing. In the best case scenario, m1 current is much lower than m of 2008. Now as time goes on, m1 will become m and the new m1 may actually be higher than current levels. This will create growth in consumer spending but I can't imagine anyone believes that a year from now cash out refinancing will be anything near where they were a year or two ago.
The formulas can be revised to be more precise, but with savings up and cash out refinancing down, the amount of consumer spending will be significantly less than it was, probably around 20%. If nothing else was to change, and consumer spending equals 70 of the economy, we can expect a fairly permanent contraction of 14-15%. That is about the contraction we have experienced which is why we are likely at the bottom of the downturn and starting to recover.
Now, discretionary income is simply not going to increase dramatically and I don't expect home prices to skyrocket either. Consumer credit is likely to increase somewhat as employment increases but realistically it is very hard to see growth in consumer spending going up fast.
Other sources of demand for the economy include exports and this can be an area of significant growth in the future.
One argument against a rapid improvement in the economy is the amount of foreign debt the nation is issuing. Interest payments on foreign debt will require money being removed from the economy and sent to the foreign holders of this debt. Now, this impact can clearly be mitigated to some extent if we improve our balance of payments and get those countries to use that money to buy US goods. Of course, this does not need to be a direct transaction, if China for example buy a lot of commodities from Russia and Russian spend that money on American products, the money does return to us ultimately. A lot of commentators like to discuss the likelihood of Chinese consumerism, and of course if we can sell items directly that will work, but it doesn't really matter if it is direct or indirect if exports can increase enough.
Can the US handle its debt? The answer is that in one way or another we will, the question is how disruptive will managing the debt be. What needs to be remembered is that every year the US produces tremendous wealth in commodities, manufactured goods and services, and this wealth will increase in value as the economy recovers. After WW2 the US had tremendous debt that the country was able to manage and prosper at the same time. To a significant extent that period was fueled by the redevelopment of Europe and Japan. I believe in a few years we will look back and see that the new prosperity was fueled by the development of China and India and the opportunities they will create for this country.
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