Dominant Causes of the Credit Crisis Part4: Where did the demand for goods and services go?

8/7/2019 Dominant Causes of the Credit Crisis Part4: Where did the demand for goods and services go?

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David Collett 2011 ANCHORAGE INVESTMENTS

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Part IV: The Dominant Causes of the Credit Crisis

Where did the demand for goods and services go?

28 April 2011

by David Collett

Where is the organic growth for demand going to come from? That is the question asked

by many CEOs lately. Growth in demand or the lack thereof is central to future growth

and economic prosperity. Why did demand not bounce back vigorously from the

2008/2009 recession despite enormous government stimulus worldwide, low interest

rates and the added injection of liquidity from central banks? As long as the dominant

causes of the crisis are not correctly identified and recognised, the remedies applied torevive the economy will remain ineffective.

Many pundits of economic growth have pointed to factors that inhibit growth and

demand. Some of the more popular ones are insufficient fixed investments, high taxes

and tight credit conditions. But high private fixed investment, low personal taxes and

credit expansion preceded the two biggest crises over the last century, namely The Great

Depression and the 2008 Credit Crisis. Although US fixed investment did not increase

that much in the period immediately preceding theCredit Crisis,fixed investment in the

rest of the world, especially China, more than made up for it. Yet, sluggishness in demand

was a cause and a consequence of both these crises. Why did it happen?

Decrease in taxes, increases in fixed investment and growing credit must, by reason of

logic, increase demand. Add low interest rates and mild inflation to these favourable

conditions and you have a perfect storm for an explosion in demand. That explosion did

occur in the years preceding both of the abovementioned crises, only to implode or to

slow to a crawl. Huge government stimulus packages, quantitative easing and near zero

interest rates failed to resurrect the relative high growth in demand that preceded the

Credit Crisis. Can the economy continue to grow without the latter?

Wealth Concentration and its effect on future growth

InPart IIof this series of blogs on the dominant causes of the Credit Crisis, we analysed

the growing divide between productivity and household income, growing income

inequality, decreasing capacity utilisation and the growing imbalance between demand

and supply covering a period from the sixties to the early 2000s. We showed how the

top wealth groups gained an ever increasing share of total US household income since

the early eighties; how their accumulated savings and investments have since caused

overcapacity; and why the lower income groups (bottom 80%) financial ability to

absorb the increased production from expanding capacity, diminished to such an extent

that it caused an imbalance between supply and demand.
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InPart IIIof the blog series, we analysed the Balance Sheet of US Households from 1962

to 2010 and showed the different savings patterns between the bottom 80% and top

20% of households in terms of income and net asset wealth. We also showed how the top

20% and especially the top 1% of households substantially increased their savings from

1983 to 2007 while the bottom 80% of households had substantial negative savings. The

effects of a worldwide savings glut on overinvestment in productive capacity and lower

interest rates are also discussed inPart III.

Evidence suggests that when too much wealth, earnings and savings accumulates in too

few hands, the ability to produce goods and services will exceed the ability to consume

those goods. This is so because those who have a need for more consumption cannot

afford to increase their consumption whereas those who can afford such increase in

consumption have no need to consume more. Few people want to buy 100 cars or 20

boats simply because he can afford it.

Consumption and expenditure of all income groups, continue to increase from the

eighties right through to 2008. The substantial increase in disposable income for the topincome groups enabled them to consume and save more. The obvious question is, how

did the bottom 80% manage to keep pace with the expansion in expenditure and

consumption when the growth in their incomes, since the eighties, did not?

Various factors played a role in filling the growing income gap between the

expenditure and income (earnings from wage and salary) of the bottom 80%. Incomes

were supplemented by tax decreases and benefits, negative savings, lower interest rates

and expanding credit over a period of three decades. Credit expansion, the most

dominant stimulus in the 2000s, was the first to waver in 2007 and lower interest rates

(mortgage rates) might be the last to go. By 2009, it was clear that the full potential of the

above sources to fill the income gap was just about fully tapped. A new stopgap

measure was implemented. Huge amounts of government stimulus were used to fill this

gap to some extent. By 2011, this government stimulus has caused many governments to

run up huge debts which they find difficult to service. As austerity measures are

becoming a more popular method to limit expanding government budget deficits, it is

clear that most countries have run out of stopgap measures.

Why does wealth concentration tend to lead to economic expansion and then

contraction? Part II and Part III tell us much about the dynamics that caused the

imbalance between supply and demand and its association with wealth concentration,

measured by income and/or net assets. To explain howand why it happens however issomewhat more difficult.

How growing wealth inequality can cause an imbalance in the

economy

As shown inPart III, wealth concentration of financial assets in the hands of the top 20%

continued to grow from 82% in 1962 to just below 90% in 2007. This is very important

statistic because the savings that households put into financial assets will always seek

investment opportunities, either to increase the supply of goods and services or tofinance credit to the consumers who wish to acquire more goods and services. Where
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savings struggle to find an investment opportunity in any of the above alternatives,

money is often temporarily diverted to the speculation circuit where money changes

hands between speculators with the exclusive intent to profit from the speculative

buying and selling of financial assets, without any intent to produce or to acquire any

goods or services for consumption. This speculative investment may include shares,

commodities, bonds and other more sophisticated financial instruments.

The chart below illustrates to what extent each category of US household invested in

different types of assets in 2004. (Financial assets includes common stock and non

equity financial assets)

Percentage Ownership of Each Category of Assets

Source: The State of Working America

The table below shows that although the bottom 80% earned only 52.4% of total

disposable income, it contributed 61.4% to total US consumption. As explainedpreviously, factors like credit expansion and negative savings enabled this group to

spend more than what they earned from wages and salaries.


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Consumption vs. Disposable Income

Percentile of allhouseholds

(1)

Percentage

share of personal

consumption in2004

(2)

Percentage of

disposable incomein 2004

(3)

Percentage of

disposable incomein 1950

Bottom 80% 61.4 52.4 58

Top 20% 38.6 47.6 42

Source: 1 2 Structural Analysis of Over-Consumption in the US: NLI Research

3 1951 Survey of Consumer Finances: Federal Reserve Bulletin

The table below demonstrates the extent to which credit has expanded, especially fromthe eighties, and the following table show how this growth in credit was distributebetween the two US household categories (measured by income).

Total Debt as Percentage of Disposable Income


The table below confirms that the major part of the fast growth in credit in the 2000s, as

reflected in the above table, was attributable to the bottom 80%.

Calendar

Year

Mortgage

debt (%)

Home equity

loans (%)

Consumer

credit (e.g.,

credit cards)

(%)

Total debt as

a percentageof income

As a

percentageof all assets

1959 38.7 N/A 17.1 61.5 10.4

1973 39.4 N/A 19.7 66.7 12.8

1989 58.3 7.9 19.2 86.7 15.5

2000 66.3 7.7 24.0 102.2 15.0

2005 95.8 11.6 24.2 131.8 18.6


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Distribution of Growth in Debt vs. Distribution of Disposable Income

Percentile of all householdsDistribution of growth in

debt 20012004

Distribution in disposable

income (from table above)

Bottom 80% 62% 52.4%

Top 20% 38% 47.6%


Data and trends in the above three tables correlate to a great extent to the basic trends as

reflected in the US household balance sheets analysed in Part III. In fact, one could say itis the logical consequence of structural changes in the economy since the early eighties,

as describe inPart II.

In order to provide some insight as to why growing wealth inequalities are likely to

create economic imbalances, we will use simplified economic models that consist of

three interdependent modules that will focus on income from labour and investment;

production and personal consumption. These closed economic models will compare

approximate trends of the 1950s and 1960s with approximate trends observed in the

2000 to 2008 period and 2010.

Throughout thisseries of blogs, wealth inequalities and changes therein are explained bycomparing two groups: the bottom 80% and top 20% of income earners. There is no

particular reason why one could not split the groups differently, such as into the bottom

90% and the top 10%, or even the bottom 99% and the top 1%. In fact, it may be more

appropriate to use the latter in many instances. The 80 and 20% groups are used

because historic data are more readily available in this format and are commonly used to

demonstrate the effects of growing wealth inequalities on economies.

Models A, B and C below, assume that there is a closed economy with a limited number

of players. In addition, total household income ($100/$200) is assumed to be equal to

the value of all products and services produced by the economy and consumed by only

two groups (the top 20% and the bottom 80%). In the real economy, savings,

government expenditure, private investment, imports and exports, taxation, and various

other factors may also play a significant role. For the sake of simplicity, however, models

A, B and C will only address those role players and economic factors that are considered

necessary to illustrate the impact of growing wealth inequalities.

Model A reflects a situation where income distribution is similar to what was observed in

the 1950s and 1960s in the United States. The bottom 80% of households earned around

57% of total disposable income and the assumption is made that they contributed 59%

to total consumption. Model B refers to the period from 2001 to 2007, where the 80%

group earned around 52% of total income but contributed 62% to total consumption.

Model C refers to 2010 where the assumption is made that the bottom 80% share income
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(without government benefits) has decreased to 50% and its consumption to 61% of

total consumption.

In Models A, B and C the 80% group contributes mainly labour to the Production Module,

where goods and services are produced for sale to the Personal Consumption Module.

For this input, the Production Module compensates them in the form of wages and

salaries. The top 20% also contributes labour to the Production Module, but its maincontribution is financial assets (finance, share capital, etc.). For its contribution, the top

20% is compensated in the form of salaries, interest, dividends, trading profits, and other

forms of remuneration associated with its financial asset investments.

Model A: Example of a Closed Economy in the 1950s and 1960s

The total compensation paid to the Household Income Module in Model A comes to $100,

of which the 80% group receives $57 and the 20% group gets $43. The 20% group

receives a higher portion of total income if measured by individual household for mainlytwo reasons. The first reason is that it owns most of the capital; more than 90% of all

common stock and non-equity financial assets (see chart above). The second reason is

that members of this group are compensated more for their labour input due to their

higher perceived value in producing goods and services. The Household Income Module

then decides how to utilize this income. The 80% group spends its full income of $57,

plus $2 it borrowed, on the goods and services received by the Personal Consumption

Module and produced by the Production Module. The 20% group spends $41 ($43 $2)

of its income on the above goods and services and saves $2, which in turn gets lent to the

80% group.

Model A: Example of a Closed Economy in the 1950s and 1960s


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By looking at Model A, there seems to be no alarming imbalance that threatens the above

closed economy. The 80% group could have conceivably serviced the cost (interest and

capital) of the $2 it borrowed and the 20% group benefited by virtue of the interest

received. More importantly, there was a market for all of the goods and services

produced by the Production Module, which in turn led to higher profits via dividends and

interest. The system also benefited labour via wages and salaries, because the Production

Module would employ all workers required to satisfy demand. Credit plays a relative

minor role in the balance between supply and demand, compared to what happened in

Model B below.

Model B: Example of a Closed Economy in the 2000s

The situation has changed substantially from Model A to Model B. It is assumed that the

closed economy doubled in growth to $200 without new entrants. It is also assumed that

the Production Module increased the quantity of goods and services due to greater

innovation and improved productivity. Importantly, expenditure patterns and the wayincome is distributed between the two groups have changed significantly from Model A.

The total compensation paid to the Household Income Module in Model B comes to $200,

of which the 80% group receives $104, or 52%, and the 20% group gets $96, or 48%. The

20% group receives a higher portion of total income as measured by household, for

reasons described in Model A. The Household Income Module then decides how to utilize

this income. The 80% group spends its full income of $104, plus $20 it borrowed, on the

goods and services received by Personal Consumption Module and produced by the

Production Module. The 20% group spends $76 ($96 $20) on the above goods and

services and saves $20, which in turn gets lent to the 80% group.

Model B: Example of a Closed Economy in the 2000s


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The imbalance in the closed economy of Model B is obvious. The 80% groups share of

total income has diminished substantially, and it borrowed a substantial amount ($20)

from the 20% group, which enabled it to contribute 62% ($124) to the Personal

Consumption Module. The 80% group therefore maintained a higher standard of living

than that justified by its income from salaries and wages alone. On the other hand, the

20% group benefited significantly from this arrangement. It received a relatively greater

share of total income as measured by household. Its net worth was increased by way of

savings and the rising value of its investments (e.g. value of listed shares also increased).

This was mainly achieved by finding a market (Personal Consumption Module) for all of

the goods and services produced by the Production Module, which led to higher

earnings. Without substantial lending by the 20% group and borrowing by the 80%

group, there was no market for 10% ($20/$200) of the goods and services produced by

the Production Module. If they could not sell the 10% of goods and services, it would

result in overcapacity or excess production and less sales to the Personal Consumption

Module. That would have translated into economic contraction and less compensation to

the Household Module.

The imbalance comes about because the production of goods and services cannot be

absorbed by the consumers (both the bottom 80% and top 20%) without the top 20%

affording ever-increasing debt to the bottom 80%. As the 80% groups debt increases

every year by the above $20, it becomes less likely that it will be able to service it. These

imbalances, however, would not have come about if the 80% group still received 58% or

more of total income as stated in Model A and/or consumed a smaller percentage of

goods and services. However, if productivity increases and more goods and services are

produced by roughly the same resourcesmainly labour and capitaland the benefits

of productivity are not shared equally between the respective wealth groups, supply will

overwhelm demand. This growing gap between supply and demand can only be bridgedby growing credit, lower taxes, lower interest rates and negative savings as it did from

1980 to 2008 - but it could not last forever.

The imbalance reaches the breaking point when the 80% group is unable to service its

ever-increasing debt from limited income growth (salary and wages) and the value of the

collateral (mainly housing) begins to collapse. This collapse in the value of collateral is

inevitable in a bubble economy because credit fuels the rise in value, which in turn fuels

a further rise in credit (as collateral values increase) to the point where it becomes

unserviceable. The actual divide between house prices, credit expansion and growth in

income (2000 to 2007) and the subsequent implosion (2008 2009) are aptlydemonstrated by the chart below.


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Median Household Income vs. National House Price Index vs.

Mortgage Credit

Source: US Census Bureau; S&P/Case Shiller; Federal ReserveFlow of Funds Account

This inability of the 80% group to service its debts has the potential to destroy the net

worth and income of both groups. The 80% groups net worth is destroyed b y the

decreasing values of its members homes, while the value of their debt (mortgages and

other forms of debt) remains the same. In addition, as production is cut back and job

losses increase, the Production Module aims to cut costs in an attempt to remain

profitable, and to ensure maximum compensation to the owners of capital (share capital,bonds, debt, etc.). This further undermines the 80% groups ability to negotiate a higher

price for its labour, and hence leads to even less income with which to buy goods and

services.

The net worth and income of the 20% group are also threatened by the following

disturbances.

1. The value of its stock investments might drop significantly in value due to an

expected decrease in future earnings,

2. The value of its debt investment deteriorates because of increasing defaults by the

80% group and a drop in value of the collateral for that debt, and


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3. There is a decrease in income from bonuses, commissions, and other compensation

previously justified by high earnings.

The higher income groups are further threatened by a lack of liquidity and by insolvency

because they or the vehicles (banks, insurers, etc.) in which they are invested, are highly

leveraged in order to maximize profits. Because neither party (mostly banks andinvestment institutions) wants to buy the others assets above the market value and

because the sale of investments at market value could make the seller insolvent in a

crisis, trading stops and the velocityof money in the economy slows. This situation is

further worsened when the creditworthiness of trading partners banks is under

suspicion. This happened to the United States and most of the other developed countries

in 2008.

If the Fed, other central banks, and governments did not step in to save the top wealth

groups and/or its investment vehicles (e.g. banks), trading could have slowed much

more than it did; and the net worth and income of all income groups could have sufferedeven greater losses. This is not to say that the alternative of no assistance from

governments and central banks would have been worse in the long run. By supplying

more than ample liquidity, at virtually no cost, to this group s various investment

vehicles (mainly banks) against their illiquid investments as security, the investment

vehicles started to speculate and/or trade among themselves, the Fed, and the US

Treasury. This speculation and/or trading increased the value of various financial assets

(especially shares and corporate bonds) in 2009 and subsequently, thereby improving

the net worth of the wealthiest owners of capital. Despite receiving this extensive

assistance from the Fed, credit lines to most of the 80% group have been cut and the cost

of finance increased in many cases. The rationale is obvious: why lend to people whocannot service such debt, who have little hope of real income growth, who have

insufficient collateral, or whose financial position will probably deteriorate further due

to increasing job losses? Neither is it sensible to invest in further capacity as capacity

utilisation has dropped to all-time lows. Hence, trading with each other and the

government was the best option for the banks and other investment vehicles.

Model C: Attempts to stimulate demand via government

assistance

In Model C, the top income group lends its savings to the government instead of the

bottom 80%. This has two distinct advantages. Firstly, it is much more secure form of

debt. Secondly, it is just about doing the same job as their previous lending to the bottom

80%. It stimulates demand for goods and services, because government now has the

responsibility to assist the consumer (e.g. tax concessions, unemployment benefits, food

stamps, etc.) and stimulate the economy.

A further change is that the bottom 80% now receives an even smaller share (50%) of

the income cake due to its negative real (inflation adjusted) income growth and greater

unemployment. Governments attempted to fill the income gap of the 80% between

earnings and consumption expenditure but can only do so for a limited time.


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Model C: Example of an economy where government replaces top

20% as funder of bottom 80%

Once most governments debts have reached unsustainable levels, it will probably be

forced to applyausterity measures, because the only other realistic alternative is to raise

taxes significantly. Some governments, like the United States, which can print more of its

own money to fund government budget shortages, may avoid the above for the time

being. However, such money printing comes with the threat of hyperinflation.

If austerity is pursued, a major portion of demand from the bottom 80% will disappear

for good, because there are nothing (credit, lower taxes, etc.) left to fill the gap between

real income from earnings (salaries and wages) and the level of expenditure that

supported the economy in the past. Utilisation of capacity has to drop, resulting in less

investment, less employment, less income for the bottom 80% and further decrease in

demand. The concentration of wealth will accelerate and the remaining wealth of a major

former driver of demand, the bottom 80%, will continue to disintegrate. A substantial

rise in the real income of the bottom 80% can change the picture but there is little

evidence that this is likely to happen, given the structural defects in the current economy

and the US government and Federal Reserves (and many other governments) policy to

keep wages flat, as to prevent secondary inflation effects from occurring.
http://en.wikipedia.org/wiki/Austerityhttp://en.wikipedia.org/wiki/Austerityhttp://en.wikipedia.org/wiki/Austerityhttp://en.wikipedia.org/wiki/Austerity


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Due to high unemployment, there is little room for labour to negotiate higher wages.

Most increases in production are now achieved by way of increased productivity which is

made possible by requiring more input (time and labour) from the currently employed,

mechanisation, outsourcing and improving technology.

Central banks have expanded the money supply via quantitative easing in an attempt to

stimulate the economy. This liquidity flowed mainly to the owners of financial assets thatare owned (90%) by the top income groups or the financial vehicles (hedge funds, banks,

etc.) in which they are invested. The hope is that this group will invest the additional

liquidity in the production of goods and services, thereby creating extra jobs. But why

would an investor do this given the existing low utilisation of production capacity and

the continuing threat to growth in organic demand? Furthermore, in an economy where

rapidly increasing wealth concentration (measured in terms of income distribution) is

now the accepted norm, how could any new investment, hope to create more demand

than supply? If investments over the last three decades created overcapacity and failed

to keep supply and demand in balance, why would it be different this time, especially

where the beneficial support from expanding credit, tax concessions, lower interest ratesand negative savings have all but disappeared?

What do the top income households or their investment vehicles do with the increased

liquidity from central banks? They are pumping much of it into the speculation circuit,

speculating on the share markets, commodity markets and other financial assets. The

rise in the value of the above assets does have some beneficial consequences for the

economy in that it creates a wealth effect that makes consumers feel better about their

financial position, encouraging those (mostly owners of financial assets) who have the

ability to increase their spending, to do so. However, it probably has more negative

consequence because of its effect on inflation, mainly due to heavy investment incommodities (oil, copper, aluminium, wheat, etc.). These speculative investments cause

the prices of commodities to rise, and higher commodity prices are slowly but surely

working its way through to consumer products. When wage increases dont match price

increases caused by inflation forces, demand effectively drops because the bottom

income groups can buy even less goods and services (in terms of quantity) with its

limited income.

Why doesnt the 20% group spend more of its income on consumption

to make up for the loss of spending by the 80% group?

Wealthy households needs have a limit. It is similar to the law of diminishing returns;

that determines that for every additional unit that one consumes the added benefit or

satisfaction that one derives from it diminishes. For example, say a household has bought

four cars for each inhabitant. It is unlikely that there is a need to buy a fifth or sixth car.

Irrespective of his or her wealth, few people want to buy 100 cars simply because they

can afford to do so. The same goes for food, clothing, electronic equipment, and so forth.

Once the needs of a household have been satisfied, it will tend to save the balance of its

income. On the other hand, most of those in the 80% group have little discretionary

spending and are more likely to have many unsatisfied needs that they would like to

satisfy if they could. Thus the 80% group would increase spending and consumptionsubstantially if it had access to additional income or credit.


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Conclusion

Organic demand can only come from an increase in real personal income, especially

those income groups that are more likely to increase its consumption expenditure as

their incomes increase. This lies at the heart of the dominant causes of the Credit Crisis

and a stuttering economy. Economic policy that in effect opposes real wage increases,

does not give much hope for the future.

Increases in businesses inventory levels, speculative investments in commodities, lower

interest rates, government stimulus and quantitative easing may have been a relatively

successful stopgap measure that supported economic growth from 2009 to 2011. It may

even continue for months or another year, but the hour of truth is drawing nearer as

these stopgap measures cannot continue indefinitely. Continuance of some of the above

stopgap measures can by itself cause future economic ruin.

Neither Britain nor Irelands austerity measures have produced convincing evidence that

it could save the day or serve as an example to prevent economic ruin. In the end we maybe left with two choices: find a way to increase the income of the lower income groups or

face up to severe economic contraction.

In future blogs we will expand on the inflationary effects of excessive savings, low

interest rates and quantitative easing.


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David Collett is a chartered accountant with more than 25 years experience in the field of

forensic investigation. He has acted as an expert on many subjects such as business,

investment and share valuations; fair presentation in financial statements and prospectuses;

lax credit standards, credit risks and professional liability.

Over the past decade he closely followed the financial markets. Through a series of

presentations made to the finance and investment communities, he forecasted the collapse of

financial markets and the 2008 stock market crash.

For more information about David and his work, please visit:

http://www.anchorage-investments.com.

Copyright David Collett 2011.

Whilst every effort was made to ensure the accuracy of this article, neither this document; nor its author,

David Collett; nor any publisher of this article; offer any warranties (whether express, implied or

otherwise) as to the reliability, accuracy or completeness of the information appearing in this article.Neither do any of the above parties assume any liability for the consequences of any reliance placed on

opinions expressed or any other information contained in the above article, or any omissions from it. Its

content is subject to change without notice. Any information offered, is intended to be general in nature

and does not represent any investment or business advice of any nature whatsoever. If you choose to

rely on such information you do so entirely at your own risk. Neither David Collett nor any third party

involved in publishing this article, assume any responsibility or liability for the outcome of such reliance .

Contact Us:[email protected]://false-gods-fleece-the-faithful.com
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Dominant Causes of the Credit Crisis Part4: Where did the demand for goods and services go?

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