January 24th, 2006

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Is the econ meltdown coming?

Bank America announced a drop in profits as a consequence of consumer bankruptcies. This follows on JP Morgan missing earnings estimates based on higher than expected credit card defaults.

This may just be a blip. The change in the bankruptcy laws that took effect last year making it harder to discharge credit card debt encouraged a rush of filings, impact from Katrina and Rita, spike in oil prices, etc. all would produce a spike in credit card default and loan defaults.

On the other hand, I've been waiting for the "nightmare meltdown" scenario for awhile as one of my ways the economy could collapse. It works on the theory that the current economy is rather like a giant Ponze scheme. Consumer spending drives overall economic expansion. That's financed by debt and refinanced by home equity. All of which is supported by low interest rates.

But, unless real wages rise, the cycle can't last. And real wages have not generally been rising when adjusted for inflation (although they have in certain economic sectors).

In the happy version, we get a tappering off of spending and a "soft landing." As home prices stabilize and interest rates rise on both home equity loans and credit cards, gradually diminishing consumer spending. This limits inflation. At the same time, tax cuts fuel needed investment in infrastructure (making businesses more willing to spend on workers and products, increasing wages and maintaining economic activity as consumer spending tapers down)and boost business and consumer confidence. While not the same strong GDP growth, we maintain the "Goldilocks economy" of just right growth, low inflation, and modest gains in real wealth.

In the meltdown version, the rise in interest rates increases the default rates on credit cards and mortgages. Lending institutions do what they need to do to maintain profit margins -- they increase rates. In addition, banks foreclose on properties in default. The rise in rates puts pressure on over extended consumers, further increasing defaults in a viscious cycle. Meanwhile, foreclosure dumps new housing capacity on an already saturated market. This drives home values down and reduces the number of new housing starts, which has been a significant driver of the economy. The rise in interest rates and defaults drops consumer confidence and creates a significant decline in consumer spending triggered by higher interest rates, tighter credit, and diminishment of the "wealth effect." The drop in consumer spending creates a further drag on the economy, creating further job losses and defaults.

The changes in the bankruptcy laws will make it difficult for middle income and upper income consumers to shed debt. This will further inhibit needed consumer spending (since under the new bankruptcy law, the bankruptcy court must appoint a trustee that will devote protion of the bankrupt's income to paying credit card debt). It will also create a large amount of "bad debt" held by banks and other lending institutions, which creates a further drag on the economy (one of the factors in Japan's lengthy economic malaise was the inability/refusal of lending institutions to write off trillions of yen in bad debts, creating artificial assets that could not be redeemed and incurred expenses to maintain, and which made the institutions unpalatable for consolidation or investment).

Since these factors are synergistic, we should expect a "snowballing" effect over a relatively brief period of time.

One can postulate a variety of possibilities between "soft landing" and "meltdown," particularly dependent on the willingness of government to intervene if a crisis begins to emerge. Of course, how the current government fiscal situation will impact the ability to respond is another unknown.

All I can say is if we were a developing nation with this economic situation, IMF wouldn't lend us a dime until we got our deficit and balance of trade under control. OTOH, there is something to be said for the fact that the U.S. is enough of a special case to deserve different rules.

But I will look with interest at the results for other lending institutions, and for subscription services. A rise in the defaults on cable subscriptions outside the area impacted by Katrina, for example, would be another useful straw in the wind.