Saturday, January 31, 2009

Open Letter to President Obama

Dear Mr. President:

Ref: Accept Some Deflation─ Caused by Permanent Demand Destruction─ in Your Bailout Plans

I admire your tenacity and the tenacity of your financial management team in their efforts to rescue our financial system from a systemic collapse.

I’m sure the financial rescue plans, as engineered by your financial rescue team, are well thought out and have considered a wide range of possible scenarios and outcomes, including the possibilities of inflation [caused by trillions of bailout dollars pumped into the system] or deflation [from huge permanent demand destruction in products, services and credit].

Deflation caused by permanent demand destruction for products, services and credit is a reality [and not just a possibility] and could impact the outcome of your teams rescue plans. Here’s why some degree of deflation [caused by permanent demand destruction] can be a good thing in your efforts to re-ignite moderate inflation into the financial system. Your financial rescue plans might just work [because of some degree of permanent demand destruction] in solving the current financial crises…

In summary, what your financial rescue team is doing: “Injecting trillions of dollars in the US economy, the Fed is luring the consumers [and speculators with leverage] back to the same old habit [that got us into the current financial mess in the first place] of living beyond our means to borrow and spend.” After spending trillions of dollars, the Fed will eventually succeed and cause inflation and that in turn will force Fed to raise the interest rates at a later date causing another asset class─ the Treasury-Bond─ bubble burst. And the “boom-bust” cycle will repeat itself, perhaps of a much smaller magnitude given the possibility of tighter banking rules, regulations, regulatory oversight, tempered leverage, global risk aversion, and of course the permanent demand destruction.

For this scenario─ preventing deflation in exchange for future boom-bust cycle of much smaller magnitude─ to play-out, permanent demand destruction will play a major role. Without the existence of permanent demand destruction, the trade-off between “preventing deflation” vs. “accepting the boom-bust cycle of much smaller magnitude” will not work. Some degree of Permanent Demand Destruction for products, services and credit, in the near future, is desirable and hopefully will materialize as a reality. Here’s why…

Most economic models and analysis approach the inflationary issues as a two dimensional model like… action and reaction… supply and demand… price and quantity… money supply and interest rates… interest rates and Bond bubble.

Unfortunately it is not that simple and most everyone approaches the “supply and demand” as a two dimensional economic model. The two dimensional approach to economic analysis seemed to have worked fine in the past because, even though the third dimension [permanent demand destruction] existed in the past, its impact was not huge [because of population growth, immigration and rise in living standards from much lower levels] and it was not realized for a long period of time due to slow consumer reaction to changes. And when the impact of this third dimension [demand destruction] was realized, it had arrived slowly and since its impact was not felt immediately… it was, therefore, considered as the result rather than the cause in the economic models. In summary let me explain…

There is a third dimension [demand destruction] that needs to be considered in any economic model in this day and age… the age of instant communications and the Internet. This third dimension is the “permanent demand destruction” from today’s informed consumer… the buyer of products and services who is also motivated [now] with the desire to store money, in one form or the other, for the future. When you enter the permanent demand destruction in to the equation, your argument of money supply… inflation… higher interest rates… Bond bubble burst scenario will not hold in the near future. In my humble opinion, this time it will play-out differently from the conventional wisdom…

Permanent Consumer Demand Destruction for Products and Services:

When you permanently destroy huge demand [by the consumer], the supply side [businesses] make adjustment to their business model by cutting production, cutting CAPX, cutting operating cost and letting employees go. In this scenario when there is less demand from consumers [and businesses] for both cash and credit… the risk of Bond bubble bust is delayed if not mitigated altogether. The argument in favor of consumer driven demand destruction is as follows…
The consumer of today recognizes that the trillions of dollars poured into the US [from all over the world] and that is what supported their credit binge to spend and spend. The [almost] free money pushed the consumers to rush into buying products and services they did not really need, rush into tech stocks, then the rush into real estate, then the rush into commodities, and then rush into U.S. government bonds. Over the years all of these asset classes [except the U.S. Government Bonds for now] have blown-up in the consumers face. Not only that, the financial machinery that funneled trillions of dollars of the free worlds savings [from across the globe] into the US financial system has now blown-up as well and the money velocity has come to a screeching halt. Banks are over leveraged, they don’t trust each others financial health and they are not lending.

Consumers are not borrowing either; they are downsizing and cutting cost…

· Banks are not lending to qualified consumers… but that could change;
· Consumers has little or no equity to borrow against… not going to change anytime soon;
· Days of free money are gone forever… because the savers from all over the world are now wise to the financial shenanigans of American financial wizards and are not looking to send their life savings to America any time soon;
· Consumers are now motivated, by the blow-up of almost all asset classes in their faces, to start saving money for their future commitments and retirement… going from negative savings to almost over 6% now;
· Consumers finally realize that they don’t really need three of everything [homes, cars, jewelry, minks/furs, TVs, cell phones, computers, and electronic gadgets].
· Consumers finally realize that they don’t need to buy a Hummer or new model car every other year;
· Consumer finally realizes the rising cost of energy for driving, heating and cooling… the present drop in cost is temporary we all know;
· Consumer finally realizes that the increasing cost of real estate taxes even though their homes are 40% less in value to-day… taxes always go up and not down;
· Consumers finally realize that they don’t need to re-model every five years and buy new appliances every three years;
· Consumers finally realize eating home can save them thousands of dollars over the course of the year;
· Consumers are loosing jobs left and right in all sectors of our economy… there are no safe heaven… not even in the health and consumer goods;
· Consumers are de-leveraging en-masse and there are no asset classes worth investing [speculating] at this time… and perhaps for a long time.

The studies indicate that by the end of year 2008, there will be over 1 billion Internet users. That means, most all of the educated population of the world, will be globally connected by the Internet. And the boundaries of time and space will disappear. People will gather in public forums of their common interests to network and share information. These people will be the consumers, investors, vendors, partners, friends, enemies, management, or employees of the public companies. In a public forum like this, that allows us to maintain our anonymity, there will be no place to hide for the incompetent or the unscrupulous.

Add to this Internet phenomenon the instant communications afforded by the TV, and its producer’s desire to provoke debates on issues, that in the end, when all is said and done, informs and educates the public at large. What you have is a well informed, wiser and more responsible consumer that is all set to “destroy demand” for the un-necessary, unscrupulous and the irrelevant.

Permanent Businesses Credit Demand Destruction:

Businesses now see this consumer demand destruction as a clear reality and are adjusting their business models accordingly by cutting production, cutting CAPX, cutting operating costs, de-leveraging finances and letting employees go. And as such, eventually, after the initial denial period to accept demand destruction, there will be less demand for cash and credit from these businesses.

On surface it seems that if these businesses could borrow money earlier, like in the August/September time frame, they might have postponed downsizing and waited a little longer before letting employees go. However, that window of opportunity is gone and the reality of wide spread “demand destruction’ has become a reality. The reality of demand destruction is apparent in thousands of employees being laid-off by bellwether companies like Microsoft, Google, JP Morgan and the like.

Granted, that in due time the wealthy consumers and businesses will come back into the credit markets to borrow so they can speculate in products, plants, production, stocks, commodities and real estate. But that time is years away, when there are clear signs of stability and growth in any of the known asset classes for investment.

Permanent Destruction of Collateral Asset Values at the Financial Institutions:

To this witches brew, let’s add the cause of our current credit crises and see what it means for the free supply of money in our financial system. I’m sure you and I both have our own set of facts, analysis and opinions. But the core fact that no one denies is: “the leverage used at financial institutions world-wide and lack of regulatory oversight was the main cause for this global credit crises.”

The regulatory oversight, or lack of it, will be debated and some day there will be rules and regulations in-place to prevent future systemic melt-down and risks. In the meantime, however, either because of banking laws or because of banks own desire to mitigate risks in this financial environment, the banks and financial institutions out there are busy trying desperately to de-leverage. This means banks [and financial institutions] will first try to shore-up their equity/debt ratios before lending out the money received from TARP and other Fed bailouts. There is, by the latest estimates, over $3 trillion dollar in systemic losses in the US alone. The money losses did not change hands… it just vanished in thin air. What are left behind, however, is the un-acceptable levels of leverage, collateral risk and vastly impaired equity/debt ratios at US financial institutions.

In summary, before we see inflation we will first see some degree of deflation due to permanent demand destruction for products, services, and credit. If we are lucky and the trillions of dollars in Fed money do work, in the best case scenario, we may see Stagflation and not reach full-fledged deflation. That is our hope!

Please plan for [and accept] some degree of deflation from permanent demand destruction in your agenda─ to introduce inflation in our financial system─ to fight the specter of full-fledged deflation. Hyper inflation [as the result of trillions of bailout dollars injected by the Fed] in the short term does not seem possible in view of deflationary pressures of permanent demand destruction for products, services and credit. However, any effort to flood the economy with freshly printed money, or borrowed money, will not bring the demand levels to “the way we were” before this financial crises. A flat or moderate growth in GDP, for the next few years, seems to be the most plausible scenario and that’s what your administration should plan for!

Limited amount of bailout funds for our financial institutions is, perhaps, the right thing to do. However, excessive amount of bailout funds will only attract the unscrupulous and not bring the consumer demand [and the GDP] to the levels of recent past. In all probability, these bailout funds will not reach to those intended and only line the pockets of the same greedy, unscrupulous, and self-centered tarts that got us in this financial mess in the first place.

Please, for God sake, don’t entice the consumers and businesses to go back to the old ways of borrow and spend… and live beyond their means. No society or civilization that lives beyond its means has ever survived. History is our witness!

God bless America.

Anant Goel