Thinking in Trillions

The US economy is a multi-trillion dollar train-wreck. President Obama said it correctly last Monday during his news conference when he explained that it is not your usual recession. As a matter of fact, his Q&A - thanks to the precision and power of his thinking - makes an impressive education to the layman of what is going on and his logic for the stimulus package.

And I have been tempted for sometime to explain how that is so based on my understanding of economics. Here I shall try.

The total financial asset of the US economy is about US$55 trillion ("T"). That is the aggregate value of all homes, fixed assets, corporations, personal savings, stock, bonds, real estate etc. Think of that as total net worth.

The US economy produces US$14T of GDP a year. That is approximately 23% of the global GDP which makes the global GDP to be about US$60T. Think of that as income.

The US Federal Government makes up US$2.9T of the GDP, which is the amount it spends. To fund it, in 2008 it collected US$2.6T in taxes. The rest US$0.3T is the deficit funded through borrowings.

The total US Federal Government debt is nearly US$11T, which has risen US$5T within the last 8 years.

The stimulus package will add US$500bn of new spending (the remaining US$300bn will be tax cuts) in the next two years. Pro-rated to US$250bn of new spending a year means adding 8.3% to the federal budget annually. If the entire stimulus - both spending and tax cuts - were to be totally debt funded (which is likely), it will add 7.2% to the US Federal Government debt.

The stimulus spending of US$250bn per year is half the defense spending (38% if the running costs of wars in Iraq and Afghanistan are included); which is about the same as the amount for debt service (in 2008); which is about 40% of Federal expenditures on Medicare and Medicaid.

Now, lets consider the first of four crises, the mortgage crisis.

The total value of US home mortgages is about US$10T. Banks holds those mortgages as "assets" both through direct mortgage lending as well as an investor in mortgage derivatives.

The home mortgages are collateralized against the value of homes. The aggregate value of US homes peaked at US$13T in 2006 and has fallen to about US$8T - 8.5T, meaning US home mortgages as a whole is US$1.5-2T under-water. The "wealth" destroyed by this asset-deflation/bursting-of-the-bubble is bourne by both homeowners and banks.

Which brings us to the second crisis, the financial crisis.

The total capitalisation of US banks is about US$0.6T.

As the banks' asset value which were held as mortgages (or mortgage derivatives) decline, that will need to be written-off against the bank's capital base. Assuming that homeowners take the first hit (because banks tend not to lend 100%) the exposure of banks are still between US$0.5T - US$1.0T ... and growing by US$0.1T for every additional 1% fall in house prices. At this rate, US$0.6T in total capital base can disappear quite quickly and that's how banks become insolvent.

Hence the US has been under a financial crisis (at least since March 2008) because as banks are straddle with bad assets and fighting against insolvency, the ability of the US financial system to keep functioning comes under threat.

Which brings us to the third crisis, the credit crisis.

Banks are just one of many players in the financial sector. At any given time, financial transactions take place between any combination of counterparts: brokerages, insurance companies, pension funds, investment funds, credit card companies, trade credit, hire-purchase, car loans, student loans, commercial credit lines, consumer pre-payments, notes/bonds (issued by governments, local governments, municipalities, corporations, public bodies etc.). They all have one thing in common: credit i.e. people parting with their monies because they believe they have enough trust the counterpart to get the money back.

Since September 2008, many of these markets are in different degrees of dysfunction. However, due to aggressive intervention by the Fed in September and October, the worst did not come to pass. Nonetheless, there is still a significant contraction in the amount of credit available within the financial system (e.g. the commercial paper market shrank from US$2.2T in mid-2008 to US$1.6T in Feb-2009) and any that is available is a higher cost.

Which brings us to the inevitable - the economic crisis.

The economic crisis is not about the wealth of the US economy rather it is income (remember, the US$14T a year).

Imagine the US economy as a human body (as we will discuss later, it is not even a particular healthy one). It just encountered (1) a huge trauma - lets say it has a seizure from partying for 72 hours running [the mortgage crisis] - which reduced the blood flow to the heart causing (2) a heart attack [the financial crisis] which caused (3) a sudden (but thankfully temporary) fall in the blood flow to around the body [the credit crisis], which unsurprisingly caused (4) massive cell damage leading to organ failure [the economic crisis].

However, the US economy itself is the only thing that can fix all its other crises - and over time, there is no doubt it will because the US economy has structural advantages such as favourable demographics to push growth along. For as long as the US economy keep going, it will generate US$14T of economic output a year to slowly plug the hole from lost asset value from the mortgage crisis, to recapitalize the financial system, to generate cash flow to pay and reassure creditors ... and ultimately to make the economic wheel go around again i.e. maintain the productive capacity* of the economy to generate the next US$14T or more of economic output.

What has been fuelling the productive capacity of the US economy has been personal consumption - 72% of the GDP - partly debt fueled. Personal consumption in the US has been on uninterrupted growth since 1978. With the fall in house, equity value and pension funds, the total fall in US personal net wealth in 2008 was almost US$9T - coupled with the tightening of the credit market - personal consumption is falling drastically.

The current estimate is that the US economy at current rate will fall US$1T below its productive capacity annually for the next 2 years i.e. a -7% contraction in GDP. The stimulus package @US$0.4T annually will not make up the entire shortfall.

And critically, consumption - unlike investment - does not by itself grow the productive capacity of the economy. If we think of the productive capacity of the economy as cells in the body. During injury or illness, cells tend to die, even-though the body needs to have them in order to recover. Anytime a worker is laid off, investment is reduced, production is cut, technology/R&D is cut, the productive capacity of the economy is reduced. For the US economy, the body has been keeping itself alive (or even look outwardly robust) mostly through junk food that merely kept the body going but did nothing to keep it healthy or growing. What this also means is that the productive capacity of the US economy has not been growing at a self-sustaining manner through a positive return-on-investment. Instead, it has been growing in a zero-sum-game through consumption which do not have a return.

Any visitor to the US expecting to see 21st century infrastructure or technology would in most case be disappointed. Airports, highways, telecommunication systems, public transport are often 25 years or older. In fact, many date back to the Works Progress Administration projects by FDR as his stimulus program to bring the US out of the Great Depression.

That is both a challange as well as opportunity for the Stimulus Package. Because so little investment has been taking place the return on investment should be pretty robust - every $ invested may yield a large multiplier of economic effect - which in turn will expand the economy's productive capacity. That is important because there is no point to an economic recovery by merely going back to where it was before. To recoup the costs of the Stimulus Package - plus the much larger costs of recapitalizing the financial system and restore the wealth lost to the mortgage bubble - the US economy need to grow to have more productive capacity than what it had earlier. That is the key: because every 0.1% in additional growth in the GDP will over 25 years painlessly recoup the costs of the Stimulus Package ... and doing so in the right way by growing the productive capacity.

So I believe it is right that Obama included billions in what he called "down-payments" for his goals to invest in other areas for economic reforms: alternative energy, energy efficiency, health care reform, education, scholarships and infrastructure. If anything, I hope he will use this as a springboard to reform and reinvest in those critical areas of the economy even more in the months to come.

Investing in structural reforms of the economy stands to repay the short-term spending many fold in the years to come. It is true they are not the purist view of stimulus for stimulus-sake because they take longer to implement and so the effects are slower but the return-on-investment - from structural changes to the economy - is potentially huge. They are the catalysts to shape the "creative destruction" of the current economic model as it evolve into one hope to be a larger, stronger and more sustainable one. For example, US$2T of annual US economic output comes from the most wasteful healthcare system in the world. If reforms means the US spends as much per capita as Canada (who does not seem to be doing too badly) that is US$1T a year of additional lift to the US economy - and lesser drag on the competitiveness of US corporations for whom employees' healthcare is part of payroll costs. Likewise for energy and transportation infrastructure.

It is a dillemma that policy choices during a downturn is often counter-intuitive and contradictory to the longer term choices. Whatever the virtue of cutting personal consumption, if it keeps falling too drastically that is a lot of productive capacity to be lost making recovery even harder. So personal consumption has to be brought to a soft-landing, particularly stimulus spending can double as a social safety net targeted at maintaining the health, shelter and food needs of the unemployed and for his family. In the US, if you lose a job, you lose healthcare for the whole family and without the income you may lose your home, and the downward spiral beckons. Whatever the arguments for and against a welfare state, there is a social and economic cost to ignoring anyone to lose his health or his home or not being able to feed himself. What is broken often takes longer to fix and by ignoring his plight society makes it harder for him to be productive again. So this component of the Stimulus Package cannot be ignored.

Lastly, it should not be forgotten that in the US, most public services are provided by the States through their own budgets raised from local taxes. Because of their heavy reliance on property tax and sales tax, state budgets are decimated by the economic crisis. What is making it much worse is that most states have a balance-budget-requirement in their constitutions; i.e. when tax revenue falls they are legally obliged to cut their expenditure accordingly. So what gives? State and local level taxation maintains the school system, public hospitals, funds public transport, funds the police, paramedics, fire service and local services like parks and libraries ... which is just about all the most important services that underpins a civilized society. The Stimulus Package allows the States to get an infusion of Federal money for the State's portion of Medicare and Medicaid obligations (which often consumes the largest share of the budget - and in a recession this can only go up as more people fall into poverty), thus cushioning the amount of cuts that will be required on other areas.

One often forgets the difference between a civilized society and the uglier faces of capitalism (think of how many cities where the rich live behind walls keeping crime and squalor outside) comes down to public services that maintain a minimal quality of life for everyone. The impact of cutting one public bus line, or closing the local park, or letting crime go up, or cutting funding for schools means a lot to society. I read in St Louis that as the city considers which bus route to cut, hundreds worry about having having no means to get to work, seniors cannot get to the hospital etc. For others, these are jobs: bus drivers, policeman, librarians etc.

Going back to our patient, its been said in cardiology that "time is muscle". The faster you treat a heart attack, the less the muscle damage and the better the chance for recovery. What has been done so far only stablizes the patient: the Fed provided emergency blood transfusion (The Fed and FDIC flooding the market with US$trillions in funds and guarantees) and the Stimulus Package provides shot of drugs to keep the heart pumping and stimulate tissue-repair. Unless policy makers act quickly to save the destruction of the heart muscle (i.e. the productive capacity of the economy undermined through job-loss, good companies going bust, investments pulled), it would be very difficult to fix the heart attack [financial crisis] and to allow the body to recover from the trauma [mortgage crisis].

So I see the Stimulus Package as the necessary first-shot in a multiple-course treatment. Collectively as a society, asking to borrow and spend 3% of the annual income or 0.7% of the total wealth to keep the economy and society from crashing, it is small money especially when compared to the scale of the challenges and compared to the potential for pay-back. It is a small start to a long and expensive treatment that will continue with finding the US$1 - US$1.5T to recapitalise the financial system ... and eventually to structural reforms that will require US$20T to fund the health care and retirement of the US baby boom generation ... and move to a alternative energy economy .... to educate the largest number of school age children in US history.

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This article is partly inspired by a marvellous must-read article in the NYT. The Big Fix - The Real Economic Challenge for Barack Obama

http://www.nytimes.com/2009/02/01/magazine/01Economy-t.html