Friday, November 11, 2011

How we could have avoided the 2008 recession & How to avoid similar ones in the future

Nobody likes a Monday morning quarterback or Captain Hindsight, but I think that it's important to discuss how we could have avoided the 2008 recession so that we can: a) get out of the economic funk we are still in, and b) to avoid or to minimize the damage from future bubbles that might arise.

In a previous post, I mentioned that the main cause of the 2008 recession was the high price of gasoline. This doesn't mean that there weren't other causes; it just means that we should talk about the disease (high oil and natural gas prices), and not just the symptoms (people foreclosing on houses because they were losing their jobs because of the high oil and natural gas prices.)

Sure, we hear about the housing bubble as major cause of the 2008 recession. But remember that we had a large tech stock bubble in the 2000's and we didn't have a massive recession in 2000, like the one in 2008. When you think about it for awhile, you're realize that a bubble alone can not be the cause of a recession. Let me explain this in detail.
    Let's image that we all own stocks in Company A. All of a sudden, the stock price of Company A starts increasing rapidly. If we think to ourselves "That's nice, but let's not act as if I'm now richer", then we will be okay when the price of the stock drops. The problem occurs when we convince ourselves "This is great, now I can take out a loan to go on a nice vacation."  In this case, when the bubble bursts, then you are left with a loan that you must (and should) pay back. So, the problem is not the bursting of the bubble; it's the mindset that the bubble was real and that this means that you can spend more money on luxuries than is justified based off your actual income.

What I think happened, between 1998 & 2000, is that people on average did not significantly increase their consumption of luxuries, even as stock prices of internet companies were going through the roof. Many people continued to work hard and continued to purchase luxuries just the same as before, and instead assumed that their increasing internet stock investments would mean that they could retire sooner than expected.
On the other hand, between 2003 and 2007, people on average did increase their consumption of luxuries, such as houses larger than what they could afford. We collectively forgot that a house is not an asset. (For example, the price of a car depreciates with price...why did we all think that the price of a house should increase in time?)



Some people who owned over-valued stock investments during the bubble thought that they were rich, and ended up buying expensive houses 'knowing' that they could always sell their stock investments to pay the housing loans. Some people ended up spending more on luxuries than could actually be justified once the bubble burst, and as mentioned above, some people spent money on luxuries (such as houses) thinking that these luxuries were actually assets that increase in value with time. [Think about the fallacy of this logic:  if a house were really an asset that increased in value, then we all should purchase as large a house as possible and watch its price increase in value in time. However, if we all purchased large houses, we'd be consuming large amounts of exergy building the houses, but the houses don't help us find new sources of exergy (solar, fossil fuels, geothermal, wind, nuclear, etc...) and the houses don't generate work from those sources of exergy, they consume exergy, that's it. A house protects the people living there so that they can go out and make a living, but the house itself is not an asset in the same way that a power plant is an asset.]

But we can't go through life always afraid that what we are investing in will be nothing but a bubble. The real question is:  How do we know know when an increase in our investments is real and when is it just a bubble? Is there a way for us to tell real wealth from false wealth?

I have two answers to this question:
1) At the global level we can differentiate between real wealth from false wealth by measuring the production of work (in kWh) and the rate of growth of the production of work (% growth / year.) When the real growth rate is near zero or negative, then we need to change our consumption habits.
2) Though, at the local level of investing in an individual company, the only suggestion I have is that we must all do a better job of researching the companies in which we invest. And asking ourselves the question: can this company really provide a positive rate of return on work invested? For example, are we investing in this company because we have wishful thinking or because we have done our homework and expect this company to produce a positive rate of return on work invested?

When we don't do our research, it's easy for us to create bubbles. And what ends up bursting the bubble? Reality 
We don't live in a post-modern world where if you believe something is true, then you can always make it so. We live in the real world, and in the real world, societies have to generate a positive rate of return on the mechanical and electrical work invested. If they don't generate an overall positive rate of return on investment, they begin to shrink. And nobody enjoys being in a society that's shrinking; we'd all rather be in a growing society. But on the other hand, most of us would prefer to spend money on luxuries than spend money on assets like natural gas wells, pipelines and power plants. Most of us prefer to act as if we were rich, and let other people do the hard work, like being roughnecks, electricians, pipe-welders, coal miners, steel workers, power plant design engineers, cost-estimators, and project managers, to name just a few difficult and productive jobs.

The problem between 2005 and 2008 was that we collectively acted as if we could continue to spend, spend and spend more on luxuries (spending on houses rather than oil wells, cars rather than pipelines, fancy clothes rather than power plants.) But this spending on luxuries above what could be justified by our generation of work could not continue forever as the price of oil and natural gas prices were increasing between 2005 and 2008. This incresase in the price of gasoline and natural gas was due in part to demand and due in part to the decreasing rate of return on work invested in producing gasoline and natural gas during this time period, such as the decline in production in Mexico and the North Sea, the slow trend towards heavier and sour crude oil, and the disturbances such as Hurricane Katrina or terrorism against pipelines in the Niger River Delta.
(Though, it should be noted that the rate of return of oil and natural gas production has increased recently since the development and improvement of horizontal drilling and fracturing techniques. And this gives us hope that if we decide to invest more in productive assets like natural gas wells and natural gas power plants, we can get ourselves out of this rut that we face.)

The drop of stock prices from mid 2007 until early 2009 was due mostly to reality kicking in. People eventually realized that their so called "assets" might really be worth a lot less than they paid for it. This sucks for those people (like myself) who own large toxic-assets, but we (and I) don't have anybody to blame but ourselves (myself.

When the price of oil and natural gas was increasing between 2003 and 2008, we should have cut back on luxuries so that we could invest more of our money into drilling for oil and natural gas. Instead, US companies (via commercials and advertising) told us to continue spending money on luxuries (as if spending money on luxuries could keep the economy going), and the US government continued to spend, spend, and spend more (spend money, regardless of whether it was on luxuries or productive capital, thinking falsely that any type of gov't spending would have a positive return on investment.) The US government was spending money on two major wars, subsidizing ethanol, subsidizing prescription drugs, and fighting wars on drugs and terror. How did the government afford all of this while oil and natural gas prices were increasing and while taxes on the wealthy were cut?   In part, the money came from borrowing from China, and in part, the money came from printing money via the Federal Reserve & US Treasury.

The problem with printing money when the economy isn't actually growing is that this especially hurts the poor and the middle class. When the currency inflates, then the purchasing power of the dollar decreases. The poor and the middle class can't purchase as many items with their dollar as they used to be able to purchase. Well, here's the problem with that. The poor and the middle class spend a larger portion of their after-tax income on items that have a positive rate of return on investment, such as cars to get to/from work, food, and health care to stay alive.

Even worse than just increased spending, the US government decreased the tax rates for the wealthy. The problem with decreasing the tax rate for the wealthy is that it encourages the consumption of luxuries (i.e. objects that don't provide a positive rate of return on work invested.) Higher taxes forces the wealth to re-invest their profits back into companies with positive rates of return on investment. Examples of luxuries include, but are not limited to, fancy cars, fancy houses, drugs, fancy clothes, yachts, luxury boxes at sports venues, extreme sized TVs, and vacations in Patagonia. The reason that all of the items listed above are luxuries is that they all consume electrical and mechanical work, but they don't have a return on the work invested. For example, building and sailing a yacht is a compete waste of exergy. It's a status symbol. Luxuries are fine if the economy is growing, but not when the economy is shrinking. Instead, when the prices of gasoline and natural gas were increasing, we should have increased taxes on luxuries. More money needed to have gone into the exploration and production of exergy resources with positive rates of return on investment. Taxing luxuries incentives us to reinvest our money back into productive enterprises and discourages the consumption of luxuries. Of course, this is not what we did leading up to the 2008 recession. We collectively created a bubble of false hope that purchasing luxuries is sustainable, and eventually reality popped the bubble.

So, how do we learn from the past and improve our current economy?

1) Maintain an electricity-backed currency (i.e. have a currency that maintains a constant average price for the generation of electrical and mechanical work, and therefore eliminates the inflation tax that hurts the poor and middle class.) Maintaining a constant price means removing currency from circulation when the prices for electrical and mechanical work increase, and it means printing more currency when the prices for electrical and mechanical work decrease.

2) Increase taxes on luxuries when the prices of electrical and mechanical work increase. Decrease taxes on luxuries when the prices of electrical and mechanical work decrease. One way (though not necessarily the best way) to implement a tax on luxuries is to tax that part of one's income that doesn't go into productive enterprises. And when the economy is doing well (i.e. electricity and fuel prices are decreasing), it is possible to decrease the tax on luxuries because the government is able to bring in revenue by printing money to maintain a constant price for electricity and fuel. This process of increasing or decreasing the tax on luxuries based on how well the economy is doing will incentivize all of us to make sure we are part of a growing society. It incentivize us to work hard so that we don't see an increased tax rate.

This two-fold process provides a feedback mechanism for the economy. It forces us to shun luxuries when fuel and electricity prices are high, and it allows us to be more libertine when fuel and electricity prices are low. Instead, what happened in the decade of the 2000s is that there was no feedback mechanism to tell us that we should be consuming less luxuries as the price of gasoline was increasing. Instead, you had a President of the US who continued to tell people to consume, consume and consume some more, even as increasing gasoline prices were lowering the rate of return on investment of our productive assets, such as power plants and vehicles.

You can call the two-fold process described above a form of "feedback control" or "chaos control", but it only works if governments obey the rules that they initially lay out. This means that the rules should be automatic, and not left to some politician to actually implement. If the government are not forced to follow the rules, then politicians will be likely to break the rules because most politicians are short-sighted and don't want to increase taxes on luxuries when electricity prices are increasing. If the feedback mechanism isn't automatic, then feedback mechanism described above most likely won't work and it won't get people to change their bad habits (such as buying expensive houses even as gasoline prices are going through the roof.)

And with that, I welcome comments and suggestions to the two-fold process described above.
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Note: the definition of a luxury item in this post is very different from the definition of a luxury good on wikipedia. They define a luxury item as a good for which demand increases more than proportionally as income rises, and is in contrast to a "necessity good", for which demand is not related to income. I think that this is a silly definition because it misses the whole point of what a luxury item is. It's a status symbol that can't be used to generate a rate of return on electrical or mechanical work invested into the product. It's something we purchase to show other people that we have an underlying positive rate of return on investment, and therefore, we are somebody with whom you should be a friend or a business partner.
In contrast, the purchasing of (most) food can be seen as a non-luxury because some types of food are used to generate a positive rate of return on investment, i.e. you require food in order to move and to think.

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