A Hypothesis

Historical data shows us that price drops typically follow market contractions. Why? Simple. People have less disposable income, there is less consumer spending, therefore the goods that are suddenly stuck in the supply chain must be moved out less the distributors be crushed by the debt that financed the acquisition of these products. What is the response? Drop prices, and liquidate. This was, for example, clearly seen in Brazilian coffee prices immediately following the market crash of Black Tuesday. Prices fell 30% to 60% almost overnight, sucking all of the money out of the state run system for coffee trading, killing government revenue, depleting gold reserves, and leading to a revolution. Why am I talking about Brazil and coffee prices? Simple. I was browsing the BLS data sets today when I noticed a set of numbers that at first appear to be quite nice, but in reality are the surface indicators of something far more dangerous. I am talking, of course, about the Consumer Price Index, Import/Export Price Index, and various Producer Price Indexes. Lets take a look, shall we?

I give you, the Consumer Price Index

This image paints a picture. Prices dropped by the greatest 1 month percentage change since before the start of the graph (1998). However, they are already beginning to rise as sharply. I think this is the beginning of a story. The end of the story will probably be a change of similar magnitude in the opposite direction, followed by a short drop, and then a stabilized rate of increase above the historical level (increased inflation, see earlier posts on the matter).
Let's check out the

Import / Export Price Index

What does this interesting graph tell us? Simply that the entire integrated globalized supply chain is encountering the exact same but perhaps even more severely than we are. This is a lot like stretching a rubber band too far, and then watching it snap back and hit you in the face. As distributors dump inventory in response to reduced consumer spending, they are also suspending their orders up the chain to the manufacturers. If anything, they are probably doing so even more "severely" than they are liquidating inventory (if you're getting crushed under debt created by inventory that you can't sell, the only thing you'll be more passionate about than getting rid of said inventory is avoiding purchasing any more until you know that you'll actually survive long enough to take delivery). Manufacturers can take the hint, and cut production. This is why people are getting laid off from plants. While there are certainly a lot of Americans losing their jobs at factories here that are cutting back, factories on the other side of the world are simply closing their doors; permanently. In addition to the tragically skyrocketing Chinese unemployment rate there is also the danger of an upcoming goods shortage and the terrifying specters of high inflation and protectionism.
Many of these goods are not things that people truly don't need, just things that they cannot afford right now. Think of all the durable or semi-durable goods that you may have been considering replacing in the next few months, but will now endure without. These are not only your washing machines, but also your computers, your personal electronics, and even some more consumable consumer goods such as paint. I'm just leaving the PPI out of this mess right now because there is enough data here already, but I assure you the same phonomenon is going on there as well, and upstream manufacturers will suffer the exact same way that consumers will. But why will we suffer? These goods are not being produced at the rate that we would normally consume them. Some of them are simply not being produced at all. What happens when the supply chain is purged, an eighth of the distributors have gone out of business, the factory is running at half capacity, and we suddenly actually need these things? The prices will be high. Higher than they were when we decided that we couldnt afford them.
What is the message? This is not a recession, this is not a simple slip in people's confidence, it's not a bump in the road. This is a cyclical downturn that is not ony putting the breaks on the economy, it's filling the gas tank with sugar and ripping out a few of the spark plugs. We may even be in the process of slashing our own tires here because we can't afford to fill them up with air. What have we done in response? We have given a lot of money to a lot of people who will spend it on the goods that create the least value, probably just goods that are stuck in the chain and wont move. We will use our "stimulus" package to purge the system and prime the pumps to fill our world with goods shortages, greater unemployment, further failures, and God help us, real inflation.

Stimulat?

I've received some early feedback indicating that links, to data, actually help me to make a point more effectively. Very well, I shall link things.
Today I woke up to discover this AP story about the passage of the rectified stimulus package. The article focuses on the tax breaks that were passed for lower and middle income Americans, namely the controversial rebate issued to even those who don't pay any income taxes. This $13 per week is insufficient.
Why is this tax break insufficient? It's too weak and it's too spread out. If you have followed my previous posts, you should be familiar with the concept that the crisis is extended by a lack of good information, namely, uncertainty, leading to cyclical reductions in periodic investment resulting in steadily declining capacity utilization (probably even follows an S curve in the end, why not).
This cycle is broken by a periodic engagement that results in greater than expected returns, essentially, people being surprised in an upwards direction rather than a downwards direction, and deciding to invest a greater amount in the next period (i.e. hire some people back, restart plants, etc). $13 per week for a large segment of the population is a lot of money when considered on the grand scale of the entire economy, but it's peanuts in the big pool of consumer spending, especially when spending against high margin goods is what we really need to stimulate the economy. Think of it this way. With that money, lots of people will be able to make an extra trip to the grocery store every two weeks, or purchase a new DVD every week, or something 'expensive' like a new coat every two months. Where are they going to spend this money? Walmart of course!
The problem with spending all of this money on goods which cost almost nothing is that... well... the goods cost almost nothing. They are all made in China or Mexico (as they would not be profitable to produce with American labor), they are not taxed on import, and then they are sold at places like Walmart which capture almost all of the profits. This is, in essence, an excellent stimulus for our trade partners (China, Mexico, Canada) but a terrible stimulus for us.
Now at least we know the price of the American electorate: $13 per week, plus (unemployment) benefits

What's next?

If I had a crystal ball, I would not be whispering its secrets into the void. I cannot predict the future any better than the next man could, but I can consider what is to come and ponder its implications. That all being said, this is what I think might happen next.
The banks have been wounded, money is not cheap, any method of recovering the loss must be considered. The costs of acquiring the means to fuel growth have risen to the point where staying put is a challenge in and of itself. Ambition is beyond the means of the masses.
As the cost of money rises, the cost of doing business for those who rely on it so heavily also rise. The costs of the goods provided then, must also rise. To those who are able to endure this endeavor, the writing on the wall is clear. Risk is not an option, stability is the objective, so those who cannot give more than they take are slid overboard to swim for themselves.
As costs at the top rise, they trickle down into the real killing fields, the Small and Medium Businesses. These unusual entities are what the politicians refer to, somewhat unknowingly, as "main street." But on main street, rising costs slaughter margins and enterprise slips woefully into loss. Those without the stomachs or the wallets to endure the wear and tear of negative growth simply fold up their hopes and dreams into their briefcases, and wander home. At some point, you have to pay the mortgage; which is a challenge when you're putting more money in at the office than you're getting out. After all, those who drive industry cultivate skills which maintain value even when they cannot leverage that value effectively in their own endeavors. There will be other jobs for these people to take.
The same may not be true for those that they had given purpose to. When the shop closes, who does the clerk turn to? Their function, up to that point, had been encapsulated in an organism that created value through the organized application of their labor. Alone, there is little that they can do; except to go home and apply for unemployment insurance.
As the efficiencies created through thousands of years of applied man effort are suddenly lost, the cost of provisioning anything, in real terms of effort applied, rises. The scarcity of money ceases to be an issue, as the real world cost of provisioning everything grows. We respond by infusing money, attempting to dilute this most unpleasant concentration of pain. In the process, we simply dilute the value of the money. This is the truest sense of inflation.
As the masses begin to suffer, with or without the thin blanket that government aid has wrought them, the businesses that simply closed awaiting better conditions are slowly dissolved in an acidic wash of depreciating assets and uncontrolled inflation. The value which had previously been salvaged and preserved scatters like dust in the wind.
The banks, grumpy and weary, lack the necessary resources to do anything but lose value. They too, begin to clear out their desks. What is to be gained through losing?
Rinse, repeat.

Is this dramatic and dire? Of course. We can all hope against all hope that it will never come to these most unpleasant conditions. However, it is critical to realize that while it does not seem so at this point, such an outcome is exceptionally possible, and rests, invisibly, but a razors edge from our present state.
What can we do? We must keep the furnaces burning. We cannot rest, even for a moment, to catch our breath. We must do what we can to fuel the fires, to equip those who would rather fight than give with up the weapons that they need to wage war on our decaying condition. Are these the banks? Are they the huddled masses? The captains of industry? No. The banks and the big businesses are too big for the government to save. There simply isn't enough paper to print all of the T-Bills it would take to finance the continuing operation of the largest segment of the american economy at efficient scale when the required demand does not exist. Similarly, printing money and giving it to bankers might allow them to forestall a few mortgage calls, but the fundamental problems remain unchanged. Even if they had the money to lend, it makes no sense for their largest customers to take it in an economy where it seems unlikely that they would be able to both profit and pay it back.
So who do we help? We help the keystones, the Small and Medium Businesses. These are the tireless, and stubborn individuals who left their posts within the system because they felt the deep desire to go out and make something where nothing existed before. They will fight for they have worked tirelessly to build, and in so doing, will marshal an army of engaged organization that will fight against the darkness until they beat it back, or succumb.
How do we help? We fix the margins. While the cost of goods and services in the absence of scale cannot be easily helped, the government's cut can. If we are now so determined to inject capital by borrowing money on an unprecedented scale, we cannot we also simply consider the possibility of collecting a little less? If the government tightens its own belt, those of us who are forced to feed it three times a day may just be able to carry on a little longer, and more importantly, those who we employ will carry on with us. Maybe, just maybe, we might start to even see a way out of this mess; lord knows everyone out there who is wondering if they will be able to make payroll three months from now is searching with unbearable purpose for a path through the darkness. We should do whatever we can to help them in their quest.

Launch

We should start with where we are, and then work backwards. The economy is spinning down. A recession is like a pothole, a deep deep pothole. You hit it with your car, hard, it rattles you, causes you to drive more cautiously for a moment, maybe slow down a little. You recall, reconsider, re-evaluate, and proceed with caution; as though you expect there to be more potholes. However, you are relieved to discover that it was an unusual event, an unexpected and unconsidered phenomenon, but nothing persistent, nothing threatening. Your expectations are ultimately exceeded, found to have been too cautious, too pessimistic.
In the context of the economy, you put money, effort, time, blood sweat and tears forward in one period, and expect a particular payoff in the next. This time, we had a set of expectations, we thought we all understood what it meant to have a liquidity crisis. This ancient concept of broad based market failure in the lending industry seemed distant, alien, but discrete and understandable. We accepted that there would be a disruption, we hunkered down, the economy shed some load, and we entered into a recession. Then everything changed. We took our cautious step back, and still managed to be further disappointed. Acting rationally, as all rational actors would, we took the only action that we could: we lowered our expectations. Unfortunately, we were again frustrated by failure.
Can you see the emergent pattern? the overarching behavior? Our collective activity magnifies into a common spiritual vibe. We look to not only our own performance, but that of our neighbors, the members of our community. We don't live in a vacuum, we draw from our surroundings in the hope that what we can take in will allow us to make better decisions. When those around us fail we notice and take warning. Uncertainty is the gasoline on which this fire is fed.
And now, as we all strain our eyes to see the light at the end of the tunnel, we can perceive only a misty gray darkness. Voices whisper at us from the shadows, assuring us that help is coming, that everything is really alright, insisting that our sense that serves us so well in the best of times is simply failing us now. They tell us that the end is there, even if we cannot see it. Those who would naturally feel in the darkness for a way out of this mess are quietly told to hold back, less we leave anyone behind. There is suffering near the back we hear, amid the huddled masses. Those who pull forward hardest will simply be given the greatest load, the heaviest burden.
We cannot work our way out of this mess waiting in the darkness. Those who crave the light must try, now more than ever, to find it. It is their purpose to lead the rest of us out.
Mind you, this is all very abstract. But I will finish an abstract discussion off with an even more abstract point. If you were lost in a maze with a group of people, what would you rather have? Food for those who don't have enough to last the winter, or a hungry man who craves freedom more than life itself, and is willing to lead the masses out.