Amit Paranjape’s Blog

US Financial Crisis – The Role of the Consumer (PART 2)

Posted in Current Affairs, Financial Markets/Economics by Amit Paranjape on October 8, 2008

 

US Financial Crisis – The Role of the American Consumer  PART 2

 

Thanks for all the feedback on the first article (US Financial Crisis – Who Is To Be Blamed) in this series. This issue has definitely touched a nerve with many more people than I had anticipated! The response rate has been terrific. In this second part, I am going to summarize some of the points of view that I received from readers and then continue further discussions on the role of the American consumer. Once again to clarify, I am not saying the American consumer is the only cause of the current financial crisis; I am simply highlighting their role in it, which I think is often understated.

 

 

The across the board feedback that I have received represents two distinct streams of thoughts. The first one is centered on how the system was the primary culprit in this whole mess. The system refers to the Banks, Fannie Mae & Freddie Mac, Government Regulators, etc. The second stream takes a more fundamental stand around the level of debt (or ‘leveraging ratio’). It argues that fundamentally, debt is not a bad thing. Companies routinely take large amounts of debt. The primary issue is deciding what levels are the right levels. What is the equilibrium point?

 

I agree with both these streams of thoughts. I have literally seen hundreds of articles and dozens of commentators on CNBC, CNN blaming the ‘system’ and talking about that ‘poor main street consumer’. That really led me to further elaborate on the role of this ‘poor’ consumer. It is amazing to note how the US media becomes totally populist (and in a sense the global media as well, that always looks at the US media for ‘best practices’) and quickly sides with the ‘main street consumer’ when things go wrong. I guess this is not a whole lot different from the electoral politics. What ever happened to true and objective journalism? I would never know.

 

I agree the consumer didn’t really play a primary role in the complicated CDOs and other exotic interbank instruments that were traded between financial institutions. These bets proved horribly wrong, in cases of some institutions such as Lehman Brothers, Bear Stearns and Merrill Lynch. A lot has been written about this and I will not elaborate further. These bets did play a huge role in the current mess. However, the end consumer was still an important catalyst creating a bottom level source for these hierarchical instruments. (I am using the term ‘hierarchical’ to highlight the fact that some of these instruments can be better explained as 2nd order/3rd order/4th order aggregated debt instruments). At the end of the day, many of these instruments in a sense were aggregations of end consumer debt.

 

Many blame the ‘system’ for grossly easing up credit. How was the ‘poor’ consumer going to figure this out? Majority of these ‘poor consumers’ are what I am terming as ‘21st century Illiterates’. I will explain this concept in detail at a later point in this article.

 

When it comes to the right debt ‘equilibrium’ there are many different schools of thoughts and theories. I am not an economist, and hence I wouldn’t add a new one to this list! Some argue that the strong growth of the US economy in the 1980s and 1990s hinged on high debt driven consumer spending. Maybe that was partially true. But clearly, it was operating on a thin edge, with minimum margin for error. When it was a little overdone, coupled with rising government deficits (as happened in the current decade) this quickly tipped the economy cart over the equilibrium knife-edge. And when it comes to this whole debate around deficit led spending driving economic growth, I am a little confused. Isn’t China the fastest growing country in the world today? They have achieved double digit growth for many years running. And they have one of the highest savings rate in the world?

 

Here are some interesting statistics that I recently came across. In the 1960s and 1970s, American savings rate was in the 10-20% range. In the roaring 1980s, it was 4%. Sometime in the 1990s, it turned negative and has since then stayed negative. In 1980s it was lot more difficult to get a car loan than it is today. Today, an average consumer has 9 credit cards and $17,000 of debt. Enough has been discussed on the housing debt numbers. There was this great commercial that use to appear on American TV a few years back. If only I could get a copy of that on YouTube, it would make my points so much better! The commercial was for a debt consolidation agency and it showed a middle-aged man talking about his great mansion, his great car, his great pool, how his family enjoys a great life-style, and on and on. At the end, he asks a simple question in a really funny way, ‘How do I do all this?’ And then he answers, ‘By talking on debt!’, and continues…. ‘I am in debt up to my eye-balls…I can barely pay my finance charges! Somebody, please help me!’

 

Many Americans do blame to government for budget deficits (at least a big percentage of the voters seem to…). But no one seems to be blaming the consumer deficits? The consumer today lives in an ‘instant gratification’ society where if he likes a 60 inch LCD TV in Best Buy, he wants it right away. Even if doesn’t have the money, he can always get the ‘No interest for 12 months, followed by easy $50/month installments’ deal. How very attractive! Is such consumption, really helping the US economy grow? I am not sure. It is definitely helping the Asian economies to grow for sure! Many such examples can be given, but I will add just one more.

 

Consider this; a single engineer in her early 40s is working in a large manufacturing company in the Dallas/Forth Worth Metroplex. She has a mid-level position, earning her around 70-80K per year, a decent salary but nothing great. She wants to live the ‘American dream’. This definition of the dream itself changes from state to state, especially when it comes to housing. In Texas, in this woman’s case, it translates to a living in a 4,000 sq ft ‘house’. Well, to ‘afford’ (‘afford’ being a relative term by itself…) such a house on a 30+ year mortgage (yes, 40 yr mortgages were recently introduced, to add to the zero down mortgages already present…), she had to pick a suburb that was 40 miles from her workplace. But that shouldn’t be a problem, should it? The great American freeway system which incidentally has eliminated the need for any public transportation should get her to the workplace in comfort and in quick time! She still needs a car though…but not any car. She has to ride in style. She will not settle for anything other than a big 8 cylinder GMC Suburban (A SUV that has a rated seating capacity of 8-10, but could easily accommodate twice as many passengers, if not more in the developing world. It has a 6.5 liter V8 Gasoline engine). Of course, this SUV doesn’t come cheap either; but then there are always those zero down loans to the rescue. And I am not even going to discuss the gas mileage and the price of gas here…I think you get the idea. The recent surge in oil prices have maybe finally forced the American consumer out of these gas guzzling behemoths, but I doubt if it has altered the fundamental consumption drive highlighted in this example.

 

All the debt that this woman is taking on, what economies are they really driving? The American car companies are already in deep trouble. Chances are she might have bought a Japanese SUV. And the gas guzzling nature of this beast of a vehicle helps power other ‘not so stable economies in the world’.

 

And I haven’t even talked about ‘retirement savings’. It is an irony – discussing retirement savings and negative savings rate together!

 

What is the view of an average consumer living in Springfield (no, I am not referring to Homer Simpson…and that is not the stereotypical image of an average American consumer that I have in my mind) with regards to his debt? Does he realistically believe that he can pay it off in a decent amount of time, and then save enough money for retirement? And how much money does he really need for retirement? Most Americans I have come across frankly don’t think too much about retirement planning. Even fewer have an idea of a target for retirement savings and their estimated expenses in future. It’s one thing for a 20 something or a 30 something to carry a substantial debt and be carefree about retirement planning. But it is amazing to note the number of people in their late 40s and 50s who still carry substantial amount of debt. These people in my view have absolutely no idea of what their ideal debt leverage ratio should have been in the first place. They have already tipped the equilibrium. They are simply taking a shot in the dark as far as retirement is concerned. Do they think that social security alone would be sufficient? And with the rate the government deficits are growing, some experts predict that even social security, ‘that sacred cow’ may be sacred no more.

 

The reason I am bringing the retirement savings topic is to further highlight the lack of foresight and long-term planning of the consumer. This again highlights the ‘illiterate’ nature of the global 21st century consumer.

 

What is causing the consumer to make these series of bad decisions/mistakes? I can think of two primary reasons. First one is the desire for ‘instant gratification’. It symbolizes the ‘Live for today, who cares about tomorrow attitude’, or the strong belief ‘Tomorrow will be better, my earnings will continue to grow no matter what happens’. I am not a psychologist and can’t claim any expertise in understanding this human nature/human values. The second reason I think is a phenomenon I will call ‘21st century global Illiteracy’. I think this is very important.

 

In the 20th century, illiteracy was something that was thought to be primarily confined to the developing world. Literacy was very simplistically defined as the ability to read and write. By this definition, nearly 100% of the developed world and an ever growing percentage of the developing world would be termed ‘literate’. In the developing world, it is often repeated over and over that the one of the primary root causes of all the social, political and economic problems is lack of literacy. However, now that we are turning ‘literate’, are we really resolving these issues? I would like to argue that merely reading and writing doesn’t constitute true literacy. To be literate, one needs to really understand one’s world that we live in. Today, there are ever increasing tools of knowledge and information. Yet most people don’t know the most basic information. This lack of knowledge is what I would like to term as the ‘21st century global Illiteracy’. In the next part of this series (Part-3), I will explore this concept further.

 

[Continue onto the 3rd part in this series: ‘The Clueless Global Leadership’]

 
 

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  1. Sarang said, on October 8, 2008 at 3:22 am

    I think it is not ignorance that drives American people to “bet everything” but an innate sense of optimism. Having dominated innovation in the past century, most Americans see unlimited wealth for the making and new ideas inevitable. It is only when this cycle breaks that I think America is in trouble. The fact that housing becomes the most exciting investment is the worrisome part. I think the way out is to buck conventional wisdom and spend more on new/green technologies etc so wealth will be created rather than conserved.

  2. Dev said, on October 8, 2008 at 8:50 pm

    A note about the “negative savings” in US.

    Obviously “Joe Sixpack” is really long way from the prudence and thrift advocated by the Calvinist forefathers.

    However, the negative savings figures that everyone sprouts may not be accurate. I think the official savings numbers strictly refer only to bank deposits. Any and all of the money in 401(k), IRA, money-markets, stocks/bonds in brokerage accounts is not counted. ie. investment != savings.

    This does not imply that the median net-worth in America is high enough (to sustain one through retirement). Just that aggregate net inflow of domestic money into all these assets is certainly not negative. It’s just not called savings. Also, that’s just aggregation. I don’t know what the case for the median family is.

  3. Arati Halbe said, on October 10, 2008 at 10:08 am

    I agree with you about the role that consumer plays.

    We can see that the tendency of debt beyond capacity is growing. I am not sure how much that happens in India.
    But at least in my circle of friends and acquaintances i have not seen anyone buy petty stuff (TVs, mobiles etc) on loan. I am not sure how much that happens in more pompous cities e.g. Delhi🙂
    I feel it only makes sense to take loan for that stuff which will either appreciate in value or will have a direct impact on your net earnings at the end of the day. For example, in the current scenario, real estate appreciates or if buying yourself a vehicle greatly increases your effeciency and you are able to cater more customers, improve your top line and eventually bottom line.
    One should not get carried away with what facilities are available. The traditional wisdom should be followed after fully understanding the rationale behind it.

    Kind of sidelining a bit here : Pune has been (should I say had been?) a good example of consumer power. It is difficult for any manufacturer to throw new stuff and expect people to buy just because it is new/trendy or fashionable. Things do not (?? did not??) sell here unless they are value for money. Quite contrary from Bombay/Delhi. This is just to get attention to the fact that if the consumer decides, the so called “system” (which actually the consumer is part of) can be led to a direction consumer wants.

  4. vaishali said, on October 10, 2008 at 10:18 am

    Interesting write up! I am not sure if the deficit is good or bad for the economy since I don’t know much about macroeconomics. There is also a school of thought that says sometimes even deficit is good for the economy. And spending more gives rise to more economic activity which in turn helps the growth.

    That apart what I have started to think is the younger IT software generation and call center people of India are saving very less as compared to their US counterparts. Even a young call center employee buys a mobile worth Rs. 25000 Property prices in India have shot up ruthlessly and many people have bought homes on very high loans due to peer pressure. If interest rates rise from 7% to 13% the loan installment will eat up some people’s entire monthly salary which is indeed the case. As far as retirement planning is concerned in the US they at least have social security. In India when this IT generation retires they are not going to have any pension and EPF will certainly not help pay all the bills considering the inflation in India.

  5. Sam said, on October 10, 2008 at 5:01 pm

    Amit – You have rightly brought out the behavioral traits of the consumer which have been inculcated over years in a “open/free” economy. It’s a lifestyle and that lifestyle is slowly but surely spreading its roots here in india – metros to start with. “I want my cheeze and I want it now”! or “buy now pay later” is catching up. I have observed how Pune’s real estate boom has been fueled by rampant loans and how my colleagues stretched their budgets from 25 lakh to 50 lakh (and now much beyond that) which otherwise would not have been possible.

    But overall this global phenomenon is a good learning for indians, though probably western world has seen these cyclic events repeat a number times over last few decades.

  6. […] This blog (trak.in) is focused on Indian Business. Amit Paranjape also has a series of posts (one, two, three) that you might find interesting. He also writes about Pune’s history, restaurant […]

  7. […] It is worth looking at the ‘If for them…then why not us!’ argument. The big financial institutions had catastrophic failures/near failures, primarily due to the housing bubble collapse and risky investments over the past few years. In some sense, this once in a hundred year event had its origin in fairly recent past. The housing bubble began at the turn of this decade. [For a more comprehensive discussion regarding the 2008 Financial Crisis, please look at my earlier articles on the same topic: US Financial Crisis: Who Is To Be Blamed? and US Financial Crisis: The Role Of The Consumer ] […]


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