© David Collett 2011 ANCHORAGE INVESTMENTS

Part IV: The Dominant Causes of the Credit Crisis

Where did the demand for goods and services go?

28 April 2011
by David Collett

Where is the organic growth for demand going to come from? That is the question asked
by many CEO’s lately. Growth in demand or the lack thereof is central to future growth
and economic prosperity. Why did demand not bounce back vigorously from the
2008/2009 recession despite enormous government stimulus worldwide, low interest
rates and the added injection of liquidity from central banks? As long as the dominant
causes of the crisis are not correctly identified and recognised, the remedies applied to
revive the economy will remain ineffective.

Many pundits of economic growth have pointed to factors that inhibit growth and
demand. Some of the more popular ones are insufficient fixed investments, high taxes
and tight credit conditions. But high private fixed investment, low personal taxes and
credit expansion preceded the two biggest crises over the last century, namely The Great
Depression and the 2008 Credit Crisis. Although US fixed investment did not increase
that much in the period immediately preceding the Credit Crisis, fixed investment in the
rest of the world, especially China, more than made up for it. Yet, sluggishness in demand
was a cause and a consequence of both these crises. Why did it happen?

Decrease in taxes, increases in fixed investment and growing credit must, by reason of
logic, increase demand. Add low interest rates and mild inflation to these favourable
conditions and you have a perfect storm for an explosion in demand. That explosion did
occur in the years preceding both of the abovementioned crises, only to implode or to
slow to a crawl. Huge government stimulus packages, quantitative easing and near zero
interest rates failed to resurrect the relative high growth in demand that preceded the
Credit Crisis. Can the economy continue to grow without the latter?

Wealth Concentration and its effect on future growth

In Part II of this series of blogs on the dominant causes of the Credit Crisis, we analysed
the growing divide between productivity and household income, growing income
inequality, decreasing capacity utilisation and the growing imbalance between demand
and supply covering a period from the sixties to the early 2000’s. We showed how the
top wealth groups gained an ever increasing share of total US household income since
the early eighties; how their accumulated savings and investments have since caused
overcapacity; and why the lower income groups’ (bottom 80%) financial ability to
absorb the increased production from expanding capacity, diminished to such an extent
that it caused an imbalance between supply and demand.

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In Part III of the blog series, we analysed the Balance Sheet of US Households from 1962
to 2010 and showed the different savings patterns between the bottom 80% and top
20% of households in terms of income and net asset wealth. We also showed how the top
20% and especially the top 1% of households substantially increased their savings from
1983 to 2007 while the bottom 80% of households had substantial negative savings. The
effects of a worldwide savings glut on overinvestment in productive capacity and lower
interest rates are also discussed in Part III.

Evidence suggests that when too much wealth, earnings and savings accumulates in too
few hands, the ability to produce goods and services will exceed the ability to consume
those goods. This is so because those who have a need for more consumption cannot
afford to increase their consumption whereas those who can afford such increase in
consumption have no need to consume more. Few people want to buy 100 cars or 20
boats simply because he can afford it.

Consumption and expenditure of all income groups, continue to increase from the
eighties right through to 2008. The substantial increase in disposable income for the top
income groups enabled them to consume and save more. The obvious question is, how
did the bottom 80% manage to keep pace with the expansion in expenditure and
consumption when the growth in their incomes, since the eighties, did not?

Various factors played a role in filling the growing “income gap” between the
expenditure and income (earnings from wage and salary) of the bottom 80%. Incomes
were supplemented by tax decreases and benefits, negative savings, lower interest rates
and expanding credit over a period of three decades. Credit expansion, the most
dominant stimulus in the 2000’s, was the first to waver in 2007 and lower interest rates
(mortgage rates) might be the last to go. By 2009, it was clear that the full potential of the
above sources to fill the “income gap” was just about fully tapped. A new stopgap
measure was implemented. Huge amounts of government stimulus were used to fill this
gap to some extent. By 2011, this government stimulus has caused many governments to
run up huge debts which they find difficult to service. As austerity measures are
becoming a more popular method to limit expanding government budget deficits, it is
clear that most countries have run out of stopgap measures.

Why does wealth concentration tend to lead to economic expansion and then
contraction? Part II and Part III tell us much about the dynamics that caused the
imbalance between supply and demand and its association with wealth concentration,
measured by income and/or net assets. To explain how and why it happens however is
somewhat more difficult.

How growing wealth inequality can cause an imbalance in the

economy

As shown in Part III, wealth concentration of financial assets in the hands of the top 20%
continued to grow from 82% in 1962 to just below 90% in 2007. This is very important
statistic because the savings that households put into financial assets will always seek
investment opportunities, either to increase the supply of goods and services or to
finance credit to the consumers who wish to acquire more goods and services. Where
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savings struggle to find an investment opportunity in any of the above alternatives,

money is often temporarily diverted to the “speculation circuit” where money changes
hands between speculators with the exclusive intent to profit from the speculative
buying and selling of financial assets, without any intent to produce or to acquire any
goods or services for consumption. This speculative investment may include shares,
commodities, bonds and other more sophisticated financial instruments.

The chart below illustrates to what extent each category of US household invested in
different types of assets in 2004. (Financial assets includes common stock and non –
equity financial assets)

Percentage Ownership of Each Category of Assets

Source: The State of Working America

The table below shows that although the bottom 80% earned only 52.4% of total
disposable income, it contributed 61.4% to total US consumption. As explained
previously, factors like credit expansion and negative savings enabled this group to
spend more than what they earned from wages and salaries.

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Consumption vs. Disposable Income

(1)
Percentage (2) (3)
share of personal Percentage of Percentage of
Percentile of all consumption in disposable income disposable income
households 2004 in 2004 in 1950

Bottom 80% 61.4 52.4 58

Top 20% 38.6 47.6 42

Source: 1–2 Structural Analysis of Over-Consumption in the US: NLI Research

3 1951 Survey of Consumer Finances: Federal Reserve Bulletin

The table below demonstrates the extent to which credit has expanded, especially from
the eighties, and the following table show how this growth in credit was distribute
between the two US household categories (measured by income).

Total Debt as Percentage of Disposable Income

Consumer
Total debt as As a
Calendar Mortgage Home equity credit (e.g.,
a percentage percentage
Year debt (%) loans (%) credit cards)
of income of all assets
(%)

1959 38.7 N/A 17.1 61.5 10.4

1973 39.4 N/A 19.7 66.7 12.8

1989 58.3 7.9 19.2 86.7 15.5

2000 66.3 7.7 24.0 102.2 15.0

2005 95.8 11.6 24.2 131.8 18.6

Source: The State of Working America

The table below confirms that the major part of the fast growth in credit in the 2000s, as
reflected in the above table, was attributable to the bottom 80%.

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Distribution of Growth in Debt vs. Distribution of Disposable Income

Distribution of growth in Distribution in disposable

Percentile of all households
debt 2001–2004 income (from table above)

Bottom 80% 62% 52.4%

Top 20% 38% 47.6%

Source: The State of Working America

Data and trends in the above three tables correlate to a great extent to the basic trends as
reflected in the US household balance sheets analysed in Part III. In fact, one could say it
is the logical consequence of structural changes in the economy since the early eighties,
as describe in Part II.

In order to provide some insight as to why growing wealth inequalities are likely to
create economic imbalances, we will use simplified economic models that consist of
three interdependent modules that will focus on income from labour and investment;
production and personal consumption. These “closed” economic models will compare
approximate trends of the 1950s and 1960s with approximate trends observed in the
2000 to 2008 period and 2010.

Throughout this series of blogs, wealth inequalities and changes therein are explained by
comparing two groups: the bottom 80% and top 20% of income earners. There is no
particular reason why one could not split the groups differently, such as into the bottom
90% and the top 10%, or even the bottom 99% and the top 1%. In fact, it may be more
appropriate to use the latter in many instances. The 80 and 20% groups are used
because historic data are more readily available in this format and are commonly used to
demonstrate the effects of growing wealth inequalities on economies.

Models A, B and C below, assume that there is a “closed” economy with a limited number
of players. In addition, total household income ($100/$200) is assumed to be equal to
the value of all products and services produced by the economy and consumed by only
two groups (the top 20% and the bottom 80%). In the real economy, savings,
government expenditure, private investment, imports and exports, taxation, and various
other factors may also play a significant role. For the sake of simplicity, however, models
A, B and C will only address those role players and economic factors that are considered
necessary to illustrate the impact of growing wealth inequalities.

Model A reflects a situation where income distribution is similar to what was observed in
the 1950s and 1960s in the United States. The bottom 80% of households earned around
57% of total disposable income and the assumption is made that they contributed 59%
to total consumption. Model B refers to the period from 2001 to 2007, where the 80%
group earned around 52% of total income but contributed 62% to total consumption.
Model C refers to 2010 where the assumption is made that the bottom 80% share income
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(without government benefits) has decreased to 50% and its consumption to 61% of
total consumption.

In Models A, B and C the 80% group contributes mainly labour to the Production Module,
where goods and services are produced for sale to the Personal Consumption Module.
For this input, the Production Module compensates them in the form of wages and
salaries. The top 20% also contributes labour to the Production Module, but its main
contribution is financial assets (finance, share capital, etc.). For its contribution, the top
20% is compensated in the form of salaries, interest, dividends, trading profits, and other
forms of remuneration associated with its financial asset investments.

Model A: Example of a Closed Economy in the 1950s and 1960s

The total compensation paid to the Household Income Module in Model A comes to $100,
of which the 80% group receives $57 and the 20% group gets $43. The 20% group
receives a higher portion of total income if measured by individual household for mainly
two reasons. The first reason is that it owns most of the capital; more than 90% of all
common stock and non-equity financial assets (see chart above). The second reason is
that members of this group are compensated more for their labour input due to their
higher perceived value in producing goods and services. The Household Income Module
then decides how to utilize this income. The 80% group spends its full income of $57,
plus $2 it borrowed, on the goods and services received by the Personal Consumption
Module and produced by the Production Module. The 20% group spends $41 ($43 – $2)
of its income on the above goods and services and saves $2, which in turn gets lent to the
80% group.

Model A: Example of a Closed Economy in the 1950s and 1960s

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By looking at Model A, there seems to be no alarming imbalance that threatens the above
closed economy. The 80% group could have conceivably serviced the cost (interest and
capital) of the $2 it borrowed and the 20% group benefited by virtue of the interest
received. More importantly, there was a market for all of the goods and services
produced by the Production Module, which in turn led to higher profits via dividends and
interest. The system also benefited labour via wages and salaries, because the Production
Module would employ all workers required to satisfy demand. Credit plays a relative
minor role in the balance between supply and demand, compared to what happened in
Model B below.

Model B: Example of a Closed Economy in the 2000s

The situation has changed substantially from Model A to Model B. It is assumed that the
closed economy doubled in growth to $200 without new entrants. It is also assumed that
the Production Module increased the quantity of goods and services due to greater
innovation and improved productivity. Importantly, expenditure patterns and the way
income is distributed between the two groups have changed significantly from Model A.

The total compensation paid to the Household Income Module in Model B comes to $200,
of which the 80% group receives $104, or 52%, and the 20% group gets $96, or 48%. The
20% group receives a higher portion of total income as measured by household, for
reasons described in Model A. The Household Income Module then decides how to utilize
this income. The 80% group spends its full income of $104, plus $20 it borrowed, on the
goods and services received by Personal Consumption Module and produced by the
Production Module. The 20% group spends $76 ($96 – $20) on the above goods and
services and saves $20, which in turn gets lent to the 80% group.

Model B: Example of a Closed Economy in the 2000s

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The imbalance in the closed economy of Model B is obvious. The 80% group’s share of
total income has diminished substantially, and it borrowed a substantial amount ($20)
from the 20% group, which enabled it to contribute 62% ($124) to the Personal
Consumption Module. The 80% group therefore maintained a higher standard of living
than that justified by its income from salaries and wages alone. On the other hand, the
20% group benefited significantly from this arrangement. It received a relatively greater
share of total income as measured by household. Its net worth was increased by way of
savings and the rising value of its investments (e.g. value of listed shares also increased).
This was mainly achieved by finding a market (Personal Consumption Module) for all of
the goods and services produced by the Production Module, which led to higher
earnings. Without substantial lending by the 20% group and borrowing by the 80%
group, there was no market for 10% ($20/$200) of the goods and services produced by
the Production Module. If they could not sell the 10% of goods and services, it would
result in overcapacity or excess production and less sales to the Personal Consumption
Module. That would have translated into economic contraction and less compensation to
the Household Module.

The imbalance comes about because the production of goods and services cannot be
absorbed by the consumers (both the bottom 80% and top 20%) without the top 20%
affording ever-increasing debt to the bottom 80%. As the 80% group’s debt increases
every year by the above $20, it becomes less likely that it will be able to service it. These
imbalances, however, would not have come about if the 80% group still received 58% or
more of total income as stated in Model A and/or consumed a smaller percentage of
goods and services. However, if productivity increases and more goods and services are
produced by roughly the same resources—mainly labour and capital—and the benefits
of productivity are not shared equally between the respective wealth groups, supply will
overwhelm demand. This growing gap between supply and demand can only be bridged
by growing credit, lower taxes, lower interest rates and negative savings – as it did from
1980 to 2008 - but it could not last forever.

The imbalance reaches the breaking point when the 80% group is unable to service its
ever-increasing debt from limited income growth (salary and wages) and the value of the
collateral (mainly housing) begins to collapse. This collapse in the value of collateral is
inevitable in a bubble economy because credit fuels the rise in value, which in turn fuels
a further rise in credit (as collateral values increase) to the point where it becomes
unserviceable. The actual divide between house prices, credit expansion and growth in
income (2000 to 2007) and the subsequent implosion (2008 – 2009) are aptly
demonstrated by the chart below.

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Median Household Income vs. National House Price Index vs.

Mortgage Credit

Source: US Census Bureau; S&P/Case Shiller; Federal Reserve—Flow of Funds Account

This inability of the 80% group to service its debts has the potential to destroy the net
worth and income of both groups. The 80% group’s net worth is destroyed by the
decreasing values of its members’ homes, while the value of their debt (mortgages and
other forms of debt) remains the same. In addition, as production is cut back and job
losses increase, the Production Module aims to cut costs in an attempt to remain
profitable, and to ensure maximum compensation to the owners of capital (share capital,
bonds, debt, etc.). This further undermines the 80% group’s ability to negotiate a higher
price for its labour, and hence leads to even less income with which to buy goods and
services.

The net worth and income of the 20% group are also threatened by the following
disturbances.

1. The value of its stock investments might drop significantly in value due to an
expected decrease in future earnings,
2. The value of its debt investment deteriorates because of increasing defaults by the
80% group and a drop in value of the collateral for that debt, and

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3. There is a decrease in income from bonuses, commissions, and other compensation

previously justified by high earnings.

The higher income groups are further threatened by a lack of liquidity and by insolvency
because they or the vehicles (banks, insurers, etc.) in which they are invested, are highly
leveraged in order to maximize profits. Because neither party (mostly banks and
investment institutions) wants to buy the other’s assets above the market value and
because the sale of investments at market value could make the seller insolvent in a
crisis, trading stops and the velocity of money in the economy slows. This situation is
further worsened when the creditworthiness of trading partners’ banks is under
suspicion. This happened to the United States and most of the other developed countries
in 2008.

If the Fed, other central banks, and governments did not step in to save the top wealth
groups and/or its investment vehicles (e.g. banks), trading could have slowed much
more than it did; and the net worth and income of all income groups could have suffered
even greater losses. This is not to say that the alternative of no assistance from
governments and central banks would have been worse in the long run. By supplying
more than ample liquidity, at virtually no cost, to this group’s various investment
vehicles (mainly banks) against their illiquid investments as security, the investment
vehicles started to speculate and/or trade among themselves, the Fed, and the US
Treasury. This speculation and/or trading increased the value of various financial assets
(especially shares and corporate bonds) in 2009 and subsequently, thereby improving
the net worth of the wealthiest owners of capital. Despite receiving this extensive
assistance from the Fed, credit lines to most of the 80% group have been cut and the cost
of finance increased in many cases. The rationale is obvious: why lend to people who
cannot service such debt, who have little hope of real income growth, who have
insufficient collateral, or whose financial position will probably deteriorate further due
to increasing job losses? Neither is it sensible to invest in further capacity as capacity
utilisation has dropped to all-time lows. Hence, trading with each other and the
government was the best option for the banks and other investment vehicles.

Model C: Attempts to stimulate demand via government

assistance

In Model C, the top income group lends its savings to the government instead of the
bottom 80%. This has two distinct advantages. Firstly, it is much more secure form of
debt. Secondly, it is just about doing the same job as their previous lending to the bottom
80%. It stimulates demand for goods and services, because government now has the
responsibility to assist the consumer (e.g. tax concessions, unemployment benefits, food
stamps, etc.) and stimulate the economy.

A further change is that the bottom 80% now receives an even smaller share (50%) of
the income cake due to its negative real (inflation adjusted) income growth and greater
unemployment. Governments attempted to fill the “income gap” of the 80% between
earnings and consumption expenditure but can only do so for a limited time.

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Model C: Example of an economy where government replaces top

20% as funder of bottom 80%

Once most governments’ debts have reached unsustainable levels, it will probably be
forced to apply austerity measures, because the only other realistic alternative is to raise
taxes significantly. Some governments, like the United States, which can print more of its
own money to fund government budget shortages, may avoid the above for the time
being. However, such money printing comes with the threat of hyperinflation.

If austerity is pursued, a major portion of demand from the bottom 80% will disappear
for good, because there are nothing (credit, lower taxes, etc.) left to fill the gap between
real income from earnings (salaries and wages) and the level of expenditure that
supported the economy in the past. Utilisation of capacity has to drop, resulting in less
investment, less employment, less income for the bottom 80% and further decrease in
demand. The concentration of wealth will accelerate and the remaining wealth of a major
former driver of demand, the bottom 80%, will continue to disintegrate. A substantial
rise in the real income of the bottom 80% can change the picture but there is little
evidence that this is likely to happen, given the structural defects in the current economy
and the US government and Federal Reserve’s (and many other governments) policy to
keep wages flat, as to prevent secondary inflation effects from occurring.

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Due to high unemployment, there is little room for labour to negotiate higher wages.
Most increases in production are now achieved by way of increased productivity which is
made possible by requiring more input (time and labour) from the currently employed,
mechanisation, outsourcing and improving technology.

Central banks have expanded the money supply via quantitative easing in an attempt to
stimulate the economy. This liquidity flowed mainly to the owners of financial assets that
are owned (90%) by the top income groups or the financial vehicles (hedge funds, banks,
etc.) in which they are invested. The hope is that this group will invest the additional
liquidity in the production of goods and services, thereby creating extra jobs. But why
would an investor do this given the existing low utilisation of production capacity and
the continuing threat to growth in organic demand? Furthermore, in an economy where
rapidly increasing wealth concentration (measured in terms of income distribution) is
now the accepted norm, how could any new investment, hope to create more demand
than supply? If investments over the last three decades created overcapacity and failed
to keep supply and demand in balance, why would it be different this time, especially
where the beneficial support from expanding credit, tax concessions, lower interest rates
and negative savings have all but disappeared?

What do the top income households or their investment vehicles do with the increased
liquidity from central banks? They are pumping much of it into the “speculation circuit”,
speculating on the share markets, commodity markets and other financial assets. The
rise in the value of the above assets does have some beneficial consequences for the
economy in that it creates a “wealth effect” that makes consumers feel better about their
financial position, encouraging those (mostly owners of financial assets) who have the
ability to increase their spending, to do so. However, it probably has more negative
consequence because of its effect on inflation, mainly due to heavy investment in
commodities (oil, copper, aluminium, wheat, etc.). These speculative investments cause
the prices of commodities to rise, and higher commodity prices are slowly but surely
working its way through to consumer products. When wage increases don’t match price
increases caused by inflation forces, demand effectively drops because the bottom
income groups can buy even less goods and services (in terms of quantity) with its
limited income.

Why doesn’t the 20% group spend more of its income on consumption
to make up for the loss of spending by the 80% group?

Wealthy households’ needs have a limit. It is similar to the law of diminishing returns;
that determines that for every additional unit that one consumes the added benefit or
satisfaction that one derives from it diminishes. For example, say a household has bought
four cars for each inhabitant. It is unlikely that there is a need to buy a fifth or sixth car.
Irrespective of his or her wealth, few people want to buy 100 cars simply because they
can afford to do so. The same goes for food, clothing, electronic equipment, and so forth.
Once the needs of a household have been satisfied, it will tend to save the balance of its
income. On the other hand, most of those in the 80% group have little discretionary
spending and are more likely to have many unsatisfied needs that they would like to
satisfy if they could. Thus the 80% group would increase spending and consumption
substantially if it had access to additional income or credit.
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Conclusion

Organic demand can only come from an increase in real personal income, especially
those income groups that are more likely to increase its consumption expenditure as
their incomes increase. This lies at the heart of the dominant causes of the Credit Crisis
and a stuttering economy. Economic policy that in effect opposes real wage increases,
does not give much hope for the future.

Increases in businesses’ inventory levels, speculative investments in commodities, lower

interest rates, government stimulus and quantitative easing may have been a relatively
successful stopgap measure that supported economic growth from 2009 to 2011. It may
even continue for months or another year, but the hour of truth is drawing nearer as
these stopgap measures cannot continue indefinitely. Continuance of some of the above
stopgap measures can by itself cause future economic ruin.

Neither Britain nor Ireland’s austerity measures have produced convincing evidence that
it could save the day or serve as an example to prevent economic ruin. In the end we may
be left with two choices: find a way to increase the income of the lower income groups or
face up to severe economic contraction.

In future blogs we will expand on the inflationary effects of excessive savings, low
interest rates and quantitative easing.

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David Collett is a chartered accountant with more than 25 years experience in the field of
forensic investigation. He has acted as an expert on many subjects such as business,
investment and share valuations; fair presentation in financial statements and prospectuses;
lax credit standards, credit risks and professional liability.

Over the past decade he closely followed the financial markets. Through a series of
presentations made to the finance and investment communities, he forecasted the collapse of
financial markets and the 2008 stock market crash.

For more information about David and his work, please visit:

http://www.anchorage-investments.com.

© Copyright David Collett 2011.

Whilst every effort was made to ensure the accuracy of this article, neither this document; nor its author,
David Collett; nor any publisher of this article; offer any warranties (whether express, implied or
otherwise) as to the reliability, accuracy or completeness of the information appearing in this article.
Neither do any of the above parties assume any liability for the consequences of any reliance placed on
opinions expressed or any other information contained in the above article, or any omissions from it. Its
content is subject to change without notice. Any information offered, is intended to be general in nature
and does not represent any investment or business advice of any nature whatsoever. If you choose to
rely on such information you do so entirely at your own risk. Neither David Collett nor any third party
involved in publishing this article, assume any responsibility or liability for the outcome of such reliance .

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