It’s the Economy, Stupid

January 28, 2009 § Leave a comment

One of Bill Clinton’s campaign slogans when running against Bush 41 was, “It’s the Economy, Stupid.” As applicable as it was in the 90’s, it’s even more so now. As I was reading today’s daily dose of doom and gloom economic news, I couldn’t help but remember something Robert Reich said a few months ago at UC Berkeley. Back in September, I went to Berkeley (my alma mater, Go Bears!) for a Cal in the Capital alumni reunion.

For this reunion, Robert Reich, former Secretary of Labor, current UC Berkeley professor, and overall brilliant genius, was the guest speaker. He said something that night that was so simple, yet so complex. A 5th grader could grasp the simplicity of what he said, but for some reason, our Senators and Representatives could not. He essentially said, this nation needs a bottom-up approach to the economy rather than a top-down approach. He gave the analogy of building a house. The most important part of the house isn’t the façade, rather, it’s the foundation. With a weak foundation, the house will topple over. Likewise, by strengthening the base of our economy (i.e., ensuring that the working class have jobs and increasing the purchasing power of the middle-class), we are, in essence, strengthening our foundation. I would take this analogy a step further by suggesting that a house with a strong foundation has a better chance at withstanding an earthquake or other natural disaster. Much like a house, a country with a strong economic foundation has a far better chance at weathering tough economic times.

It’s amazing how often people forget such a simple concept. What affects the working class negatively, will eventually make its way up. I used to work in finance, and in the early part of 2007, when the job market was beginning to weaken and the subprime mess hit, I often heard coworkers discuss how it didn’t affect them. These conversations were followed by much laughter, and the optimistic (and now laughable) idea that the market, at the end of the year, would end either up a little, or up a lot. Well, clearly that hasn’t been the case, especially with November’s 401k-murdering bottom. There was one particular conversation where someone mentioned that jobs being lost were merely part-time jobs that high school kids would take after-school, that the subprime crisis “only” affected people with poor credit, and the type of people with subprime credit tended to have a poor educational background and were generally not working professionals. Riight. Wishful thinking perhaps? Because obviously the subprime crisis, though not entirely directly, has in fact impacted working professionals.

Let’s go back to Economics 101–which, evidently, our Ivy League/Top 10 School Financial CEO’s slept through. For the sake of simplicity, let’s say you have a guy named Average Joe. Average Joe is, well, average. Average Joe also happens to work 9-5 at a factory that manufactures cars in, ooh I don’t know–Michigan. Then there’s Sana the Engineer. Sana the Engineer works as an engineer for the same company that manufactures the cars at the factory Average Joe works for–she lives in Silicon Valley. Then of course, we have Dr. Patel. Dr. Patel is a dentist in a small town in Texas where Average Joe has relatives. He is also in Average Joe’s health provider network–so Average Joe can go to him when he visits his relatives in Texas. This brings us to the 4th member of our 6-degrees of seperation network: Mr. Waldervilt the III. Mr. Waldervilt the III is the CEO of X Investments headquartered on Wall Street. Coincidentally, Mr. Waldervilt the III’s firm specializes in private equity and, well, investments, and is the primary investment firm for the car manufacturing company that Average Joe and Sana the Engineer work for. Average Joe and family live in a cute one-story house with a white picket fence; down the road from Average Joe are bigger two-story houses. Average Joe wants to refinance his house. However, he was considered subprime because of his credit, and thus, would have a tough time getting a better rate. Fear not Average Joe! Appraiser Friend is here to your rescue! Average Joe’s appraiser friend comes over to appraise Average Joe’s house. Being a good friend, Appraiser Friend inflates the value of Average Joe’s one-story, white picket fence house to match closely with the two-story houses near him. Joe goes to refinance his house, and his lender, believing that Joe’s $187,000 dollar house is actually worth closer to $600,000 agrees to refinance at better rates despite the fact that Average Joe not only has bad credit, is high risk, but would likely never be able to afford a $600,000 house on his salary (not to mention, Average Joe also has a family to take care of, as well as medical bills).

Sana the Engineer also lives in a house. But her house is closer to $2.5 million since it’s in the heart of Silicon Valley where everything is ridiculously priced. But it’s okay, because Sana is an engineer making close to $130,000 (combine this with her engineer husband’s salary, and they are prime borrowers). Dr. Patel lives in virtually the middle of nowhere, so the price of his house combined with his salary allowed for him to have already paid off his mortgage years ago. One day, Mr. Waldervilt the III and company notice that investing in subprime is hot and all the “cool” kids on Wall Street are doing it. They invest in bundles of subprime mortgages where the risk is high, but instead of getting a return of 3-4% (which is what they would get with prime/low risk mortgages), they would be getting 10%. Mr. Waldervilt the III is blinded by dollar signs, so he doesn’t realize that as he’s refurnishing his office with $87,000 rugs (because money ain’t a thang baby, when you got subprime investments! Oh snap!) and taking his executives out for a retreat at an exclusive hotel in California spending close to 1/2 a million dollars, Average Joe is having trouble with his mortgage payments. Average Joe and family cut back on expenses–this includes all discretionary spending, and of course trips to the dentist.

Average Joe’s neighbors decide they too need to cut back on spending just to make their mortgage payments. Mr. Patel notices a decrease in patients and has to lower the cost of overhead; so he lays off a few people. These people were planning to buy a car from the company that Average Joe works for, but cannot now afford one. The car company Average Joe works for now has a supply of cars that exceeds demand. Since these cars are NOT fuel efficient, and oil prices suddenly increased dramatically, they saw a further drop in demand. “Darn! Why didn’t we invest in alternative fuel/energy research for our cars?” they think. But alas! It is too late now. Demand is low. So the car company located in Michigan has no choice, but to reduce overhead. They do this by shutting down a factory, and downsizing their other factories. Unfortunately, Average Joe, whom we have come to love so dearly, has also been laid off. He can’t make his mortgage payments or go to the dentist. Sorry Dr. Patel, but at least you have a house with no payments to make.

Sana the Engineer on the other hand, is enjoying sunny California, and isn’t too worried about job security. After all, the company is still going to come out with new models of cars and will always need engineers. Unfortunately for Sana the Engineer, the company decides they need to downsize even more, and since no one is buying gas-guzzling machines, they have no reason to keep engineers. So they lay off a bunch of engineers and high tech professionals in their Silicon Valley office. Meanwhile, the base of the economy is slowly weakening as the lower-middle class and upper-middle class are losing their purchasing power. Mr. Waldervilt the III finally snaps out of his dollar-trance and realizes that his investment bank that had weathered out the Great Depression was in big financial trouble. Because consumer confidence was low, and people weren’t spending, stocks were dropping. The private equity injected into the company Average Joe and Sana the Engineer worked for was quickly eroding its value, and since Average Joe couldn’t pay his mortgage, the high risk subprime mortgages that Mr. Waldervilt the III’s investment bank had invested in accrued no value or money.

These high risk investments had just become toxic on his company’s balance sheets. The car company Average Joe and Sana the Engineer formerly worked for couldn’t keep up with their finances and debt, and had no choice but to file for Chapter 11. Mr. Waldervilt the III’s investment bank loses its stock value by 63% the next day. Mr. Waldervilt the III has no choice, but to lay off 20% of the working professionals that work for his firm, and shut down their Hong Kong office. With no income, Sana the Engineer and her engineer husband decide that they can’t afford to live on just one person’s salary with such a large mortgage payment for their $2.5 million dollar home. They decide to put it on the market. Unfortunately, no one is buying a house. They slash the price from $2.5 million, to $1.5 million, and they keep slashing until they can slash no more. Unfortunately, no one is buying houses and they can’t pay their mortgage–the bank repossesses their home. Average Joe’s formerly “$600,000” house is also repossessed by the bank and loses its inflated value. Dr. Patel still has his original house, but cannot afford to spend on the luxuries he once did–further contributing to the decline in stock value of so many companies facing a lack of consumer demand. And what of Mr. Waldervilt the III? Well, he resigned with a golden parachute. His severance package was 75% of his salary for a year, and he still received his bonus–for failing.

Moral of this story: Like a house, an economy with a strong foundation will have a better chance at weathering tough, economic storms.

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