A Vicious Cycle

In talking with a friend yesterday, I mentioned that we have lived through events that always seemed at the time would forever alter our way of thinking and living, most recently, of course, 9/11 which was preceded by the bursting of the internet bubble. But, life pretty much returned to normal (aside from airport security, entering office building, going to stadium events and fear mongering as a political tactic) after a few years. I have not lived through a macro event that has profoundly change my life for the worse. In the past century, there was the Depression and the two World Wars, all of which I missed. Are we now experiencing such an event or will our economic life be back to normal within a few years? I can't answer that but what I can say is that it is easier to understand how a downward vicious cycle could play out then it is to create a scenario whereby life returns to normal.

Here's what I'm questioning: Are we starting a vicious economic cycle in which the contraction in liquidity, reduces consumer spending, reducing production, resulting in job losses, resulting in further reductions in spending, etc.

We are already experiencing the vicious cycle of asset deflation: falling prices causing margin calls which cause selling, pushing prices down, causing more margin calls, etc. Now here's how Paulson screwed up (just one of many ways): the original TARP was set up to buy mortgage backed securities from the banks. This provided some price support for that debt and at least temporarily shored up the banks and hedge funds. When he announced that he was scrapping that plan, the price support for those assets fell away and although I have no data to back this up, I believe it has caused more forced selling in the market.

One factor that I believe will slow down any recovery is that products last longer. The idea of built in obsolescence simply doesn't exist anymore - except for maybe ipods and cell phones. TVs, automobiles, refrigerators, ovens, blenders, have very long life spans. If people don't have the money and financing is hard, cars do not have to be replaced every three or four years for shiny new models and TVs and stereos seem to last forever. Better products and improved productivity in a contracting economy could further exasperate this downturn by further reducing manufacturing and increasing unemployment and depressing the economy.

I can only see two possibilities for an economic revival: 1) The developing and emerging markets grow and thrive without the US consumer, and 2) The US government invests heavily in large public service projects such as infrastructure and energy.

I honestly don't know what will play out and, let's face it, it is very difficult to know the long term effects of any event when you're in the middle of it.

As for the stock market, by every short term indication, it is way oversold.