The Stock Market Faces Headwinds From Falling 401K Contributions

There a relatively new correlation between the stock market and employment, 401K contributions, that isn't receiving the attention that it deserves. Over the last 20 years, the stock market has enjoyed the benefit of a positive inflow of cash from 401Ks and retirement plans. It is likely that you will see this tailwind become as headwind for the market as more people draw on 401Ks and fewer people contribute. While there may be a net positive inflow in different sectors, inflows will be significantly lower than in the past.

There are three factors driving increased use of retirement savings. First, people are getting older and need income to live. Second, the unemployed will need a way to live and retirement savings is much cheaper than consumer debt. Third, even those that keep their job will need to need to paydown debt. Borrowing against a retirement plan will be attractive to many. In short, people are going to start using retirement accounts more and more.

This capital drain will cause some headwind for the market. This drain is going to occur at the exact same time as people reduce their commitment to retirement savings. There are three factors which will make people realize that saving for retirement makes no sense when they face insolvency in the present.

First, many of the unemployed have lost access to 401K plans which will constrain the inflow of capital into the market. They can't contribute a portion of a salary even if they have found a parttime job. Beyond the loss of employee contributions, the market is going to lose capital committed by employers as a match. In the net, the capital inflows from retirement plans will be growing more slowly over the next few years.

Second, companies are looking for ways to cut costs. As part of this initiative, employee benefits are under constant scrutiny. This scrutiny may play out in 1 of 3 ways. Companies may eliminate the benefit outright. Even if they keep the benefit, they may reduce or alter the matching payments. Even if the companies keep the benefit with the same matching terms, the market will still feel the loss of inflows if the company changes the match from cash to restricted stock. Given the labor market, it is difficult to image many companies increasing the capital allocated to matching retirement savings for employees.

Third, the most likely factor in reducing retirement savings will be the deleveraging of America. It is very difficult to justify saving for the future when the present is insolvent. Americans will shift resources currently set-aside for retirement to paydown debt. This process will be exacerbated by banks which are increasing interest rates and fees on access to credit. The basic problem is that consumer debt isn't tax deductible where retirement income is.

To give you some idea of how unfavorable retirement saving is vs consumer debt. If an employee puts away $1,000 with a $1,000 employer match, it will be worth almost $300,000 when the employee retires after 30 years (assuming an 8% return). After taxes, it will be worth something less. $1,000 of consumer debt at 14% will be almost 5 million dollars after 30 years. It isn't going to take a CFA for people to figure out that retirement savings simply makes no sense when they owe any consumer debt much less 2 trillion dollars of it.

The New Normal

The government’s efforts to save the economy have met to date with mixed results. On the positive side, the larger banks have shown profits, where even Citigroup has shown a profit of sorts. On the negative side, unemployment is increasing and underemployment is skyrocketing. The media has termed this the new normal. I would prefer the term what-the-hell-did-you-expect to describe the near-term prospects for the economy.

Here is the problem. The economic equivalent of Boyle’s Law is that you cannot create or destroy economic demand without creating wealth. The government cannot create wealth. The government can shift demand from one business to another by changing the relative cost of goods. It can shift demand from the future to the present by lowering the cost of consumption, ie interest. The government cannot create demand by itself, nor can induce economic prosperity with fiscal stimulus.

Stimulus without innovation is nothing more than borrowing prosperity from the future. It is unavoidable truth that when you create demand in one industry, say in autos with a cash-for-clunkers program, you are reducing demand somewhere else. When I spend $20,000 on a car, it is $20,000 that I am not spending elsewhere. In the case where I borrow the $20,000, it is $20,000 that I am not spending sometime else. The sum of the government’s effort is zero, where we are pushing demand from one business to another or from the future to the present.

I serve as an illustration of the problem. I am replacing perfectly workable air conditioners and heaters because the government is taking money from someone else to help me pay for it. The money that I am spending replacing the perfectly good air conditioners and heaters means that I am not doing the painting which actually needs to be done until next year. This is a zero sum game at best – and a negative sum-game should we find that good painters become bad air conditioner installers.

The government’s current approach to stimulus is far from a best case situation. We are heavily subsidizing the auto and lending industries. Both of these industries suffer from massive excess capacity. In the best case of the example above, a good painter becomes a good air conditioner installer because the increase in demand will lead to hiring. In the America in 2009, however, businesses aren’t hiring because the increase in demand serves only to soak-up excess inventory. So, the painters just become unemployed. This is why you see the GNP bottoming but unemployment increasing.

Price is the market mechanism for clearing inventory. Instead of allowing the price to clear excess inventory, the government is stealing demand from elsewhere to justify the existing price. The market works best when it is allowed to punish these people who cannot price products well. In this case, the market is punishing random people who had nothing to do with the poor decisions in the first place. The consequence is socialization of stupidity, in which the foolish benefit at the expense of everyone else.

This consequence is most clear in banking, where the government has decided to subsidize risk. We have lowered the cost of capital well below it true value. These subsidies have led many businesses to form a bank holding company. Subsidies in the case of health care and agriculture are of debatable merit, but they at least subsidize a public good. Comically enough, we are encouraging people to take risk during a credit crunch when capital should be treated with a premium. This is a level of stupidity that should be beyond even government bureaucrats.

The earnings report from Goldman Sachs is an unavoidable outcome of our folly. 80% of Goldman’s earnings came from proprietary trading. The report doesn’t indicate the amount of public assistance that Goldman received. But, as a bank holding company, it is entitled to borrow at the discount window. It can access the Treasury Auction Facility. It can issue debt backed by the FDIC. So while it may have paid back the TARP funds, Goldman Sachs has many lines of public assistance to subsidize its proprietary trading group. Is proprietary trading a public good?

Folks if you are wondering why we are seeing mixed messages in the economic results. It is because the government has one of the worst economic agendas since the Great Depression.
Even by government standards, this is simply stupid.

"What Conservatives Don’t Get"

The Conservative mantra of the day blames the current financial crisis on the government’s over-regulation of an otherwise sound banking system. They want you to believe that the crisis stems from an intrusive government forcing lending standards lower by government fiat, namely the CRA. While the government is at fault here, the government's intervention in the banking system is only a component of a much larger problem.

People think for a second. The entire sub-prime market is only 500 billion dollars. Every mortgage could go bad, and you are looking at a something less than a 250 billion dollar loss. The real estate market has lost over 3 trillion in value or more than 10 times as much – and we have yet to see even 50% of the sub-prime mortgages default. If the Community Reinvestment Act was a fault, why is the housing crisis centered in the condo markets of Vegas, Phoenix, and Miami.

The housing crisis is a serious problem, but it is only a part of the larger problem which is debt, specifically consumer debt. In economic terms, investment debt is unpredictable, where the economic impact of the debt depends on the success of the investment. Consumer debt on the other hand is very predictable. It pushes demand forward getting consumers to buy today what they would normally wait to buy. When we express future demand today, we pull revenue streams forward, thereby overstating present revenue.

The builder, unfortunately, doesn’t think that his revenue is overstated, and neither does the banker who starts lending on looser and looser terms. To them, the boom will never end. So the builder, in turn leverages his wealth, buying things from people who find themselves suddenly richer. Those people in turn leverage their wealth, and so on and so forth, until the economy is brimming with imaginary wealth entirely built upon imaginary revenue.

The problem is that at some point there isn’t enough future demand to pull forward. We hit that point in 2007. Housing demand for 2007, 2008, and 2009 had been depleted, having largely been filled in 2004, 2005, and 2006. There was no cheaper capital to pull into the game of low interest rates. In fact, we were experience the opposite as interest rates on variable notes reset higher, forcing the housing crisis. Higher rates forced people to sell at the exact same time that demand was falling. This was the housing crisis.

In the net, the problem wasn’t the marginal poor person buying a house that he couldn’t afford. The problem was the near-rich person who bought the swimming pool for the house that he couldn’t afford. It was people spending imaginary wealth, borrowed from bankers who imagined growing revenue streams. Having worked in banking for 20 years, I can assure you that the government didn’t force bankers to make bad loans any more than the zoo keepers force lions to eat red meat. The government simply lowered interest rates below the rate of inflation and stood back to watch economic gravity take hold.

The government is almost entirely responsible for this mess, but as conservatives lets at least blame the right people, and learn the right lesson. Failing to assign the blame for economic bubbles is the reason that so many politicians try to create them.

A Market Solution For Solving The Housing Crisis

While there is a lot commentary on the failures of the government’s plan to address the housing crisis, few offer alternative solutions. This article outlines a better way to deal with this problem, and not surprisingly, it is by letting the market work.

The government has thus far employed the Neville Chamberlain approach to economics: “we have jobs in our time”. An $8,000 tax credit will stimulate demand this year, but mostly by pulling demand forward from 2010 and 2011. Low interest rates do not help housing unless you lower the risk inherent in the loan. Lowering the cost of risk or giving people $8,000 tax credits is welfare. It simply shifts demand from the future to the present, and from non-housing goods to housing.

The downside to the government's effort is, of course, that we will get to the future at which point slack demand will prolong the recession. We have not only pulled demand from the future into housing, but we have pushed it away from productive sectors. So government’s solution is in short: fix housing by breaking everything else. The net effect is to encourage people to build houses that no one wants, nor can afford.

Unlike the government’s approach, this solution actually changes the dynamics of housing. It lowers the likelihood of future foreclosures even if asset values continue to fall. It is a series of incentives which get people to refinance their loans with additional capital. This is materially different than what the government is doing because the refi’s under the current program require neither additional financial or human capital. (Human capital is the upkeep you do on your house).

Here is the consequence. There is a home in Michigan the mortgage on which is about 25% underwater. The owner likes the place enough to keep the mortgage current. But in the back of his mind, he knows that it is likely that this house is going into foreclosure, so he invests zero into the house beyond the monthly mortgage. In his mind, he no longer owns the home, but is simply renting it from the bank. He treats the house like rental property.

Incentives can take many forms, but I will illustrate one as an example. Currently people are not allowed to take a tax loss on a primary residence. The government could enable people who refinance an upside-down mortgage with additional capital to take a tax loss based on the amount of the capital that they add to the loan. No one would dispute that paying say $10,000 into a loan that is $25,000 underwater is a tax loss. No sensible lender on a non-recourse loan would refuse to accept said money to refinance the loan.

Here is why this approach is better than what the government is doing. The market knows more about loan quality than the government does. The government’s approach is unfocused, wasting billions of dollars on loans that no one intends to repay as demonstrated by the default rate on loan modifications (more than 50%). People will only put more money into a loan that they plan to pay-off. So the market will direct the incentives to loans which the borrower at least thinks are good.

This transaction isn’t for everyone, and really is meant to show the consequences of the incentive. The guy in MI would take this deal because he doesn’t want to be a renter. More important than increasing the loan quality, this approach gives him an incentive to invest human capital in the house, if nothing more than raking up leaves. He happens to be rather handy with tools, and is more than willing to work on the house provided that the he shares in the benefit of the work. At this point, however, all of his work goes to the bank because that house is heading for foreclosure when he gets tired of paying so much in rent.

Again, this is just an example, here are the factors that you want to see in any incentive :

1) Verifiable : In the case above, the mortgage lender will get a check for additional principal.
2) Tied To Existing Housing : We do not want to encourage people to build more houses
3) Focused: The government may create the incentive, but the market must allocate it for it to work.

The current discussion of inflation and deflation is focused narrowly on money supply, which is important but only a small part of the equation. Gold bugs worry that printing money will lead to massive inflation. Deflation proponents argue that the government is not adding to the money supply because the new money simply replacing demand that has been lost to the deleveraging process. These oversimplied views of inflation miss the point: inflation is as much a function of the supply of goods and services as it is a function of money supply.


Once you factor in the supply of goods, and services you will see a struggle between inflationary and deflationary forces that will play out in this country on an uneven basis across the economy. Inflation will affect industries differently based on capacity, profit margins, productivity and exposure to a falling dollar. Secondly, you have to consider on what the government spends money rather than how much money is printed. Some industries will experience inflationary pressures sooner than others, while some industries are going to be stuck in a deflationary cycle for a long time.


For the near term, inflation in aggregate is unlikely. Today, the economy has massive over capacity, resulting from a decade long build-out to support consumer demand that was fueled by debt. That debt pulled consumption forward from the current recession into the boom years. So our industrial capacity exceeds consumption demand, and will for a long time. That demand is gone, but the capacity is here, and it will be here fighting inflation until it is worked off over a longer period of time. Basically it is very difficult to pass along higher prices when you have 10 competitors who are willing to hold the line on prices.

The discussion also misses the question: how is the money going to be spent? Not all government spending is equal. It is possible that, and has on rare occasions, government deficit spending leads to disinflation. For example, the money that the government spent on building out the Internet, has had significant deflationary affects by promoting productivity and competition. The inflationary impact of government spending is really a question of ROI. Wisely spent money isn’t inflationary, where as poorly spent money is.

As you consider what the government is spending the money on, you should worry more about inflation. The bulk of the money has gone into the financial system where it creates no supply of goods or services. The vast majority of the new money enables the Fed to hold troubled assets. This new money serves only to protect the foolish from the consequences of their action. Only the silliest of bureaucrats talk about making money on these investments. We are making pennies on the Goldman Sachs and State Streets while losing dollars in AIG, Citibank, and the rest of the portfolio.

Worse, the government is altering consumer demand in order to fight deflation where it is needed, at the expense of creating it where it is not needed. Housing in this country is overpriced. Cars in this country are overpriced. Yet, the government encourages us to buy houses, cars, and energy efficient products. When a buyer takes these incentives, it is at the expense of other parts of the economy. In my specific case, I am replacing a perfectly good air conditioner which is an energy efficient one solely because the government will pay me to do something stupid. Given the size of that expense, I am not painting my house which actually needs to be done. While this is my individual decision, it is clear from the statistics on car sales and retail sales that there is a transfer of consumption from retail to autos that is in part caused by cash for clunkers program.

The net effect of this is going to be terrible for the long-term economy, which leads me to believe that inflation wins out in this struggle over time. The government thinks that it is smarter than the market. In my case, the air conditioner company wins, while the painters and my neighbors lose. Whatever economic activity that is created by the winners will be more than offset by the economic loss created by the losers. People who need to be farmers, or painters, or waiters will continue to live on the government’s dime working in banking, and auto production, and whatever other business the government decides is good for the economy. At which point, money supply is somewhat beside the point.

Why The TARP Has Made Things Worse

Ronald Reagan once observed that the most terrifying words in the English language are: I’m from the government and I’m here to help. In the past year, the government has proved that he was a master of understatement.

In March of 2008, Congress spent billions of dollars to stave off financial calamity when Bear Sterns closed in on failure. Six months later Congress spent hundreds of billions to stave off financial calamity when Lehman did fail. Now six months later we are being told that we need to spend over a trillion dollars to stave off financial calamity. As the economic outlook continues to worsen, why isn’t someone asking whether the government‘s actions are helping or hurting the economy.Why are things are getting worse each time the government tries to help?

The answer is in a house in Michigan, another in Kansas, and a mostly vacant lot near my home in Marietta. It is in the 401K statement of virtually all Americans. The answer is evident to very person who runs a yard service. The answer is all around us. The real question is why is no one in Congress listening.

The answer is in a Michigan home which has lost approximately 35% of its value. The owner started with 20% equity, but his mortgage is underwater and falling. He likes his home so he keeps the mortgage current, but is not investing in it beyond the mortgage payment. He isn’t painting the house, replacing the wiring, or many of the other things that he would be doing without government interference. He is letting the house devalue because in his mind he expects the government to renegotiate his mortgage based on the appraised value of the house. In his mind, any investment in the house actually has a negative return.

The answer is in a mostly vacant lot in Georgia. The bank has replaced the developer as a patient investor in a partially completed condo project. The bank has a generous uncle who provides the 5% capital that makes patience possible. If the bank had to pay market rates for capital, this property would have been sold to an entrepreneur willing to invest new capital and new ideas into the project. Instead of producing jobs and wealth in Georgia, the property sits idle, depreciating.

The answer is the 401K statement of virtually all Americans. The government borrowed the money which it gave to the banks allowing them to comfortably hold depreciating real estate projects. That capital came from somewhere. In all likelihood, that capital came from the stock market, which is down 40% since the government started helping. It also came from real estate projects that were never started. It came from Christmas presents that were never bought. Basically we fixed the banking industry by breaking everything else.

Whether it is the Treasury’s Asset Relief Program (more commonly known as “TARP”) or buying bad mortgages, the government’s efforts are creating enormous economic displacements some of which are counter-productive. The TARP, for example, traps capital in the hands of the people who didn’t see the crisis coming. If that isn‘t foolish enough, the government also limits what these companies can pay to attract better managers of capital. At the same time, this program penalizes better-run banks which have to raise capital in the open market where it is much more expensive. In short, we subsidize weak managers of capital at the expense of good managers, and we wonder why the economy is faltering.

Capitalism is simple. It requires two things: stability and confidence. Confidence drives investment because it stems from the belief that tomorrow will be better than today. Instability translates to risk, which is ultimately priced into every transaction. Risk is sand in the machine. Last summer, my yard service increased my prices by 22% because of rising energy cost. When I asked them about the impending price decreases to reflect falling energy prices, the owner shrugged and said he couldn’t lower prices because he had no idea when energy inflation would return. He smiled and offered me a variable rate indexed to oil. I declined because I have no idea what the price of oil will do.

We may have fixed the banking crisis, but we did so by breaking everything else. Now the government is going to help fix the housing crisis. Where is Ronald Reagan when you need him?