The Economic Advisor

4 Reason the Economic Crisis Isn’t Over

There has been a great deal of talk recently about “green shoots” and a pending economic recovery.�Unfortunately, when I analyze the financial and economic landscape, one conclusion becomes quite clear:�The economic crisis isn’t over, it’s just getting started.�The federal government’s astonishing debt and deficit levels, combined with a consumer who is saving more and spending less, will lead to higher unemployment, more bailouts, an increase in interest rates and adverse inflation.�Below are the four main problems the U.S. economy faces.�

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1)The Consumer is Broke- Over the last 25 years, consumer spending as a percentage of GDP rose from 61% to 70%.�� This incredible increase in spending has been fueled by both a decrease in savings as well as an increase in household debt.�The following government statistics tell the story:

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��������� Since the early 1960s, the average Personal Savings Rate has been about 7%.�By 2006, the Personal Savings Rate actually fell below 0%.

��������� Since the Reagan years, the Household Debt Service Ratio has averaged 12%.�Today, even with extremely low interest rates, this ratio has increased to about 14%.�

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Presently, a paradigm shift is taking place.�Having seen the value of their investments and homes significantly decline, households are increasing savings, paying down debt and, as a consequence, spending less money on discretionary items.�We’ve already seen the Personal Savings Rate rise to over 4% this year and I expect this rate to get back to the aforementioned 7% historical rate.���

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This shift in consumer spending habits will have a profound effect on the economy.�Basically, there’s too many companies making too much stuff, and too many stores selling all this stuff.�Expect more layoffs and reduced corporate profits in the coming years.

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2)More Bailouts on the Way - While the government bailouts of the banks and automobile companies have been astonishing, there will certainly be more bailouts over the next few years.�The Federal Deposit Insurance Company (FDIC),commercial real estate firms and life insurance companies are all facing a crisis of historic proportions.

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A)FDIC - If a bank fails, the FDIC guarantees that each depositor will get their money back (up to a limit).�The FDIC pays for these guarantees by collecting a small fee from each bank, based on the size of each bank’s reserves.�Since the start of the economic crisis, the FDIC’s assets have dropped from $60 billion to about $13 billion.�While $13 billion sounds like a sizeable sum, it’s�only a tiny fraction of the amount they guarantee.�There are over 300 banks on the FDIC’s watch list (the banks most likely to fail) and these banks have total deposits of about $200 billion, which is 15 times more than FDIC assets.�In other words, if more than 6% of these banks fail, the FDIC will be broke.�Even worse, the FDIC guarantees a total of $5 trillion in deposits.�This means�the FDIC has 1/3 of a cent for every dollar they guarantee.

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B)Commercial Real Estate - During a recent speech, Dennis Lockhart, president of the Atlanta Federal Reserve Bank�said, “On our watch list this year as a risk to the [economic] outlook is continuing worsening in the commercial real estate sector.”��With available office space increasing rapidly and rents dropping fast, a significant portion of the $400 billion in commercial real estate loans coming due in the next year are in serious jeopardy without a bailout.

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C)Life Insurance Companies - Life Insurance companies hold an astounding $5 trillion in assets to pay for the future claims of their policy holders.�Unfortunately, a majority of their assets are in commercial real estate, mortgages, bonds and equities.�All of these asset classes have either had precipitous drops in value or are in jeopardy of facing staggering losses in the near-future.�

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More bailouts will cause the federal government to take on more debt.�As we’ll see in the next section, increasing levels of federal debt are going to drive interest rates to an extremely high level.

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3)Interest Rates on the Rise - The U.S. public debt is nearly $7 trillion and about 40% of this debt matures within one year.�Moreover, the Obama administration expects to borrow an additional $2.5 trillion this year.�Combined, that’s $5 trillion which needs to be raised in the next year.�Unfortunately, the bad news doesn’t stop there.�It’s quite possible $500 billion or more of the current holders of short-term debt will not reinvest their money in U.S. Treasury debt.�If that happens, $3 trillion of new money will need to come into the Treasury market to buy debt securities in the next year. The only way to attract anywhere near that number of buyers would be for interest rates to increase dramatically. �Rising interest rates will

�Furthermore, even if interest rates were to double from their current rate, I still have a hard time believing more than $2 trillion in debt can be sold.�When this situation comes to pass, the buyer of last resort will be the Federal Reserve.�When the Federal Reserve begins buying huge amounts of Treasury debt, inflation will start to increase rapidly along with interest rates.

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4)Accelerating Inflation - Inflation is defined as an increase in the supply of money.�The Federal Reserve buys U.S. Treasury debt with freshly created money, thereby increasing the money supply.�Once the Federal Reserve becomes a major buyer of U.S. Treasury debt, you can count on inflation becoming endemic.�Rapid inflation can wreck an economy as people begin to focus on spending their money quickly and speculating on investments which will hold their value.�

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While the huge amount of federal stimulus money has momentarily slowed the deterioration in the economy, the talking heads, economists and investors who believe an economic recovery is right around the corner will be sadly mistaken.�The combination of reduced consumer spending and rapidly increasing federal debt will lead to an economy with little or no growth, rising interest rates and pernicious inflation.�

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My next article will focus on investments that will flourish in this economic environment.�

Randall Reinwasser MBA, CMFC is an Investment Advisor and President of http://www.401kFinancialAdvisor.com an SEC regulated investment advisory firm located in Fountain Hills, Arizona. Please visit our website if you’d like to contact me or are interested in obtaining unbiased 401k investment advice.