Monday, December 29, 2008

Be Stingy - Help the Economy!

This has been an unusual year, to say the least.

Gas went from a high of nearly $5 a gallon in some places (in some places more than that!) to a low of $1.50 in others (and even less than that!) all in the matter of a few months.

When markets shift like that, it should make you nervous.

What drove the price of gas up? Some say speculators. Some say demand. Others say low output from refineries, combined with problems associated with pipeline damage and hurricanes. In reality, it probably was all of these to some extent.

What drove prices so far down? A staggering drop in demand. How is than even possible?

To begin with, understanding how prices are affected by demand is important. Even a small drop in demand or a small increase can cause prices to fluctuate wildly.

For example, suppose in a small town there are 100 homes for sale and 99 buyers. Well, clearly, someones home is not going to sell. So that homeowner will drop his price. As a result, perhaps one of the buyers will buy his house instead. This in turn will cause another homeowner to drop his price. Perhaps if prices drop enough, another buyer will appear to snatch up a bargain.

Conversely, if there are 99 homes for sale and 100 buyers, one buyer is not going to get a house. He might bid up the prices in an attempt to buy a home, which in turn can cause a bidding war.

If the median home price in our mythical town is $100,000, it is not hard to see how a small bidding war, between even a few buyers, can increase home prices by as much as 5-10%, as the incremental monthly cost of ownership is not that great. Similarly, it is not hard to see how even a small discrepancy between the number of sellers and buyers can drop prices dramatically - again by as much as 5-10% without effort. And all this because of a ONE PERCENT difference between buyers and sellers!

So you see, our "housing bubble" was not due to huge demand and the collapse was not due to a huge drop in demand. People still want houses, just not as much as before. If demand drops 5-10%, housing prices can drop 20-30% easily.

Gasoline works the same way. Economists have often argued that the demand for gasoline was inelastic - that is to say that the amount we need is the amount we need, and that's that. But the experiences of the last 40 years, since the oil embargo of 1973 tells another story. Americans can dramatically alter their consumption of gasoline. And even small changes in consumption patterns can cause HUGE changes in pricing.

In the last decade, Detroit has sold a lot of 10 mpg trucks, much to everyones dismay. After decades of restraint, GM introduced a 8.3 liter V-8, Ford a V-10, and Dodge a "hemi" 5.7. And Americans bought them, usually nestled in the engine bay of a 6,000 lb truck or SUV. The days of small engines and small trucks, it seems, were gone for good.

And of course, Americans did not "need" such vehicles. If you look at the horsepower and displacement ratings of HEAVY DUTY trucks from the 1930's and 1940's, you'd be shocked to discover that most had horsepower ratings lower than many family sedans today. Yet they literally hauled tons of cargo at a time. Larger engines mean greater off-the-line acceleration, but little else.

Once gas hit $4 a gallon, filling these behemoths become problematic. People started trading down, driving slower (or accelerating more slowly) and taking fewer trips. Demand dropped - not by much, but it dropped, to levels lower than seen in decades. And this relatively small drop was all that was needed to create more supply than demand and drive prices plummeting.

As the economy has worsened, and more importantly, as NEWS of the economy worsening has spread, people are thinking twice about major purchases, and even shopping more carefully than ever before. I know I am, for example.

While some of us do not NEED to be frugal, doing so helps the overall economy. Even if you can "afford" to waste gas, if you use less, it keeps the price of gas down - and this in turn helps us all. Shopping carefully and comparing prices and quality keeps retailers and manufacturers on their toes - to increase efficiency and improve quality - and lower prices.

Of course, there is a downside to all this frugality. In the heady 2000's, we all spent money like drunken sailors. I rarely looked at grocery store prices back then - only ingredients and quality. How much it cost was "whatever". And this was true for many people besides myself and for items other than groceries. Who cared how much gas cost, as long as it was cheap and we all had money, right?

In this new economy, people are more price-conscious than ever. Regular retailers are hurting, but Wal-Mart is doing a banging business. As a result, some retailers and manufacturers are going to go under - those that are not efficient and have low overhead. Retailer Linens 'n Things went bankrupt because they could not service their staggering debt load - their overhead was simply too high. This means unemployment for yet more people - more people who in turn will shop more carefully, scrutinize prices, and in turn put more folks out of work.

What this also means, fortunately, is that other businesses will do better. Bed Bath & Beyond will no doubt benefit from the sudden demise of its #1 competitor. Their profit margins will increase as a result - until some savvy entrepreneur realizes that maybe it is time to get into that market space.

In short, we are having a long-overdue belt-tightening. Workers will appreciate their jobs more, as they become scarce. Employers will insist on more productivity from their employees. Prices will be much more competitive. Efficiency will improve. That is, until we all start making money again and go back to our same old bad habits.

This time may be different, though. Our population is aging, and as more people than ever reach retirement age, the impetus to live stingy will increase. More folks like me will start to work out budgets, shop their insurance, and check the cost per ounce on spaghetti sauce. The stingy lifestyle could be the next big thing.

And this is not necessarily a bad thing. As I have demonstrated, you can live quite a comfortable life in this country on not a lot of money. You can "have it all" without having to pay through the nose. By keeping careful track of your spending (plugging those holes in the rowboat) you can live better, with less.

And by being a more careful consumer, you put pressure on the retailers and manufacturers to provide a better product at a better price. In short, being stingy helps us all.

Keep up the good work!