I knew exactly when 2008 was over. How? I watched the giant Waterford Wedgwood crystal ball descend on Times Square, like I do every year. It's a classic symbol of starting the New Year with a clean slate.
Five days later, I stumbled across this headline: "Waterford Wedgwood Files for Bankruptcy." Less than a week into the New Year, and the maker of one of the most eminent symbols of starting anew was shattered by a crumbling global economy. Totally reassuring, I know.
No surprises then that another recent headline read, "Consumer Confidence Drops to All-time Low."
Stop, drop, and panic
It's true. Consumer confidence -- a monthly survey asking 5,000 households how they feel about a basket of economic circumstances -- fell to an all-time low of 38.01 in December. For perspective, the average reading going back to 1967 is 97.1. One year ago, it was trudging along at 87.32. As recently as September, it was in the sixties. Confidence might be the only thing that fell faster than stocks in the past few months.
I suppose the inner optimist in you could take it as contrarian indicator. During the last recession, consumer confidence bottomed out in March 2003 -- the very month the market began a four-year surge and stocks like Yahoo!
But let's also not forget that the stock market and the economy are two different creatures. The market looks ahead, whereas the economy is here and now. While stocks could easily rebound in the not-so-distant future, the plunge in consumer confidence might haunt us for a while, especially in today's environment. Why?
We got familiar with all sorts of acronyms in 2008: CDS, MBS, ABS, CDO, and everyone's bailout favorite, TARP. Now, let's meet 2009's acronym of the year: ZIRP, or Zero Interest Rate Policy. It's the new reality now that Fed Chairman Ben Bernanke is out of bullets, slashing interest rates to zero to free up credit.
The typical recession-fighting weapon is to cut interest rates, loosening up the credit spigot and getting consumer confidence rollin' again. This time around, that weapon's already been exhausted -- the tools used to get consumers moving again are pinned up against a wall. Since 70% of GDP comes from consumer spending, the pain is felt nearly everywhere, but the biggest losers are companies like Sears Holdings
Credit has, of course, been hit with a nuclear bomb. To boot, the fear of more economic bedlam makes saving for a rainy day especially attractive. When people either cannot or choose not to spend, aggregate demand goes down. When demand goes down, prices go down. When prices go down, wages go down. When wages go down, demand goes down. And around and around we go, rinse and repeat.
Take a simple example: Let's say a home costs $200,000, but you think prices will keep dropping month after month. What do you do? You postpone buying until next year. By postponing, demand (and price) falls even more. Now that same home costs $190,000. Your anti-spending behavior has been vindicated. Now you know prices will keep falling. You're a genius. So you postpone again. And again. Then your wage gets cut, and your ability to spend falls even more.
Eventually, with the expectation of deflation in full force, hoarding money becomes the smart thing to do. If enough people embrace this mind-set, deflation feeds on itself. Yet, since interest rates are already zilch, there's little Bernanke can do to break the cycle (save for a slew of experimental measures like buying Fannie Mae
It's called a liquidity trap, and it's about as cool as a cold sore.
Where to now?
What does a liquidity trap have to do with consumer confidence? They're really one and the same, and that's what's daunting about the whole thing. The mechanism needed to boost consumer confidence is an end of the credit freeze, getting people to spend at least enough to put a floor under job losses. Problem is, the liquidity trap poses a total roadblock to get spending back in gear. The lower consumer confidence is, the deeper the liquidity trap will get; The deeper the liquidity trap gets, the lower consumer confidence will fall. Chasing cat, meet tail.
Someday the trend will break, and inflation will reign again. I, for one, think that day is a ways off. With consumer confidence in the pits and a liquidity trap smothering its recovery, deflation is threat No. 1 in 2009.
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Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Sears Holdings is a Motley Fool Inside Value recommendation. The Motley Fool is investors writing for investors.