I have just taken a look at the consumer credit figures for September, released just yesterday by the Federal Reserve. The data do show some modest deleveraging, especially when looking at the recent increase in nominal GDP. However, it is still not clear to me that the scale of deleveraging is great enough to induce a recessionary relapse.

My baseline for deleveraging is Debt to Nominal GDP – when debt to GDP goes down, that shows deleveraging. For example, for the latest data released in September for Q2 2009, Private sector total debt to GDP (incl. financial services) in the U.S. was 292.2% of GDP. Because of the huge drop in nominal GDP, this was actually up from 283.0% when the recession began in Q4 2007. For households, the number was 96.8% in Q2 2009, up slightly from 95.9% at the end of Q4 2007.  What this shows is that deleveraging has yet to begin in earnest as debt levels have remained relatively high even while GDP had collapsed.

The lack of deleveraging is probably a result of financial stress. In the Great Depression, the personal savings rate dropped from 4.5% in 1929 to 4.1, 3.9, –0.9, and finally -1.5% in 1930-1933.  People had to use savings to service debt as the deflationary spiral took hold.

So, in the absence of quarterly data on debt levels, I look at data from things like consumer credit for a proxy.  On a seasonally-adjusted basis, consumer credit declined to $2.471 to $2.456 trillion. That is the lowest since June 2007 and marks the ninth consecutive monthly drop.

However, looking at the non-seasonal data makes plain what is happening:

Nonrevolving credit is now increasing along with GDP. Look at the area highlighted in red; that coincides with the 3.5% real GDP print we just saw. On the other hand, revolving credit is getting crushed. Below is the reason why (click to expand):

Credit from commercial banks and savings institutions have dropped off a cliff.  When you hear people saying that banks aren’t lending, this is what they are talking about. In Q3, banks are lending again (think cash for clunkers) because nonrevolving debt is up.  That’s also why GDP is up. But, revolving credit lines (credit card lines) are being cut.

My conclusion is largely the same as last month, namely I had anticipated more deleveraging than we are seeing. However, consumer credit is only coming down on the nonrevolving side. And given the stabilization in house prices and increases in refinancing activity, I wouldn’t expect mortgage debt levels to be down substantially. When we see Household Debt to GDP levels from Q3, they probably will not be substantially lower than they were in Q2.

This does support recovery but only at the risk of continued high levels of debt to GDP.

G.19 data series – Federal Reserve

Related posts:

• Data on past consumer deleveraging during recessions
• Consumer credit falls 4.4% from year ago levels
• Why is everyone saying consumer credit is falling? It’s not.
• Do the personal income data demonstrate unbalanced reflation?
• Household debt as an indicator of secular bull and bear markets

CIT has the approval of debtholders to file a prepackaged bankruptcy. This comes via Business Wire:

CIT Group Inc. (NYSE: CIT), a leading provider of financing to small businesses and middle market companies, today announced that, with the overwhelming support of its debtholders, the Board of Directors voted to proceed with the prepackaged plan of reorganization for CIT Group Inc. and a subsidiary that will restructure the Company’s debt and streamline its capital structure.

Importantly, none of CIT’s operating subsidiaries, including CIT Bank, a Utah state bank, will be included in the filings. As a result, all operating entities are expected to continue normal operations during the pendency of the cases.

All classes voted to accept the prepackaged plan and all were substantially in excess of the required thresholds for a successful vote. Approximately 85% of the Company’s eligible debt participated in the solicitation, and nearly 90% of those participating supported the prepackaged plan of reorganization.

Similarly, approximately 90% of the number of debtholders voting, both large and small, cast affirmative votes for the prepackaged plan. The conditions for consummating the exchange offers were not met.

Accordingly, CIT’s Board of Directors approved the Company to proceed with the voluntary filings for CIT Group Inc. and CIT Group Funding Company of Delaware LLC with the U.S. Bankruptcy Court for the Southern District of New York (“the Court”).

Due to the overwhelming and broad support from its debtholders, the Company is asking the Court for a quick confirmation of the approved prepackaged plan. Under the plan, CIT expects to reduce total debt by approximately $10 billion, significantly reduce its liquidity needs over the next three years, enhance its capital ratios and accelerate its return to profitability.

“The decision to proceed with our plan of reorganization will allow CIT to continue to provide funding to our small business and middle market customers, two sectors that remain vitally important to the U.S. economy,” said Jeffrey M. Peek, Chairman and CEO. “We are enormously appreciative of the extraordinary support we have received from our many constituencies. This market-based solution allows CIT to enter into the reorganization process well-prepared and positioned for a swift emergence. I want to thank our customers for their support and express my gratitude to our employees whose dedication and hard work are crucial to the future of CIT. We also acknowledge our constructive working relationship with our regulators and look forward to their continued guidance as we move through this process.”

For more than 100 years, CIT has provided much needed capital to small business and middle market customers. These two sectors play a vital role in the U.S. economy and in overall employment and job creation, representing more than 90 million employees.

Related posts:

• Obama Team considering a pre-pack Auto bankruptcy
• GM gets the green light on its section 363 bankruptcy
• The case of the dissident Chrysler bondholders
• Is the GM section 363 bankruptcy plan really a stealth re-organization plan?
• CIT: $3 Billion Credit Facility and Recap Plan

You have probably heard a lot of chatter from the media about a newfound thrift amongst American consumers.

The general take is that Americans, faced with lost incomes and wealth and burdened by record levels of debt, have moved away from the asset-based consumption models of yore. Instead of using the 401(k) or the house to do one’s savings, Americans are now saving the old-fashioned way by cutting spending and stashing money away in bank accounts.  The commonly-held belief is that we are witnessing a secular change away from excess consumption toward thrift in the household sector.

Not true.

If you haven’t noticed, asset markets in the United States are all rising: stock prices, bond prices, house prices, even gold prices and commodity prices. This certainly is not lost on the mutual fund industry.  And it is not lost on American households either.  The savings rate has declined to 3.0% after briefly hitting an 11-year high of 5.9% in May.  Welcome back to the asset-based economy.

(click on image to enlarge)

In the charts above, the left side shows how savings levels spiked up in response to the recession and credit crisis. The right side shows a fall off in the savings rate since May, just after the jobless claims numbers first began to recede.

A few factoids about the savings rate:

• Savings rates averaged 9% through 1982. They were consistently above 7% through 1992. Since then, savings rates have collapsed. From Jan 1969 to November 1997 (comprising all monthly data since record-keeping began), the 10-year average savings rate was higher in every single month than the 5.9% savings rate achieved in May 2009.
• Measuring the 12-month average savings rate, savings troughed in America at an all-time low of 1.4% in April 2008.
• Average savings has since increased monthly to the present 3.9%.
• The monthly savings rate peaked in May 2009 at 5.9%.  It declined every month to August, hitting 3.0% in August.

What should be evident from the charts above is that the collapse in savings coincided with the secular bull markets in bonds and equities and with a secular build-up of debt (see “Household debt as an indicator of secular bull and bear markets”).

My takeaway from the data during this past downturn is that American households are not necessarily saving more. As asset prices have risen, a return to the asset-based economic model seems to be taking hold. Let’s look to future personal income data from the BEA to confirm if this trend holds.

If so, the feedback between asset price increases, collateral for bank lending, increased consumption and economic growth could be more powerful than is commonly assumed. This is what could drive a multi-year recovery… that is until the next debt- and asset bubble-induced downturn ends this brief nirvana.

Related posts:

• Do the personal income data demonstrate unbalanced reflation?
• Chart of the day: Savings Rate
• US personal income data for September shows pullback
• Household debt as an indicator of secular bull and bear markets
• Stephen Roach: Americans’ abandonment of overconsumption is a good thing

I found the recent consumer credit data unsatisfying because the data seemed to point in two directions. The seasonally-adjusted data showed a large $12 billion decrease in consumer credit which received headlines. Meanwhile, the non-seasonally adjusted data showed a large $7 billion increase in consumer credit. I suspect this divergence has a lot to do with cash-for-clunkers (post here), but we can’t be 100% sure until we get another month or two of data.

Let’s delve into this issue a bit more because we are at  a critical stage in the economy right now. A lot of pundits are talking about a V-shaped recovery, while others are pointing to a secular move toward consumer deleveraging which basically spells no recovery.

I am somewhere in between, believing we will get a weak recovery that could or could not last more than a couple of years depending on the path of consumer deleveraging. While I do believe the U.S. economy is fast approaching ‘terminal debt,’ I am not convinced we are there in this particular cycle, largely due to the massive stimulus and easing. The posts which best outline this view are two recent ones, “The recession is over but the depression has just begun” and “A brief look at the Asset-Based Economy at economic turns.”

So, here are my questions on consumer credit:

• What happened to consumer credit in past downturns? 
• Specifically, how much did it decline from peak to trough?
• Was the decline mirrored by a similar fall in output as measured by nominal GDP?
• Is the pattern this time around any different?
• And what does that say about the thesis of secular deleveraging?

The way I am going to attack these questions is by looking at past recessions and peak-to-trough declines in both nominal GDP and consumer credit (note: the credit series is monthly, but the GDP series is quarterly – and I am leaving out the recessions in 1945 and 1949 because of wartime anomalies).  Here goes.

1953-54

• GDP declined 1.8% peak to trough. Consumer Credit declined 1.6%. It took 8 months to hit the previous credit peak.

1957-58

• GDP declined 2.7% while credit declined 1.6% from January to June of 1968.It took 11 months to hit the previous credit peak.

1960-61

• GDP declined 1.0% and credit also declined 1.0%.It took 8 months to hit the previous credit peak

1970

• Nominal GDP did not decline due to inflation. Credit did decline from October to November 1970 by 0.2% however.It took 2 months to hit the previous credit peak.

1973-75

• Again inflation meant nominal GDP did not decline. Meanwhile credit declined 1.8% from September 1974 to June 1975.It took 13 months to hit the previous credit peak.

1980

• Again inflation meant nominal GDP did not decline. Meanwhile credit declined 1.8% from February to June 1980.It took 12 months to hit the previous credit peak

1982.

• GDP declined 0.3% and credit also declined 0.1%.It took 2 months to hit the previous credit peak.

1990-91

• Inflation meant nominal GDP nearly did not decline (down –0.08%). Meanwhile credit declined 2.0% from November 1990 to well past the recession’s end in June 1992. It took an enormous 27 months to hit the previous credit peak. This was the worst credit cycle to date.

2001

• We cruised through this recession with neither a decline in nominal GDP or credit.

2007-2009

• GDP declined 2.7% and credit has already declined a massive 4.6%. This is the largest decline in consumer credit to date.

The table of data looks like this:

I draw the following conclusions :

• In an economic downturn, consumer credit has generally declined more than nominal GDP.
• The 1990-91 recession saw a very drawn out drop in credit and easily generated the longest time before credit regained its previous peak.
• The 2001 recession was unusual mild as it was the only time in the last 56 years that the U.S. has experienced a recession without a drop in consumer credit.
• The 2007-2009 recession has been unusually severe. The drop in nominal GDP is the largest in the last 56 years. However, the drop in consumer credit has been even worse at more than twice the largest previous decline.

None of this necessarily helps me decipher whether we are in a secular deleveraging cycle. But, the severity of the fall-off in consumer credit relative to output may point in this direction.

Related posts:

• Consumer credit down, but does it show deleveraging?
• Consumer credit falls 4.4% from year ago levels
• Unemployment claims falling faster than in half of past recessions
• Why is everyone saying consumer credit is falling? It’s not.
• Jobless claims rise slightly, weakness remains

The Federal Reserve has just released the most recent data on consumer credit. The data show outstanding consumer credit falling to $2.47 trillion in August from a December 2008 peak of $2.59 trillion – on a non-seasonally adjusted (NSA) basis. That is down 4.4% from the year ago period, continuing the acceleration of the year-on-year change that has been in place for 15 straight months. The seasonally-adjusted data tells an even worse story.

Clearly, consumers are not off to the races. Nevertheless, the NSA data do show a tiny pickup in overall consumer credit, although you have to go to the third decimal place to see it (from $2.460 trillion in July to $2.467 trillion in August.  You have to question the seasonal adjustments given where we are in the business cycle. So I am not using this data set.)

I was especially interested in the Federal Reserve’s data on Q3 consumer credit since I just crunched the numbers on their quarterly data and found that deleveraging in the household sector was not preceding as quickly as I had assumed (if at all).

What I am looking for is a sign of how consumer credit is proceeding as compared to output. But since we don’t have any monthly output data, we’ll have to wait. I will just comment on the trend.

The trend is down. Because of the decline in higher than normal inflation in 2008, we saw two peaks in year-on-year growth in credit. The first was August 2007 right before the recession began, when, adjusted for inflation, total consumer credit was growing 3.6% year-on-year. This went negative, reaching a trough of –1.5% in August 2008. Before climbing to a second peak of 1.5% in December.  Since then, the wheels have fallen off the cart and we are now down 2.9% year-on-year adjusted for inflation (all of the figures are NSA).

But, remember nominal GDP is down 2.4% year-on-year through Q2.  That is the key here.  When one makes a comparison of nominal GDP to consumer credit, there had been little deleveraging through Q2 2009.  Moreover, since prices are still falling (NSA CPI is –1.5% year-on-year through August), the change in nominal GDP will be lower than real GDP for Q3.

It is still not clear to me that debt levels, when measured as a percentage of GDP are decreasing significantly. I am, therefore, much less sold on the prospect of a secular deleveraging in the household sector than I was yesterday.

And since consumer credit is much more volatile than mortgage-related debt and a much smaller percentage of household debt, I am more interested in how the mortgage market is doing.  Right now, mortgage applications are through the roof because of ridiculously low interest rates.

Source

G.19 data series – Federal Reserve

Related posts:

• Consumer credit down, but does it show deleveraging?
• Why is everyone saying consumer credit is falling? It’s not.
• Data on past consumer deleveraging during recessions
• Chart of the day: consumer credit growth
• Household debt as an indicator of secular bull and bear markets

In my last post, I presented you with a bunch of data on debt levels broken down by sector of the economy (see “A brief look at the Asset-Based Economy at economic turns”).  I found it interesting that a secular pattern seemed to be at play when looking at the household debt charts.

Notice the three areas boxed in red on the chart to the right.

The chart measures the differential between the year-on-year change in household debt and nominal GDP.

The three areas show three distinct periods of household debt accumulation.

1. 1951-1966. The first shows household debt changes generally outstripping nominal GDP by a wide but decreasing margin. This period coincided with a secular bull market in equities.
2. 1966-1982. This second period is more volatile, but with the overall numbers lower.  In general, debt was accumulated less rapidly compared to the growth in nominal GDP. And when recession hit in 1970, 1974 and 1980, it induced a retrenchment (at least relative to nominal GDP growth). This period coincided with a secular bear market in shares.
3. 1982-?. This last period shows an enormous increase in debt growth relative to GDP growth during the 1980s followed by minor retrenchment after the 1990-91 recession and strangely also in 1997 (could this be a butterfly effect to the Asian Crisis?). But after that it was off to the races right through the 2001 recession until mid-2007.  This period coincided with a secular bull market in equities.

The pattern seems to indicate that there is a relationship between debt build-up in the household sector and stock prices.  The build-up in debt relative to nominal GDP troughed in Q3 2008 at -0.4%. As of Q2 2009, the number was +1.2%.

I see this as evidence of the so-called Wealth Effect. The data suggest that the secular bear market may not have begun in 1998 or 2000 as I have generally believed. And they also suggest that, despite the recent rise in shares, a new secular bear market may have just started in 2007. I will be curious to see what the data look like for the second-half of 2009.

Source

Z1 Data Series – Federal Reserve

Related posts:

• Americans are not increasing savings
• A brief look at the Asset-Based Economy at economic turns
• Chart of the day: household debt vs. savings
• Consumer credit falls 4.4% from year ago levels
• Data on past consumer deleveraging during recessions

This morning I again wanted to challenge my somewhat bullish medium-term outlook but bearish longer-term view on the US economy – this time by looking at the data on debt. What follows is going to be a very numbers-heavy post.  So, I apologize in advance if you are not a numbers jockey like me. But, do bear with me; I think you will find the analysis useful.

Now, as I write this paragraph, I have compiled the data, but have not yet dissected it. So I approach this without any definitive conclusions at the outset (although I must admit the last time I saw the data last year, they supported my thesis). Let’s see if the data still support my beliefs .

The Asset Based Economy View of America

My pre-conceived thesis is as follows:

1. The U.S. has been living beyond its means for a generation as reflected in the increase of debt to GDP across a wide-spectrum of sectors of the economy.
2. This increase has not been worrying to policymakers because they have only been watching debt service burdens, to the degree they have been tracking debt.
3. Because of “the Great Moderation,” interest rates have fallen, permitting a secular increase in debt to GDP levels without increasing debt service burdens.
4. The Federal Reserve has a dual mandate to support economic growth (through full employment) while maintaining low consumer price inflation (through price stability). Cognizant that debt services burdens were not acute and consumer price inflation was low, the Federal Reserve was able to target asset prices through lowering the Fed Funds Rate as a mechanism for reviving the economy when cyclical downturns occurred.
5. As a result, the Federal Reserve under Sir Alan Greenspan followed an asymmetric monetary policy of only increasing interest rates slowly in the face of large levels of asset price inflation but reducing those rates very quickly to stem asset price declines.
6. The result has been a belief that the Fed would save the economy when it ran into trouble, the so-called Greenspan Put. This has increased the appetite for risk in the financial sector and, most crucially, has meant that debt levels always increased after a brief downturn. The heroic actions of the Bernanke Fed have only increased this belief in the Fed as economic savior, sowing the seeds of the next asset bubble.
7. This Asset-Based Economic Model can last through several business cycles – but will eventually collapse when debt service burdens become too large.

So, in sum, I believe that we are now poised to either a) collapse under the weight of debt only if debt service burdens are too much to bear or b) continue apace in the Asset-Based Economy until these burdens do eventually become crushing. I see b) [this originally said a) erroneously. A reader caught the mistake. Freudian slip?] as the more likely outcome during this cycle. Whether that crushing level of debt eventually comes as the result of a decline in incomes not matched by a decline in debt burdens (deflation) or via an increase in interest burdens not matched by an increase in incomes (inflation) is a question for another day.

What I want to look at here is the narrow issue of how debt burdens have moved at turns in the economic cycle. Specifically, I am about to examine the debt to GDP levels of specific sectors of the economy as presented by the Fed Flow of Funds right around recessions. And then I will compare these levels to the growth in nominal GDP and draw conclusions based on the data (debt cannot grow more than nominal GDP for long or it is a clear sign that growth is predicated not on sound investment and productivity but on leverage). 

So, this is not an exercise in crunching the numbers to fit a conclusion, but rather a look-see at whether the data supports my thesis.

The Numbers: Federal Reserve Z1 Data Series

The Federal reserve releases a data series called Z1 every quarter.  This is the basis of my analysis (link at the bottom). The Z1 series shows debt from the following sectors of the economy:

1. domestic nonfinancial sectors credit market instruments, excluding corporate equities liability
2. households and nonprofit organizations credit and equity market instruments liability
3. households and nonprofit organizations home mortgages liability
4. households and nonprofit organizations consumer credit liability
5. nonfinancial business credit market instruments, excluding corporate equities liability
6. nonfarm nonfinancial corporate business credit market instruments liability
7. state and local governments, excluding employee retirement funds credit market instruments liability
8. federal government credit market instruments liability
9. total finance credit market instruments, excluding corporate equities liability
10. rest of the world credit market instruments, excluding corporate equities liability

My pre-conception is that the sectors I want to key in on are the mortgage market (3), the household sector (4) and financial services sector (9)

Total Debt

What should be abundantly clear from the two charts below is that the U.S. has been growing in an unsustainable way since the recession of 1982.  There was a brief period during the 1990-91 recession when the change in nominal GDP outstripped increases in debt levels, but that’s it  (note, I use year-over-year change levels throughout). This is completely at odds with the preceding period in which every recession induced declines in debt to nominal GDP comparisons.

Debt levels at the end of Q2 2009 are 357% of GDP, a massive increase from the 160% that prevailed in 1982. The data clearly demonstrate that since 1982 the U.S. has relied on an increase in debt, even during recession, to avoid downturns. My thesis of policy asymmetry is, therefore, confirmed.

Government Debt

This chart is fairly benign when you look at aggregate levels as a percentage of GDP.  Pundits forecasting an imminent increase in U.S. interest rates because of too much government debt have obviously not looked at these data. However, what is striking is the huge and unprecedented surge in debt as a percentage of GDP since the latest downturn hit.  This discrepancy to nominal GDP cannot go on indefinitely.  My general conclusion is that deficit spending can indeed continue for a long time without stoking an increase in interest rates given the low level of government debt as a percentage of GDP. This is bullish for U.S Treasuries in a muddle through economic scenario.

Household Debt

There is less here than I anticipated.  One thing is clear: the household sector has breezed through the recessions in 1990-91 and 2001 without decreasing debt significantly.  As a result, the increase in debt levels in the household sector are pretty astonishing. In 1952, it began at 24% of GDP, rising to around 40% by 1960, where it remained through the Ford presidency. Afterwards, it shot up again to its present 97%, four times the level a half-century ago.

Mortgage Debt

This pattern is largely the same as the previous one.

Consumer Credit Debt

Consumer Credit seems to be much more volatile than mortgage credit.  You can see the fluctuations in comparison to nominal GDP are greater.  And the absolute amounts are much less than in the mortgage market. The conclusion I draw from this is that, to the degree household debt levels have increased unsustainably, it is mortgage debt which is to blame.

Non-Financial Business Debt

There is a lot more volatility in capital spending as reflected in non-financial business debt levels as well.  Nevertheless, there has been a secular increase in debt levels of the business sector, from 30% in 1952 to the present 78%. The one thing to notice on the chart on the right is how short business cycles were pre-1982.  It is more striking in that chart because business debt levels always adjust during recession.

State and Local Government Debt

Since the 1960s, state and local government debt levels have been basically flat as a percentage of GDP. There is not much to say here except to note the huge spike in the mid-1980s relative to nominal GDP.  Can someone explain this for me?  I think that area circled in red is quite intriguing.

Federal Government Debt

This chart looks basically the same with the total government debt charts as Federal Government debt dominates.  What you should notice is that debt levels are lower now than they were in the 1950s and have just passed the post 1950’s high-water mark in 1993 of 49%. Again, this does suggest there is ample room for deficit spending without an increase in interest rates.  The data are more favorable for treasuries than I had anticipated.

Financial Services Debt

This is probably the key damning piece of data confirming the asset-based economy thesis.  The data are much worse than I expected.  Not only do Financial Sector debt levels rise from negligible to percentages well over 100% of GDP, but the entire post-1982 period sees zero decline compared to nominal GDP until last quarter.

What conclusions can one draw here?

1. The financial services sector is six times more important than in 1982 when its debt is measured as a percentage of GDP.
2. The financial sector protected the American economy since 1982 by increasing its debt burden relative to nominal GDP even during recession.
3. The financial services sector contracted in Q2 relative to GDP for the first time since 1982.  If this is a rear-view mirror view, that means recovery could continue. However, if this is a canary in the coalmine, that is negative for the U.S. economy. This number bears watching.

Foreign Debt

There was an absolutely massive decrease in foreign debt relative to GDP when the economy was falling. Q4 2008 saw a gap of -12.4% between the change in foreign debt and the change in nominal GDP.  The year-over-year differential has diminished as Q1 and Q2 2009 saw foreign debt increase, albeit to a level much lower than in Q3 2008.

Conclusions

Most of my basic beliefs regarding the asset-based economy are still intact.  What now seems clear to me is the degree to which the post-1982 period is a departure from the one which preceded it. Moreover, the data on the financial services sector was surprisingly stark. I would go as far as to say that the US economy depends on leverage in the financial services sector to continue growing.  I come out of this thinking it is the financial services sector more than the household sector dictating the course of events. And as the financial sector just began to really deleverage in Q2, it bears watching how this proceeds.

As for the household sector, aggregate debt levels are not decreasing substantially – not in mortgages or consumer credit. This may have changed in Q3 but given the fact that the worst of the recession was in Q4 2008 and Q1 2009, the data suggest that the consumer will not deleverage.  If deleveraging doesn’t occur in the mortgage market, the household sector will not be the cause of a double dip.  So, not having looked at debt service levels yet, I am not anticipating an imminent downturn in consumption demand or a further increase in savings – although this could change based on the data.

In the end, my somewhat more bullish medium-term outlook is justified by the data. Here, I am not talking about longer-term sustainability but the prospects of a multi-year recovery. Watch debt levels in the financial sector as a contrary indicator.

Source

Z1 Data Series – Federal Reserve

Related posts:

• U.S. unemployment claims rise sharply
• GDP: imports, inflation and local government are the story
• Kill All The Storytellers
• If the UK economy is still in recession, why are London house prices hitting new records?
• ISM: September manufacturing data disappoint; market sells off

For the last few months I have been casting around looking for bullish data points as counterfactuals to my more bearish long-term outlook. I have found some, but not enough. If you recall, early this year, I stated that we are in depression, making the case for the ongoing downturn as a depression with a small ‘d.’ Nevertheless, I was quite optimistic about the ability of policymakers to engineer a fake recovery predicated on stimulus and asset price reflation and I certainly saw this as bullish for financial shares if not the broader stock market. But, I saw these events as temporary salves for a deeper structural problem.

As a result, I have been on a quest to find data which disproves my original thesis – signs that the green shoots that everyone keeps talking about (and a term I had banned from my site) are part of a sustainable economic recovery. Unfortunately, I have concluded that they are not. This post will discuss why we are in a depression, not a recession and what this means about likely future economic and investing paths. I will try to pull together a number of threads from previous posts, add some context via Wikipedia links and draw in some good discussion via recent posts by Prieur du Plessis on balance sheet recessions and Marshall Auerback on the sector financial balances model of economics which completed the picture for me.

This post is very long and I have had to shorten it in order to pull all of the ideas into one post. Please do read the linked posts for background as I left out some of the detail in order to create this narrative.

Let’s start here then with the crux of the issue: debt.

Deep recession rooted in structural issues

Back in my very first post in March of 2008, I said that the U.S. was already in a recession, the only question being how deep and how long – a question I answered in the next post saying “we are definitely in recession. And according to Gary Shilling, this recession is going to be a big one. Worse than 2001, 1990-91 or the double dip recession of 1980-82.” This has certainly turned out to be true.  The issue was and still is overconsumption i.e. levels of consumption supported only by increase in debt levels and not by future earnings. This is the core of our problem – debt.

I see the debt problem as an outgrowth of pro-growth, anti-recession macroeconomic policy which developed as a reaction to the trauma of the lost decade in the U.S. and the U.K.. This was a period of low growth, high inflation and poor market returns, in which the U.K. became the sick man of Europe and labor strife brought that economy to its knees.  It is a period that saw the resignation of an American President and the humiliation of the Iran Hostage Crisis.

In essence, after the inflationary outcome that many saw as an outgrowth of the Samuelson-Keynesianism of the 1960s and 1970s, the Reagan-Thatcher era of the 1990s ushered in a more ‘free-market’ orientation in macroeconomic policy. The key issue was government intervention. Policy makers following Samuelson (more so than Keynes himself) have stressed the positive effect of government intervention, pointing to the Great Depression as animus, and the New Deal, and World War II as proof. Other economists (notably Milton Friedman, and later Robert Lucas) have stressed the primacy of markets, pointing to the end of Bretton Woods, the Nixon Shock and stagflation as counterfactuals. They point to the Great Moderation and secular bull market of 1982-2000 as proof. This is a divisive and extremely political issue, in which the two sides have been labelled Freshwater and Saltwater economists (see my post “Freshwater versus saltwater circa 1988”).

However, just as the policy of the 1950s to the 1970s was not really Keynesian (read Keynes’ General Theory as Richard Posner did and you will see why), the 1980s-2000 was not really an era of true ‘free markets.’ I call it deregulation as crony capitalism.  What this has meant in practice is that the well-connected, particularly in the financial services industry, have won out over the middle classes (a view I take up in “A populist interpretation of the latest boom-bust cycle”). In fact, hourly earnings peaked over 35 years ago in the United States when adjusting for inflation.

Remember, the 1970s was a difficult period in which the U.K. and the U.S. saw jobs vanish in key industrial sectors. To stop the rot and effectively mask the lack of income growth by average workers, a new engine of growth had to be found. Enter the financial sector. The financialization of the American and British economies began in the 1980s, greatly increasing the size and impact of the financial sector (see Kevin Phillips’ book “Bad Money”). The result was an enormous increase in debt, especially in the financial sector.

This debt problem was made manifest repeatedly during financial crises of the era. Not all of these crises were American – most were abroad and merely facilitated by an increase in credit, liquidity, and international capital movement. In March 2008, I wrote in my third post on the US economy in 2008:

From the very beginning, the excess liquidity created by the U.S. Federal Reserve created an excess supply of money, which repeatedly found its way through hot money flows to a mis-allocation of investment capital and an asset bubble somewhere in the global economy. In my opinion, the global economy continued to grow above trend through to the new millennium because these hot money flows created bubbles only in less central parts of the global economy (Mexico in 1994-95, Thailand and southeast Asia in 1997, Russia and Brazil in 1998, and Argentina, Uruguay, and Brazil in 2001-03). But, this growth was unsustainable as the global imbalances mounted.

Eventually, the debt burdens became too large and resulted in the housing meltdown and the concomitant collapse of the financial sector, a looming problem that our policymakers should have seen. This is why my blog is named Credit Writedowns. But, make no mistake, the housing and writedown problems are only symptoms. The real problem is the debt – specifically an overly indebted private sector (note the phrase ‘private sector’ as I will return to this topic).

This is a depression, not a recession

When debt is the real issue underlying an economic downturn, the result is a period of stagnation and short business cycles as we have seen in Japan over the last two decades.  This is what a modern-day depression looks like – a series of W’s where uneven economic growth is punctuated by fits of recession. A recession is merely a period of recalibration after businesses get ahead of themselves by overestimating consumption demand and are then forced to cut back by making staff redundant, paring back inventories and cutting capacity. Recessions can be overcome with the help of automatic stabilzers like unemployment insurance to cushion the blow. Depression is another event entirely. Back in February, I highlighted a blurb from David Rosenberg which summed up the differences between recession and depression quite well.

Depressions marked by balance sheet compression
Recessions are typically characterized by inventory cycles – 80% of the decline in GDP is typically due to the de-stocking in the manufacturing sector. Traditional policy stimulus almost always works to absorb the excess by stimulating domestic demand. Depressions often are marked by balance sheet compression and deleveraging: debt elimination, asset liquidation and rising savings rates. When the credit expansion reaches bubble proportions, the distance to the mean is longer and deeper. Unfortunately, as our former investment strategist Bob Farrell’s Rule #3 points out, excesses in one direction lead to excesses in the opposite direction.

The next day, I highlighted Ray Dalio’s version of this story because it takes a historical view and rightly emphasizes the debtor instead of the lender as the crux of the problem. Notice the part about printing money and devaluing the currency if the debt is in your own currency.

… economies go through a long-term debt cycle — a dynamic that is self-reinforcing, in which people finance their spending by borrowing and debts rise relative to incomes and, more accurately, debt-service payments rise relative to incomes. At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce aren’t adequate to service the debt. The incomes aren’t adequate to service the debt. Then begins the reversal process, and that becomes self-reinforcing, too. In the simplest sense, the country reaches the point when it needs a debt restructuring…

This has happened in Latin America regularly. Emerging countries default, and then restructure. It is an essential process to get them economically healthy.

We will go through a giant debt-restructuring, because we either have to bring debt-service payments down so they are low relative to incomes — the cash flows that are being produced to service them — or we are going to have to raise incomes by printing a lot of money.

It isn’t complicated. It is the same as all bankruptcies, but when it happens pervasively to a country, and the country has a lot of foreign debt denominated in its own currency, it is preferable to print money and devalue…

The Federal Reserve went out and bought or lent against a lot of the debt. That has had the effect of reducing the risk of that debt defaulting, so that is good in a sense. And because the risk of default has gone down, it has forced the interest rate on the debt to go down, and that is good, too.

However, the reason it hasn’t actually produced increased credit activity is because the debtors are still too indebted and not able to properly service the debt. Only when those debts are actually written down will we get to the point where we will have credit growth. There is a mortgage debt piece that will need to be restructured. There is a giant financial-sector piece — banks and investment banks and whatever is left of the financial sector — that will need to be restructured. There is a corporate piece that will need to be restructured, and then there is a commercial-real-estate piece that will need to be restructured.

Commence the fake recovery

So where are we, then?  We have left the fake recovery and are entering a new era of growth that could last as long as three or four years or could peter out very quickly in a double dip recession. By now, you have seen my post on the fake recovery, so I won’t cover that ground here.  However, I do want to highlight how I came to believe in the fake recovery and how asset prices have played into this period (the S&L crisis played out nearly the same way).  I see writedowns as core to the transmission mechanism of debt and credit problems to the real economy via reduced supply and demand for credit. Again, this is why my site is called Credit Writedowns.

In March, at the depths of the downturn I wrote:

The problem is the writedowns. You see, if you get $30 billion in capital from the government, but lose another $40 billion because of credit writedowns and loan losses, you aren’t going to be lending any money. To me, that says the downturn will only end when the massive writedowns end, not before.

The U.S. government has finally realized this and is now moving to stem the tide. Their efforts point in four directions:

1. Increase asset prices. If the assets on the balance sheets of banks are falling, then why not buy them at higher prices and stop the bloodletting? This is the purpose of the TALF, Obama’s mortgage relief program and the original purpose of the TARP.
2. Increase asset prices. If assets on the balance sheet are falling, why not eliminate the accounting rules that are making them fall? Get rid of marking-to-market. This is the purpose of the newly proposed FASB accounting rule change.
3. Increase asset prices. If asset prices on the balance sheet are falling, why not reduce interest rates so that the debt payments which are crushing debtors ability to finance those assets are reduced? This is why short-term interest rates are near zero.
4. Increase asset prices. If asset prices on the balance sheet are falling, why not create Public-Private partnerships to buy up those assets at prices which reflect their longer-term value? This is what Geithner’s Capital Assistance Program is designed to do.

So I lied, there is only one direction the government is headed: increase asset prices (or, at least keep them from falling). Read White House Economic Advisor Larry Summers’ recent prepared remarks to see what I mean. (Summers on How to Deal With a ‘Rarer Kind of Recession’ – WSJ)

I was more on target in my thinking here than I could have known. Within two weeks, the mark-to-market model was dead and mark-to-make believe had begun. It was then that I knew a recovery was likely to take hold. And it was going to be bullish for bank stocks and the broader market. What you should realize is that, despite the remaining problems in credit cards, commercial real estate or high yield loans, limiting credit growth, the changes instituted by government definitely have meant 1. that banks will earn a shed load of money and 2. that house price declines have stalled, underpinning the asset base of lenders. This necessarily means an end to massive writedowns, a firming of banks’ capital base, and a reduction in private sector deleveraging.

As an aside, I should mention that this dynamic called the asset-based economy, where economic well-being is dependent on asset prices, is far more pronounced in Anglo-Saxon countries like the U.S. and the U.K. (and Australia, Ireland, and Canada to a degree). While the free market ideal has gained sway globally, it is viewed with much more skepticism elsewhere. In Germany, for example, the term Anglo-Saxon is often bandied about as an epithet for political demagoguery to represent free market ideology. These cultural differences are something I explored in my post “Cultural attitudes on work, leisure and wealth in Europe and America.”

As for the recent asset-based economic reflation, be under no illusion that these measures ‘solve’ the problem. The toxic assets are still impaired and banks are still under-capitalized. But the increased asset value and the end of huge writedowns has underpinned the banks and led to a rise in the broader market in a feedback loop that has been far greater than I could have imagined at this stage in the economic cycle.

The double dip or the economic boom?

So what’s next?  A lot of the economic cycle is self-reinforcing (the change in inventories is one example). So it is not completely out of the question that we see a multi-year economic boom.  Higher asset prices, lower inventories, fewer writedowns all lead to higher lending capacity, higher cyclical output, more employment opportunities and greater business and consumer confidence. If employment turns up appreciably before these cyclical agents lose steam, you have the makings of a multi-year recovery. This is how every economic cycle develops. This one is no different in this regard.

However, longer-term things depend entirely on government because we are in a balance sheet recession. Ray Dalio and David Rosenberg make this case well in the previous quotes I supplied, but it was a recent post about Richard Koo from Prieur du Plessis which got me to write this post. His post, “Koo: Government fulfilling necessary function” reads as follows:

According to Koo, American consumers are suffering from a balance sheet problem and will not increase consumption until their personal finances are back in order. The banks are not lending mainly because nobody wants to borrow and, furthermore, the banks want to build their own balance sheets (raise cash) and get rid of toxic garbage…

Again, when asked what would happen if the government cuts back on its fiscal stimulus, Koo replies: “Until the private sector is finished repairing its balance sheets, if the government tries to cut its spending, we’re going to fall into the same trap Franklin Roosevelt fell into in 1937 (a crushing bear market) and Prime Minister Hashimoto fell into in 1997, exactly 70 years later.

“The economy will collapse again and the second collapse is usually far worse than the first. And the reason is that, after the first collapse, people tend to blame themselves. They say, ‘I shouldn’t have played the bubble. I shouldn’t have borrowed money to invest – to speculate on these things.’

This view of a second, more serious downturn mirrors the one I wrote of when I wrote about high structural unemployment last week. And, again, it is predicated on what government does.  I wrote last November that if government stops the support, recession is going to happen.

The U.S. economy cannot possibly work itself out of the greatest financial crisis in some 70-odd years in a mere 4 years and then expect to raise taxes on the middle class without a major recessionary relapse.

So, when you hear policy makers talking about reducing the deficit as soon as possible, what you should think is 1938 and continued depression.

Right now, if you listen to what President Obama is likely to do when we see more economic growth, you know that the government prop for the economy is going to be taken away. Koo again:

So the fact that Larry Summers was talking about ‘temporary’ fiscal stimulus had me very, very worried. That whole Larry Summers idea that one big injection of fiscal stimulus will get the US out of the recession, and everything will be fine thereafter, probably led to President Obama’s saying he’s going to cut his budget deficit in half in four years.”

Get ready because the second dip will occur. It will be nasty: unemployment will be higher and stocks will go lower than in 2009. I am convinced that it is politically unacceptable to have the government propping up the economy as Koo suggests it should. The question now is one of timing: when will the government stop propping up the economy? The more robust the recovery, the quicker the prop ends and the sooner we get a second leg down.

So to recap:

1. A depression was borne out of high levels of private sector debt, the unsustainability of which became apparent after a financial crisis.
2. The effects of this depression have been lessened by economic stimulus and government support.
3. Government intervention led to a reduction in asset price declines, which led to stock market increases, which led to asset price stabilization and more stock market increases and eventually to asset price increases. This has led to a false sense that green shoots are leading to a sustainable recovery.
4. In reality, the problems of high debt levels in the private sector and an undercapitalized financial system are still lurking, waiting for the government to withdraw its economic support to become realized
5. Because large scale government deficit spending is politically impossible, expect a second economic dip within three to four years at the latest.

Why is government spending necessary?

The government plays a crucial role here because of the huge private sector indebtedness.  In the U.S. and the U.K., the public sector is not nearly as indebted. So while, the private sector rebuilds its savings and reduces debt, the public sector must pick up the slack.  Why do I say must? It’s because of an accounting identity which comes from the financial sector balances model. Marshall Auerback says it best in a recent post:

We’ve said it before and we’ll say it again. As a matter of national accounting, the domestic private sector cannot increase savings unless and until foreign or government sectors increase deficits. Call this the tyranny of double entry bookkeeping: the government’s deficit equals by identity the non-government’s surplus.

So, if the US private sector is to rebuild its balance sheet by spending less than its income, the government will have to spend more than its tax revenue. The only other possibility is that the rest of the world stops saving on a massive scale — letting the US run a current account surplus. But that is highly implausible and socially undesirable, since it means we export our economic output, rather than consume it domestically. And if the government deficit does not grow fast enough to meet the saving needs of the private domestic sector, national income will decline, which, given the size of the private sector’s debt problem, will generate a huge debt deflation.

This is the foundation of modern monetary theory. Would that the IMF and the G20 understood these basic facts.

If the private sector is a net saver, the public sector must, I repeat must, run a deficit. That’s the law of double entry book-keeping. The only other way to prevent the government from running a deficit when the private sector is net saving is to run huge current account surpluses by exporting your way out of recession – what Germany and Japan tried in the 1990s and in this decade. But, of course, the G20 and the IMF are all talking about global re-balancing. This cult of zero imbalances is something Marshall first brought forward back in April. And it ignores the accounting identity inherent in the financial sector balances model. I highlighted this model in my post, “Minsky: Turning neoclassical economics on its head.” However, I must admit to having a preternatural disaffection for large deficits and big government which is what Koo and Minsky advise respectively – a recent cartoon shows why.  It is this knee-jerk aversion to what is viewed as fiscal profligacy which is at the core of the cult of zero imbalances.

So, what does this mean for the American and global economy?

1. The private sector (particularly households) is overly indebted. The level of debt households now carry cannot be supported by income at the present levels of consumption. The natural tendency, therefore, is toward more saving and less spending in the private sector (although asset price appreciation can attenuate this through the Wealth Effect).  That necessarily means the public sector must run a deficit or the import-export sector must run a surplus.
2. Most countries are in a state of economic weakness. That means consumption demand is constrained globally. There is no chance that the U.S. can export its way out of recession without a collapse in the value of the U.S. dollar. That leaves the government as the sole way to pick up the slack.
3. Since state and local governments are constrained by falling tax revenue (see WSJ article) and the inability to print money, only the Federal Government can run large deficits.
4. Deficit spending on this scale is politically unacceptable and will come to an end as soon as the economy shows any signs of life (say 2 to 3% growth for one year). Therefore, at the first sign of economic strength, the Federal Government will raise taxes and/or cut spending. The result will be a deep recession with higher unemployment and lower stock prices.
5. Meanwhile, all countries which issue the vast majority of debt in their own currency (U.S, Eurozone, U.K., Switzerland, Japan) will inflate. They will print as much money as they can reasonably get away with.  While the economy is in an upswing, this will create a false boom, predicated on asset price increases. This will be a huge bonus for hard assets like gold, platinum or silver.  However, when the prop of government spending is taken away, the global economy will relapse into recession.
6. As a result there will be a Scylla and Charybdis of inflationary and deflationary forces, which will force the hands of central bankers in adding and withdrawing liquidity. Add in the likely volatility in government spending and taxation and you have the makings of a depression shaped like a series of W’s consisting of short and uneven business cycles. The secular force is the D-process and the deleveraging, so I expect deflation to be the resulting secular trend more than inflation.
7. Needless to say, this kind of volatility will induce a wave of populist sentiment, leading to an unpredictable and violent geopolitical climate and the likelihood of more muscular forms of government.
8. From an investing standpoint, consider this a secular bear market for stocks then.  Play the rallies, but be cognizant that the secular trend for the time being is down. The Japanese example which we are now tracking is a best case scenario.

Not particularly uplifting, but hopefully well-documented. Your comments are very greatly appreciated.

Related posts:

• We are in depression
• Household debt as an indicator of secular bull and bear markets
• What is an economic depression?
• Some tidbits about stimulus, recovery, and the Great Depression
• What’s different about 2008?

This is just in from the FDIC (emphasis added below). It should make clear that the banking system is still weak:

Credit quality declined sharply for loan commitments of $20 million or more held by multiple federally supervised institutions, according to the 32nd annual review of Shared National Credits (SNC).

The credit risk of these large loan commitments was shared among U.S. bank organizations, foreign bank organizations (FBO), and nonbanks such as securitization pools, hedge funds, insurance companies, and pension funds. Credit quality deteriorated across all entities, but nonbanks held 47 percent of classified assets in the SNC portfolio, despite making up only 21.2 percent of the SNC portfolio. U.S. bank organizations held 30.2 percent of the classified assets and made up 40.8 percent of the SNC portfolio.

The 2009 review covered 8,955 credits totaling $2.9 trillion extended to approximately 5,900 borrowers. Loans were reviewed and categorized by the severity of their risk—special mention, substandard, doubtful, or loss—in order of increasing severity. The lowest risk loans, special mention, had potential weaknesses that deserve management attention to prevent further deterioration at the time of review. The most severe category of loans, loss, includes loans that were considered uncollectible.

Key findings were:

• Criticized assets, which included SNCs classified as special mention, substandard, doubtful, or loss, reached $642 billion, up from $373 billion last year, and represented 22.3 percent of the SNC portfolio compared with 13.4 percent in 2008.
• SNC commitment volume increased $92 billion, or 3.3 percent, while the number of credits remained virtually unchanged.
• Classified assets, which included SNCs classified as substandard, doubtful, or loss, rose to $447 billion from $163 billion and represented 15.5 percent of the SNC portfolio, compared with 5.8 percent in 2008. Classified dollar volume increased 174 percent from a year ago.
• Special mention assets, which exhibited potential weakness and could result in further deterioration if uncorrected, declined to $195 billion from $210 billion and represented 6.8 percent of the SNC portfolio, compared with 7.5 percent in 2008.
• The severity of criticism increased with the volume of SNCs classified as doubtful and loss rising to $110 billion, up from $8 billion in 2008. Loans in nonaccrual status also increased nearly eight times to $172 billion from $22 billion. Nonaccrual loans included $32 billion in credits classified as loss and $56 billion classified doubtful…
• The review identified significant deterioration in credit quality of leveraged finance credits, with these loans representing more than 40 percent of the dollar volume of total criticized assets. About 72 percent of the dollar volume of the 50 largest leveraged finance SNCs were criticized, which represents one-third of all criticized assets.
• Underwriting standards in 2008 improved from prior years, with examiners identifying fewer loans with structurally weak underwriting characteristics compared to credits written in 2007 and 2006. However, the SNC portfolio contained loans with structurally weak underwriting characteristics that were committed before mid-2007 that contributed significantly to the increase in criticized assets.

New credit standards are improving. But, due to old loans, credit quality is not increasing. It is decreasing.

Related posts:

• UBS to write down but has massive Tier 1 capital
• Moody’s anticipates huge increase in leveraged loan defaults
• Credit in the US is collapsing
• UBS is sitting on billions in bad student loans
• Quality financials are out there

Let’s say I run a company. For the sake of argument, we’ll call it a shoe store in New York City. I am making $100,000 net per year now. But, I look around me and see huge opportunity for growth. So I go to my bank and ask for a loan to expand my business.  I invest the money in expanding the store, and over the next five years I increase my earnings to $140,000.  Not bad!

Is this a well-run business?

GDP is not enough

Well, if your first instinct is to say, “you didn’t give me enough information,” I would have to agree. But, this is the way GDP statistics are used to measure the success of an economy.

Clearly then, GDP is an inadequate measure for understanding how healthy an economy is.  Nobel Prize-winning economist Joseph Stiglitz brought this issue into the public domain last week when he spoke in Paris, calling the focus on GDP a ‘fetish’ and favoring a broader measure of economic health.

Stiglitz was responding to reporters after a study on alternative measures of economic growth commissioned by French president Nicholas Sarkozy was released. At the time, Bloomberg reported Stiglitz saying:

GDP has increasingly become used as a measure of societal well-being and changes in the structure of the economy and our society have made it increasingly poor one…

So many things that are important to individuals are not included in GDP. There needs to be an array of numbers but we need to understand the role of each number. We may not be able to aggregate everything together.

Stiglitz is talking about the social costs of growth here.  Think about pollution, infant mortality rate, healthcare, life expectancy, or rates of obesity to name a few.  And his views are echoed in an article which prompted this tirade from me called “Emphasis on Growth Is Called Misguided“ by Peter Goodman in today’s New York Times.  Read it.

However, in this post, I want to focus on one narrow issue: debt.

The income statement vs. the balance sheet

In the shoe store example I gave, I borrowed money to fund growth.  In assessing how successful my growth strategy is, the obvious question is: how much did I borrow? It’s the debt, stupid.

What if I borrowed $1,000,000 at 7% interest? $40,000 is a return of 4% on that money, less than the cost of debt. In that case, the growth strategy is a loser.

We need to see the balance sheet as well as the income statement to know what is happening. GDP gives us no insight into the balance sheet of an economy, and is therefore incomplete as a measure of economic health. (I’ll leave the cash flow statement for another day!)

There is 4% growth sustained only through a rise in debt, growth that would have been 2% without an increase in relative indebtedness. And there is 4% growth fuelled by a positive return on that debt.

I am sure you have seen the graphs I published last October at the height of the panic in my post “Charts of the day: US macro disequilibria.” What should be clear from those charts is that the U.S. has been living in a period fuelled more by increases in debt and a concomitant increase in asset prices than in a world of sustainable growth.

The economics profession focus on the income sheet only

I suspect the GDP fetishism owes a lot to the models currently in use in the economics field, which focus exclusively on an economy’s income statement.

When I studied economics, in our introductory course, we used a book called “Economics – Principles and Policy” by two Princeton-affiliated professors William Baumol and Alan Blinder, a former vice chairman of the Federal Reserve (Yes, I still have the book from over twenty years ago).  The only mention of debt comes in Chapter 15 on “Budget Deficits and the National Debt” and it is basically a discussion of trade-offs between budget deficits and inflation.

Nowhere are aggregate debt levels in the private sector mentioned.  Now, I could be wrong because it is not in the index and I couldn’t find it in the book. I see this is reflective of the absence of debt as a topic in economic theory taught in universities.

In fact, the Chapter just before is called “Money and the National Economy: The Keynesian-Monetarist Debate.” I think the title says it all. Baumol and Blinder are Keynesians and they released a book to teach Economics in the Keynesian tradition.  To the degree they discuss any other economic models, it is only to weave the monetarist view into their own framework.  In the introduction of Chapter 14, the book states:

Then we turn to a very old and very simple macroeconomic model – the quantity theory of money, and its modern reincarnation, monetarism – for an alternative view of the effects of money on the economy. Although the monetarist and Keynesian theories seem to be two contradictory views of how monetary and fiscal policy work, we will see that the conflict is more apparent than real.

Now that crisis has hit, there is no inter-weaving of theories. Those two worlds, the monetarists (freshwater economists as Krugman calls them) and the Keynesians (saltwater economists in Krugman’s parlance), are at war over economic theory’s contribution to the global economic meltdown.  The Economist laments:

Economic writers will continue to try and describe the arguments wracking the field for an audience which wants to know about them, but economists need to figure out how to resolve some of these questions on their terms. If the best the dismal science can do in establishing the merit of one position versus another is make a play for the hearts and minds of lay-people, then economics is in more trouble than we all thought.

More noteworthy for me is how the salt- and freshwater types completely disregard debt, an issue central to the Austrian and Minskyian schools of thought. Paul Krugman wrote 6,000 words focused only on the income statement. There was no mention of the huge rise in debt in the U.S. and other economies like the U.K., Spain, Ireland, Iceland or Latvia. All of these countries have one common feature: asset price booms underpinned by rising debt levels.

Let’s hope we start seeing more discussion about the balance sheet in future.

Related posts:

• The Tribune files for bankruptcy
• Why the personal consumption data is important to the stock market
• Household debt as an indicator of secular bull and bear markets
• Steve Keen and the spectre of terminal debt
• Chart of the day: household debt vs. savings

Last week, I highlighted some of the ideas of Australian economist Steve Keen in my post, “Politics and reform: Say I’m a politician….”  Keen is of the Minsky camp and he believes that an unsustainable debt bubble has build up in the industrialized world which can only be brought to heel through a ‘debt jubilee.’

Below is a video clip of Keen telling Max Keiser a bit more about how he sees things.  Central to his ideas is the concept that demand for credit creates loans which create reserves, which is the opposite causality of what one sees in neoclassical economics.  This would mean that, absent a pickup in demand for credit, inflation is unlikely to reappear – irrespective of what central banks do. I will have more on this subject in later posts.

Related posts:

• Chart of the day: Excess Reserves
• Steve Keen and the spectre of terminal debt
• Steve Keen: Debt and the economy – how do we pay for all of this?
• Is quantitative easing really inflationary?
• Connecting Fed cuts with credit writedowns and quantitative easing

Stephen Roach doesn’t mince words.  He calls monetary policy during the bubble years “reckless and irresponsible” and he thinks politics is thwarting any meaningful regulatory reform, a view I also hold. I think the point of Roach’s attack is that a lot of finger-pointing has been directed at Wall Street and even Main Street. But, policy makers share much of the blame.  This is a point I tried to make in a post “Forget about Goldman” from this past summer.

Moreover, as Roach indicates, the concept that a central planner (which a central bank most certainly is) can allow bubbles to form and then clean up after the mess- is on it’s face absurd. But, clearly the Federal Reserve and other central banks are doing their level best to re-create the conditions which led to a near-financial collapse.

The money quote comes just about 4:45 through the eleven minute clip below:

Central bankers say trust us. We know what we’re doing. I don’t trust them one bit. They got us into this mess in the first place.

As for Asia, Roach sees a bright future. However, he warns that it has risen on the back of an unsustainable export-led macro-policy by selling things to people in the West who can’t afford them.  With continued private-sector deleveraging in the west likely, this dynamic has ended.

(video embedded below)

As an aside, Roach also correctly adds that the recent protectionist tariff administered by President Obama was not the result of tire manufacturers’ lobbying. Four of five of the Chinese importers are subsidiaries of U.S. firms. Obama did this to gain credibility and support from unions, a key Democratic constituency in the health care debate and in the run-up to the mid-term elections.

I should also point out that much of the U.S. trade deficit comes from such arrangements, where a U.S. company imports goods from its own foreign subsidiary.

Related posts:

• Stephen Roach sees a W-shaped recovery for China
• Stephen Roach: Downturn in Asia less severe, but recovery later
• Stephen Roach is talking double dip again
• Quote of the day: Stephen Roach
• Stephen Roach has a bone to pick with Congress

Say I’m a politician and I am concerned about my re-election prospects in 2010.  I have been a member of Congress for seven years now and have developed a good reputation as a reform-minded economic realist willing to listen to a number of competing economic ideas. However, right now I am a bit concerned about my likely 2010 rival, a respected district attorney known for being tough on crime and equally pragmatic ideologically speaking.

This past week, President Obama delivered a worthy speech on the need for reform in the financial sector. I agree with some of the broad strokes. But, quite frankly, the speech lacked in detail.  What’s more is my economic advisors have counselled me that the worst of the panic is over.  They tell me stimulus – fiscal and monetary – has worked and we are on the road to a welcome though weak recovery.

Meanwhile, I have been informed that a number of well-connected people in the financial industry are considering backing my potential 2010 rival. I have had enough money problems on my plate due to healthcare targeting my district. As I desperately need more money for my re-election campaign, getting on the finance industry’s bad side is something I do not want to happen.

What do I do?

The inside the beltway mentality

Well, unless the economy tanks between now and 2010, I would be a fool to support reforms in the financial sector, which could jeopardize my seat in Congress. Mind you, I am truly a reform-minded individual and it has been a part of my platform since I was elected in 2002. I don’t like Wall Street fat cats earning tens of millions each while people lose their homes and jobs. But, right now, everyone I respect says recovery is here. Retail sales in August just came in – up a massive 2.7%. Fed Chairman Ben Bernanke came out and said outright that recovery has arrived. I am no economist, but these guys make sense. I believe them. That’s why I am loath to even mention financial sector reform – presently being demonized by my 2010 rival as big government.

Earlier this year as things were falling apart, I had decided to inform myself. I read a number of well-respected financial blogs – some of which predicted imminent economic collapse if our big banks were not nationalized. These bloggers claimed that a depression was upon us and drastic government intervention was necessary – and, again, I tended to believe them. After all, one was a recent Nobel Prize winner and another was a winner just a few years ago.

But these individuals have since been discredited, as events have not played out as they suggested. So, as we head into 2010, I am much more interested in reining in uncontrolled government spending – as this is something about which my constituency seems to care. With recovery upon us, there is zero appetite for financial reforms in Washington and I am certainly not going to put a target on my back by trying to get some passed.

Edward here. A lot of politicians are probably thinking along these lines right now. And quite frankly, this makes sense from a political perspective.  If you are looking for reform in the financial sector, the moment has passed. And only to the degree that the underlying weaknesses in the global financial system are made manifest and threaten the economy will we see any appetite for reform amongst politicians. So, as I see it, the Obama administration has missed the opportunity for reform.

Another interpretation of events

Irrespective, I believe the need for reform is clear. Those gloom & doom economists were right because the economic model which brought us to the brink of disaster in 2008 is the same one we have at present and that necessarily means another crisis will come.

Steve Keen, an Australian economist whose theories are heavily influenced by Hyman Minsky, has a cogent analysis of the true structural deficits in the current economic model that I think bears repeating here. He warns that we are trying to kick the can down the road and this will lead to an even larger bust.

In his most recent post, he put it in terms anyone can understand.

You have just come from your annual medical checkup, where your doctor assures you that you are in robust health.

Walking jauntily down the street, you bump into a practitioner of alternative medicine. He takes one look at you and declares “You have a serious tumour! It must be removed or you will die”.

You ignore him as you always have, and continue your merry way down the street. One day later, a stabbing pain suddenly cripples you, and you collapse to the pavement.

In agony, your call your doctor, who initially refuses to send an ambulance because he knows you are well.

When you lapse into a coma and stop talking mid-sentence, your doctor concludes that perhaps something is wrong, and sends an ambulance to take you to hospital.

Initially the doctor waits for you to revive spontaneously, because he still knows there’s nothing really wrong with you. But as your pulse starts to weaken, he reluctantly calls a retired doctor who had experience of a similar inexplicable malady in the distant past.

She prescribes massive doses of tranquilisers, painkillers, vitamins, and oxygen—all substances that had been removed from the medical panoply due to recent advances in medical theory. Reluctantly, your doctor follows his retired colleague’s advice—and miraculously, you start to revive.

After a year of expensive medical treatment, you return to the same robust health you displayed before your inexplicable illness. Triumphant, if somewhat puzzled, your doctor declares you well once more, and releases you from intensive care.

As you stride confidently away from the hospital, you have the misfortune to once again bump into the practitioner of alternative medicine.

“But they haven’t removed the tumour!”, he declares.

…

One shouldn’t have to spell out the details of such an analogy, but in times of widespread denial, one has to:

• You are the economy;
• The tumour is a massive accumulation of private debt;
• Your doctor is Neoclassical Economics, and the retired colleague is a so-called “Keynesian” Economist — who doesn’t know it, since her medical textbooks were poorly written, but he’s actually following another economist called Paul Samuelson, not Keynes (and your doctor’s textbooks are so bad they don’t warrant discussion);
• The alternative medicine practitioner follows Hyman Minsky’s “Financial Instability Hypothesis” (which is based on what Keynes actually did say—as well as the wisdom of Joseph Schumpeter and, in whispers, Karl Marx);
• The moment you hit the pavement is the beginning of the Subprime Crisis; The collapse of Lehman Brothers is the moment when you slip into a coma; and
• The day the doctor takes you off life support and declares all is well … is next month.

The final reason for me being a bear is that I am that practitioner of alternative medicine. Minsky’s “Financial Instability Hypothesis” has been ignored by conventional economists for reasons that are both ideological and delusional. A small band of “Post-Keynesian” economists, of whom I am one, have kept this theory alive.

According to Minsky’s theory:

• Capitalist economies can and do periodically experience financial crises (something that believers in the dominant “Neoclassical” approach to economics vehemently denied until reality—in the form of the Global Financial Crisis—slapped them in the face last year);
• These financial crises are caused by debt-financed speculation on asset prices, which leads to bubbles in asset prices;
• These bubbles must eventually burst, because they add nothing to the economy’s productive capacity while simultaneously increasing the debt-servicing burden the economy faces;
• When they burst, asset prices collapse but the debt remains;
• The attempts by both borrowers and lenders to reduce leverage reduces aggregate demand, causing a recession;
• If the economy survives such a crisis, it can go through the same process again, with another boom driving debt up even higher, followed by yet another crash; but
• Ultimately this process has to lead to a level of debt that is so great that another revival becomes impossible since no-one is willing to take on any more debt. Then a Depression ensues.

Case for reform

I have removed the end of Keen’s post which you should most definitely read here. In it, he warns that the tumour collapse occurred in 1987 and that today we have finally reached a level of debt which is so great that another reflation is impossible.  The collapse is now.

But what if it isn’t?  For the sake of argument, let’s say that, just like in 1987, 1990, 1994, 1998, and 2002, there is indeed the ability to reflate the bubble – albeit on a diminished scale. Isn’t that what we see at present with equity prices up between 50-100% globally, with some commodity back at record high prices, and with oil up over 100% from its 2009 lows?

Why would any politician back reform if we seem out of the woods then? Reform doesn’t stuff campaign coffers. Reform doesn’t get your constituents jobs. Reform doesn’t pump up the economy in your district. And reform doesn’t get you elected.  Without imminent economic disaster to sharpen the mind, the case for reform just isn’t there for most politicians.

So, stop spinning the doomsday tale and develop a prevention plan. I happen to buy in to the doomsday scenario as the likely outcome. But unlike Keen, I am not convinced the time is now – it could be in one year.  It could be in two years – or four. Of course, others say, it isn’t coming at all.

Nevertheless, the case for real reform can be made even if it is divorced from the financial crisis, the present economic environment and the upcoming election cycle.

You are kidding yourself if you think real reform is coming to the financial sector before the mid-term elections, especially with health care, two wars and the need to ensure recovery still on politicians’ plates. Obama could go for real reform in 2011 – or in a second term in 2013. But, unless economic crisis is at our door, there isn’t a convincing argument which says reform is necessary. The same is true in Europe, by the way.

What I would like to see is economic thought leaders developing a blueprint of a financial crisis strategy which tackles both the immediate crisis issues (liquidity) and the structural, regulatory and monetary issues that create financial volatility (solvency). When crisis does occur, I believe it will be systemic in nature due to the forces Keen so lucidly explains. Therefore, a blueprint which is 1) heavy on tactics and, 2) if implemented in a real systemic crisis, is likely to work, builds credibility. This is political capital which will carry over to longer-term preventive strategies and reforms.

On the other hand, if Keen is right, we are on the verge of a very nasty relapse which will mean depression and debt deflation. And I reckon such a scenario means the political will should be there in spades.

Related posts:

• Steve Keen: On the Edge with Max Keiser
• Steve Keen: Debt and the economy – how do we pay for all of this?
• How many medical bankruptcies were there in Switzerland last year?
• Janet Tavakoli on fraud, derivatives, and bankruptcy
• The Eurozone and the spectre of banking collapse

It has been my thesis for some time that we are seeing a secular change in consumption patterns in the United States.  This will have grave implications for a world economy used to seeing the American consumer as an economic growth engine and consumer of first choice. Retail sales in the United States have fallen 10% since peaking in November 2007. Much of this decline represents a permanent fall in consumption by overly indebted American consumers.

Having finally had a chance to dissect the retail sales data from last week, I wanted to show you a few graphs which indicate how much consumption has fallen in the present downturn and what the implication is for the future global economy. But, first, I want to start with a broader discussion as to why the fall in US consumption is a longer-term change and not a cyclical one.

The Balance Sheet Recession

Numerous economies seem on the way to recovery: Germany and France, Singapore, and Hong Kong, to name a few, have all posted positive economic growth.  China looks likely to hit its 2009 growth target of 8%. But, the U.S., generally assumed to be a leader in recovery, is looking like a laggard.  Mind you, there are other laggards like Spain and Ireland too.  Why are these countries lagging?  The Balance Sheet Recession.

Nomura’s Chief Economist Richard Koo wrote a book last year called “The Holy Grail of Macroeconomics” which introduced the concept of a balance sheet recession, which explains economic behaviour in the United States during the Great Depression and Japan during its Lost Decade.  He explains the factor connecting those two episodes was a consistent desire of economic agents (in this case, businesses) to reduce debt even in the face of massive monetary accommodation.

When debt levels are enormous, as they are right now in the United States, an economic downturn becomes existential for a great many forcing people to reduce debt. Recession lowers asset prices (think houses and shares) while the debt used to buy those assets remains. Because the debt levels are so high, suddenly everyone is over-indebted. Many are technically insolvent, their assets now worth less than their debts.  And the three D’s come into play:  a downturn leads to debt deflation, deleveraging, and ultimately depression.  The D-Process is what truly separates depression from recession and why I have said we are living through a depression with a small ‘d’ right now.

Secular inflation will be non-existent

Therefore, the problem is a lack of demand for loans not a lack of supply. The Federal Reserve can print all the money it wants. But, if there is little demand for more indebtedness, it is not going to have the desired effect of permanently reflating the economy – although it can create bubbles.

The corollary of this is that inflation will be non-existent on a secular basis. For the increase in liquidity to feed into consumer price inflation, people have to actually buy more stuff.  And that’s not what happens in a balance sheet recession because people are concentrated on reducing debt and increasing savings.

Moreover, there is a huge glut of excess capacity globally now that we have had a major fall in consumption. Producers are waiting for demand to catch up with supply – not exactly the sort of situation that makes for inflation. I should point out that capacity is not fixed – it grows obsolete if unused. So, much of the investment in manufacturing capacity in China and property in America is going to have to be liquidated eventually.

But, the economy doesn’t move in a straight line. It courses through cycles. Just as we could be entering a cyclical recovery in the middle of a depression, it is altogether possible that the Federal Reserve can produce high cyclical levels of inflation despite the secular trend toward disinflation. A lot of this is likely to come through commodity prices or destruction of the currency.

For example, while the change in consumer prices has gone negative in the United States since the downturn began…

when one strips out food and energy, it has declined much less than even during the last deflation scare of 2001-2003, which caused Alan Greenspan to panic and reduce interest rates to 1%.

The discrepancy above is due wholly to changes in commodity prices.  So, if commodity prices re-assert themselves going forward, we could see a major uptick in inflation. Moreover, a fall in the value of the dollar could precipitate inflation as well.  And, finally, there is asset prices.  It is clear the Federal Reserve and the Obama Administration are targeting asset prices in order to reflate the economy. All of that stimulus can and will create cyclical inflationary forces which could be large. Nevertheless, the underlying level of demand is slack and that means secular inflation levels will remain subdued.  See my post “Central banks will face a Scylla and Charybdis flation challenge for years” for more on this concept.

This means the consumer will be under pressure

High debt and low inflation mean lower consumption growth.  It’s hard to spend more when you have a mountain of debt staring you in the face and its not getting reduced in real terms through inflation.

Look at the charts to the left.  They come from a story in Barron’s this weekend called They Shopped ‘Til They Dropped. They depict a tsunami of debt in the U.S. economy that has been building for four decades.  Even debt service levels have been inching inexorably higher since the 1980s. Clearly, the U.S. consumer is tapped out. And they are cutting consumption and reducing debt as a result.

So, for America, it is not business but consumers which are going to suffer a balance sheet recession.  In looking for evidence on Koo’s thesis, we need to look at consumption and retail sales.

Michael Shedlock recently reported on the horrible back to school sales numbers.  And Patty Edwards, a well-known Seattle-based retail analyst, was recently on Bloomberg radio with sobering anecdotal detail regarding the retail sector.  She sees no sign of an impending uptick in US retail sales and is very worried about the Christmas selling season. The audio of her conversation with Tom Keene is below (not available in the RSS feed).  It is very much in line with the balance sheet recession argument.

Shedlock’s post and Edwards’ view are very much in line with the retail sales numbers we saw late last week.  A lot of people had been looking for good retail sales numbers because they see recovery at hand.  But, the numbers disappointed, falling 0.1% from the previous month.

This puts retail sales 8.3% below year-ago levels and a full 10% below peak levels in November 2007. This is much more severe a decline than we witnessed in the shallow recession of 2001. When retail sales numbers hardly declined. In fact, on a nominal basis, they fell on a year-on-year basis only during September 2001 because of September 11th.

If one uses data both the present data series (1992 – present) and the previous data series (1967-2001), this downturn looks much more inline with the steep downturns of the 1970s and 1980s.

The key difference between then and now is the debt levels I showed you from the Barron’s article.  Let’s not forget low savings as well.

Macro Themes

One can only conclude that the asset-based economy of the last quarter century is over. It was based not just on a dubious productivity miracle but also on mountains of debt and over-consumption.  The new normal is debt reduction and savings.

What does this mean for the economy?  Here are a few macro themes:

1. Retailers are in a world of hurt, not just cyclically, but on a secular basis.  Listen to the Patty Edwards interview.  America has double the amount of retail space per capita that it did a generation ago. This is the definition of over-capacity. When a glut of supply meets a deficit of demand, you have the makings of a very bad outcome for the stocks in that sector. This is the same conclusion that the Barron’s article comes to.  The uptick in retail shares like JC Penney (JCP), Ann Taylor (ANN), and Macy’s (M) is all due to beating low earnings estimates. As a result, Abercrombie (ANF) has almost doubled. Nordstrom (JWN) is up 141% and Ann Taylor is up a massive 350%. Investors like George Soros are selling retail (Wal-Mart, Walgreen and Lowe’s).
2. Commercial Real Estate will feel the pain too. The Patty Edwards interview not only shows huge excess capacity in retail, but it shows that retailers are trying to re-negotiate contracts down.  They have Commercial REITS over a barrel because they can just threaten to close down outlets if they don’t get the contract price concessions they seek.  Back in January, I mentioned the fact that bankrupt anchor tenants like Circuit City  destroy the economics of malls for other tenants and create a domino effect.  So, if anchor retailers do not get the price concessions they want, they will shut down stores, creating a huge loss in income for all the other stores. Obviously, this will drive down the price of commercial real estate as there will be a huge glut of supply.
3. Export-oriented economies need to foster internal demand growth. Here I am talking about Germany, Japan, and China amongst the major economies.  The US consumer is out of gas and these countries are too dependent on exporting to US consumers. It is not clear who can replace her.  Certainly, the Chinese government and companies are doing their level best to foster domestic demand in China, even conspicuous consumption.  But, the Chinese are unlikely to replace Americans as the new global growth engine anytime soon.
4. The new normal is lower US and global growth. This all suggests that we are likely to see lower growth in the US and globally as a result – at least until the American consumer gets out of a hole or someone else picks up the slack.  That will likely mean we will see low-growth, short business cycles punctuated by fits of recession, all complicated by the three D’s (debt deflation, deflation, and depression).
5. One should fear a 1937-style relapse. If you recall, the Great Depression saw a major economic uptick in the years after 1932. No one would call this a boom (see the section called “recovery does not mean recovery” in my post “Economic recovery and the perverse math of GDP reporting.”) This was only a statistical recovery in the midst of a greater downturn. Eventually, stimulus was withdrawn and the economy tanked again. Richard Koo argues that Japan did not go into a 1929-style depression because it maintained much more stimulus than the US did in the Great Depression. If this stimulus is removed before the deleveraging and balance sheet repair is complete, you get a major relapse. So, beware of deficit hawks telling us that fiscal stimulus must end to eliminate deficits.  If anything, the government’s long-term deficit outlook should be eliminated via reigning in skyrocketing health care costs.
6. Banks will be in a permanent state of crisis. If we learn anything from Japan, it’s that time does not heal all wounds.  The Japanese tried to recapitalise their banking system by propping up zombie institutions.  That didn’t work.  It didn’t work in Japan in the 1990s and it didn’t work with Savings & Loans in the US in the 1980s. Why should we expect it is going to work now? But, team Obama has decided this is the way forward.  If and when an economic relapse occurs, the fragility of the banking system will be made manifest. Much of the so-called toxic assets is still on the balance sheet of American financial institutions. The same is true in countries like Germany, Spain and Ireland, to name a few. When another downturn hits, those assets will go bad and writedowns will drag down the weakest institutions.  This is the lesson of Japan.
7. Liquidate zombies while providing counter-cyclical stimulus. The banking example gives a hint to the correct policy response.  It is not a return to the bubble days of the asset-based economy.  It is not creating deficits as far as the eye can see while perpetuating overcapacity.  What policymakers need to do is allow bankrupt organizations to fail and reduce excess capacity, all the while providing enough stimulus to prevent worst-case outcomes.

When it comes to US consumers, weak spending growth will last for years. Ultimately, debt levels in the US economy must return to a sustainable level. This can happen over time, which would mean a decade-long low-growth, muddle-through economy – not a terrible outcome either for the economy or for asset prices.

Or it could happen overnight through default, bankruptcy, and liquidation – a Great Depression II scenario. The policy response in the US and elsewhere will make the difference. Right now, we are headed for a statistical recovery at best. If policymakers think we are off to the races and try to normalize policy, they will be making a heinous mistake.

Related posts:

• UK retail sales drop most in 22 years
• Data on past consumer deleveraging during recessions
• U.S. consumer spending down 1% in December
• Avoid consumer stocks
• Looking beyond the fake recovery

I have been taking a bit of a break as my trip to the Ontario’s Lake Country winds down.  It’s a beautiful place.  But, as Marshall Auerback and I were lamenting, it has become the Hamptons of Canada as everyone from Toronto is up here for the summer holidays.

But, it has been relaxing. Since I came here, I have had a chance to get away and re-charge. The news in the world economy has been getting a lot better during my hiatus.  Just this morning, data showed economic growth in Q2 in both Germany and France.

As far back as April, the data did point to a potential recovery in the US this summer. Here are two mid-June posts explaining how Paul Krugman, Richard Berner, and David Grenlaw saw this:

• Krugman sees recovery by end of Summer
• Morgan Stanley: Recession will ‘end by mid-to-late summer’

So, a lot more people are now saying recovery is at hand. Of course, it is not a done deal and I am still holding to Q4 or Q1.  But, I did want to remind you all how bearish people were just two months ago (and feel free to comment):

• When will the U.S. recover?

Now we should take this opportunity to look through the present data and onto the longer-term future. We might have a recovery so what? What does the situation look like over the medium or long term?

As I see it, any recovery now will be somewhat incomplete given high consumer debt levels and the associated weak consumer demand. Structural issue remain in the property markets and banks are systemically weak. Nevertheless, with recovery at hand or coming, here are a few posts that attempt to look beyond the immediate reflation trade.

• Bernstein: What kind of recovery are we going to get? (May 2009)
• Green Shoots or Smoking Weed? (May 2009)
• Why the personal consumption data is important to the stock market (Jun 2009)

Don’t underestimate the power of printing money – or government stimulus.  We have seen a herculean effort to stave off depression and this has clearly had a great impact across the global economy.  But, stimulus does not solve the problem of structural weakness.  The excess consumption in the U.S., the savings glut in Asia, the huge debt and leverage in Anglo-Saxon countries and the weak banking systems in America and Europe must be addressed during any recovery or…

To be continued…

Related posts:

• Discerning a real from a fake, technical, statistical, or partial recovery
• More thoughts on the fake recovery
• When will the U.S. recover?
• Morgan Stanley: Recession will ‘end by mid-to-late summer’
• Revisiting employment indicators for signs of recovery

The bloggers at bloggers at UMKC’s economics blog have been making the case that California’s IOUs are a currency.  Randy Wray’s entry last Monday was particularly provocative because he suggests a movement to loosen national government power is supporting similar moves in other jurisdictions. Wray writes:

Some commentators have argued that the proposed California "warrants" are similar to local currencies (see, e.g., Mark Thoma). In this piece I discuss experiments with local currencies and continue my argument that if California were to accept its own "warrants" in payment to itself, it could turn these into a functioning currency free of the defects of local currencies.

Interest in local currencies has soared in recent years, with nearly 100 U.S. communities experimenting with them. While proponents offer a variety of arguments in favor of local currencies, they share three common themes. First, there is concern that the use of a national, monopoly, currency creates a variety of economic, social, and environmental problems. Second, local currencies are said to improve regional communities, again across several dimensions including economic, social, political and environmental spheres. Third, many proponents want to reduce the power of national government, recognizing a relation between the monopoly of currency issue and centralization. They believe that decentralized money would shift power back to the communities.

However, previous adventures in local currencies have failed miserably as Wray later attests:

As discussed, most local currencies have failed (of the 82 created between 1991 and 2004, only 17 remained by 2004). Those that succeeded shared some combination of the following characteristics: an exchange rate pegged to a strong national currency by a trusted institution; substantial supplies of unemployed or underemployed workers; businesses operating below capacity; and a strong community spirit, led by liberal, middle class residents. These characteristics are not always easy to replicate nor are they necessarily desirable. If the goal is to displace the national monopoly currency, linking the local currency to it appears inconsistent—especially if one fears national government policy is inflating away the value of the nation’s currency.

So I have another idea, which I got from a knowledgeable reader nicknamed aitrader.  How about a Gold-backed IOU system.  In response to a recent post I wrote on the similarities in the troubles in California and Ireland, he wrote:

Now here’s a curve ball for ya: what would happen if a state or even a private bank were to issue currency redeemable in gold or silver? What would the implications be for the US Federal Reserve? This was the situation for many years in the US. Private banks often issued their own paper currency redeemable in gold and silver. There is nothing illegal about this, though one would assume a new law would be crafted and passed to prevent this from occurring. On that note here is what happened recently to a private currency issuer, http://en.wikipedia.org/wiki/Liberty_Dollar#Fed….
Interesting times…

So, let me explore his idea using Ireland instead of California.  I want to use Ireland as the example here because, in discussing my California-Ireland post, the Economist pointed out that Ireland is the place where true problems lie. The Economist says:

There is a problem with Mr Harrison’s thesis in the fiscal policy department, however. California has faced credit downgrades, but only because it is legally prevented from running deficits—it must default if it cannot make all its payments out of pocket. But California has a relatively small debt load, so far as nations go. If the state were allowed to run annual deficits, it seems highly unlikely that it would face pressure to balance its budget amid recession.

Ireland, on the other hand, is confronted by actual market pressures to prove that it can meet its obligations; it’s in trouble in an absolute sense. Ironically, both have fiscal difficulties that are not rooted in their federal status; Irish borrowing is limited by markets while California’s borrowing is constrained by the state constitution.

Point taken. So Let’s solve this problem.

Say Brian Lenihan is dispatched to consider how to prevent the government from sacking tens of thousands of workers in order to prevent the Irish from defaulting on its debt. 

He suggests that California’s IOUs are a model for Ireland, but he goes one step further adding a redemption in 5 years at a 40% premium to the present spot price for gold, which represents a 7% annual return.  Today, spot gold is trading at $950 an ounce. So, a 40% premium is about $1330 an ounce for gold.  Lenihan would offer this deal to any and all creditors of the State in lieu of cash.  The IOUs would be tradable in standardized amounts of 20, 50, 100, 1000, 10,000 and 1000,000 euros in order to facilitate a secondary market.

I got this idea from the high yield market where often bonds are issued with an embedded option to convert to equity at a premium or with PIK preferred shares thrown in as a kicker.  The point of these options is to provide a sweetener to investors in order to get the deal done.  These are the same kinds of deals that Warren Buffett did with General Electric and Goldman Sachs in 2008, and that he has previously done with USAir (now US Airways) and Salomon Brothers (now a part of Citigroup). If the embedded option increases in value significantly, the debtholder can make a lot of extra money.  For Buffett’s options in Goldman, this has already occurred.

Here’s what the ‘investor’ gets in the case of the Irish IOUs:

1. Bonds backed by the full faith and credit of the State paying a rate of interest that I suggest be a slight premium to the official 5-year bond.
2. A 5-year out of the money European option to buy gold for the full face value of the bond at today’s price.  Obviously,if you think gold is going up you would be willing to pay a lot for this option.
3. An IOU that is not just backed by the full faith and credit of the sovereign like most currencies, but that has a tangible link to a real asset, gold.

What does the sovereign get?

1. Ireland conserves cash without having to issue bonds.  Ostensibly this would mean interest rates on Irish bonds could remain lower. That’s a huge deal, especially since these IOUs would not be considered legal tender.
2. Ireland removes the restriction imposed by the Maastricht treaty as the IOUs are not cash and reduce the budget deficit.  In effect, the government is free to add fiscal stimulus without those restrictions.

Obviously, the Irish government would have to hedge their gold commitment by buying Gold futures. But, the Irish could then legitimately claim that its IOUs were more than just a piece of paper.  And, they would remove some of the constraints now impose upon it by foregoing their own currency.

Related posts:

• Pre-payments are reducing value of mortgage-backed securities
• Ireland: government blew the boom
• Gold hits all-time record high
• Spain and Ireland ‘thrown to the wolves’ after ECB move
• Ireland gets deflation

This is my translation of an article from Dagens Nyheter, a Swedish daily.

Swedish banks are planning to write down Latvian personal loans by 10 percent. However, the proposal includes only a small part of the Latvia’s mountain of debt.

The criteria for qualifying for the program, as it stands right now, is quite strict. So there is nothing which will include a very large number of private individuals in Latvia, "said Swedbank Director Thomas Backteman to TT.

On Wednesday, Latvian Prime Minister Valdis Dombrovskis on Latvian radio told of new plans to support indebted individuals.

He said that the program is based on "a certain solidarity" from the banks in the country, which are to write down the debt of the people who qualify for assistance.

But according to Thomas Backteman, the proposal comes from the banks themselves. The Latvian Banking Association has been having a discussion with the Government of Latvia on a way to restructure of private debts.

The Bankers’ Association made a proposal to provide a moratorium, that is, a temporary deferral, in the case of payments on debts to private persons.

And for those who give this concession, the state will step in and guarantee the debt. “Then we will write down the debt by 10 percent," he says.

Swedbank and SEB are the two banks with the most loan customers in Latvia. Like SEB Swedbank estimates that the economic impact of the proposal will be small:

"Our current assessment is that only a small part of SEB’s loans to households would be covered," writes Elisabeth Lennhede, press officer at the bank, in an email to TT.

And even if the debts are written down, the program would probably also mean that banks would forgo a small part of the massive credit losses that are expected to arise in Latvia in the coming years.

That’s how it is, and above all, we get a guarantee, "says Thomas Backteman.

It sounds like a transfer of risk from Swedish banks to Latvian taxpayers if you asked me.

Lettiska skulder ska skrivas ned – Dagens Nyheter

Related posts:

• Earnings results at Swedish banks show large writedowns in Baltics
• Sweden prepares for financial collapse in Latvia and major bank losses at home
• Estonia and Latvia: headed for the rails
• Why is Swedbank doing a second rights issue?
• Lessons from Swedish bank resolution policy

This comes from Reuters:

Fallout from a still deteriorating housing market caused the rate of consumer loan payments at least 30 days late to rise to 3.23 percent in the January-to-March period from 3.22 percent in the 2008 fourth quarter, the American Bankers Association said.

Delinquencies were the highest since the ABA began tracking the data in 1974. Late payments on home equity borrowings set records, rising to 3.52 percent from 3.03 percent on loans and to 1.89 percent from 1.46 percent on lines of credit.

The overall delinquency rate actually understates consumer pain because it excludes bank-issued credit cards, where credit deterioration was severe.

Remember, 2008 was all about a financial crisis.  What we are seeing now in consumer and commercial mortgage delinquencies, credit card and other consumer loan delinquencies is what one would expect  see in a normal recession. Normally we would expect this record level of delinquency to hit the bottom line at banks, especially those with large asset-backed loan exposure.  However, accounting rule guidance may distort the reporting of writedowns.  JPM releases on the 16th, BofA (BAC) and Citi (C) on the 17th.  So, we should get a good indication how things are reported then.

Related posts:

• Consumer credit down a massive 33% in Spain
• What Home-Loan Banks reveal about the effects of mark-to-market
• New Crisis Threatens Healthy Banks
• More warnings on regional banks
• Extend and pretend and the growing divide between delinquencies and foreclosures

Peterson is the former Nixon cabinet secretary and founder of the Blackstone Group. He is also a well-known deficit hawk and founder of the Peterson Foundation.  He recently wrote his autobiography, “The Education of an American Dreamer.”

Related posts:

• Obama White House: Add Larry Summers and Robert Gibbs
• A conversation with Robert Caro on Charlie Rose
• Tim Geithner on Charlie Rose
• A conversation about the growing fiscal deficit on Charlie Rose
• Twitter founder Evan Williams on Charlie Rose

I think a technical recovery will happen in the Q4 to Q1 timeframe.  But this recovery is likely to be weak, if it happens at all.  Downside risk remains. Unfortunately, the Obama administration has fired all its bullets, spending huge political capital bailing out the big banks and putting together a weak stimulus package we all knew was going to fail.

Now, Joe Biden is trying to save face, talking as if recovery is guaranteed and no further stimulus is necessary. Yet, on the eve of the G-8 summit, it takes Gordon Brown to remind us that the Great Depression II meme is still at play. If the United States wants to keep deflationary forces at bay, it will need to support the economy with fiscal stimulus. 

The problem is the U.S. government budget deficit. In April, in a post called “The Cult of Zero Imbalances,” Marshall Auerback made the case for stimulus, aware of the downside risks for the dollar and bond prices because of that deficit. Yes, there are risks for America associated with deficit-inducing stimulus in the short-term, but they can be mitigated if the Obama Administration actually showed a plan to reduce the longer-term deficit.  But, as David Leonhardt has argued, Obama’s team has no deficit reduction plan whatsoever.

So now we must contemplate America’s fiscal train wreck; and that is exactly what Richard Berner at Morgan Stanley is doing.  Here is an excerpt of his research note published today.

America’s long-awaited fiscal train wreck is now underway.  Depending on policy actions taken now and over the next few years, federal deficits will likely average as much as 6% of GDP through 2019, contributing to a jump in debt held by the public to as high as 82% of GDP by then – a doubling over the next decade.  Worse, barring aggressive policy actions, deficits and debt will rise even more sharply thereafter as entitlement spending accelerates relative to GDP.  Keeping entitlement promises would require unsustainable borrowing, taxes or both, severely testing the credibility of our policies and hurting our long-term ability to finance investment and sustain growth.  And soaring debt will force up real interest rates, reducing capital and productivity and boosting debt service.  Not only will those factors steadily lower our standard of living, but they will imperil economic and financial stability.

Later in his missive, Berner, rightly admits that economists warning about deficit spending in America have been singing this tune for quite some time.  And, as with the boy who cried wolf, no one believes them any longer. No less than former U.S. Vice President Dick Cheney said “deficits don’t matter.”

Well, they do matter.  Eventually, the day of reckoning will come.  Berner puts it this way.

Some are concerned that our reckless fiscal policy will trigger a downgrade of the US sovereign debt rating, making the financing of our burgeoning deficits more difficult.  While worries that the US will default on its debt are illogical, global investors and officials are concerned about the credibility and the sustainability of our fiscal policies.  So am I.  They fear that we will adopt policies that will undermine the dollar and the domestic value of dollar-denominated assets through a combination of risk premiums and inflation.  I worry about that too, although such policies probably would be accidental rather than deliberate.  As a result, interest rates may have to rise significantly to compensate investors, including reserve portfolio managers and sovereign wealth funds, for such dangers.  While the dollar will for now retain its reserve-currency status, such concerns put it at risk.

Definitely read his piece which is linked below.  He does an excellent job of demonstrating that healthcare is a large part of the problem and sounding the alarm for fixing it once and for all.

Source

America’s Fiscal Train Wreck – Dick Berner, Morgan Stanley

Related posts:

• Fiscal policy limited in the UK and the US
• Japanese opposition would avoid U.S. dollar bonds if elected
• Bill Gross: “Staying Rich in the New Normal”
• Rosenberg: The U.S. dollar could be next
• Is prophylactic protection needed for excessive stimulus?

Let’s say you’re an American named Maria living in Southern California.  The year is 2006.  You make $45,000 and your husband David makes another $40,000.  You have two children aged six and four and your two-bedroom apartment is getting too small.  So you decide to consider buying a house.  Eventually, you and your husband find a new home. Now, granted you know nothing about mortgage finance.  But, your guy at New Century Financial hooks you up and with the help of a teaser-rate adjustable rate-mortgage you are able to afford the home.  In the end, you shop around and get another bank you consider more reputable to match New Century’s terms. Sale Price $390,000.  As you have no money down and roll up some fees into the mortgage, the final mortgage price is $390,000 with a second piggy back mortgage of $10,000 for a grand total of $400,000 of debt.

Fast forward to 2009. The economy is in tatters but you and your husband have your jobs. You’re doing alright. And, as it turns out, you have picked wisely by buying the smallest house on the block in a really up-and-coming neighborhood.  The only problem is that house prices in your metro area are down 40%.  Your house, while down less, is still down 20% and is only worth $320,000. This is a big worry because your mortgage was a 3-year ARM and the rate is about to go way up.

Enter the federal government’s “Making Home Affordable” plan.  Just the other day HUD Secretary Shaun Donovan announced that mortgages owned or guaranteed by Freddie Mac and Fannie Mae can be refinanced up to – get this – 125% loan-to-value.  That means, you can take out a refinance loan on your house now valued at $320,000 for up to $400,000. Bingo!  That’s exactly what you need to keep your house.  Do you do it?

Debtor’s Prison

If you do go ahead, we might as well stick you in the King’s Bench because you are about to find yourself in debtor’s prison.  The Blog Seattle Bubble has this nailed (with some nifty charts to boot):

Let’s take a look at some hypothetical home borrowers who currently owe $400,000 in various mortgages with difficult terms or high rates, and whose home is presently worth $320,000. They jump on the new FHFA Home Affordable Refinance Program and refinance into a single 30-year fixed-rate loan at a 5.75% interest rate with a 125% loan-to-value ratio…

With the home value appreciation tweaked to a slightly less rosy scenario, it takes 17 years before our couple can break even selling their house.

Nice, huh?  Their comment on this is dead on:

If the goal of this new 125% loan-to-value program is to financially imprison people in their current homes for a decade or more, then it looks like it could be a rousing success. However, I’m not sure how many currently struggling home borrowers would really consider that to be much of a “help.”

I have a post from last year describing circumstances in Japan that are eerily similar. Take a look.  It’s called “A cautionary tale: story from 1994 Japan.”

Predatory Lending?

I have another angle too.  You’ll notice I mentioned Maria is no financial wizard.  She probably does not appreciate the intricacies of mortgage finance.  Here are two points to consider.

1. In the state of California, you can just walk away because first mortgages on primary residences are non-recourse.  That means that the mortgage is only secured against the house you have bought.
2. However, in the state of California, refinance mortgages are recourse loans.  What does that mean?  It means you are on the hook for that loan.  You cannot just walk away.  The bank can come after you and take your car and the stocks in your E-Trade account. They can garnish your wages. They can even take your clothes and the shirt off your back, literally.  The only thing they can’t touch is your 401-K.  But it’s down 40% anyway.

Why would you trade a non-recourse loan from which you can walk away for a recourse loan that guarantees you’ll end up as bad as some poor slob at Tappahannock?  It doesn’t seem like an incredibly appealing choice, does it?

But, of course, this is a classic case of asymmetric information because you don’t know that you are getting a poor trade, but your bank and the government do.  In fact, the bank makes more money this way because of incentives it receives for refinancing these loans – incentives, I  might add that come straight from the taxpayer to the bank via the Federal Government (see my post “How refinancing helps the likes of Bank of America and Wells Fargo”).

So, to recap, you get shackled to a house with a recourse loan because you don’t know what the bank and government do.  Meanwhile, your bank gets to forgo a writedown (remember, your loan was for the same amount as before).  And the bank gets a refinance fee which is goosed by government incentives.

Is this predatory lending? Sure sounds like it to me.

Related posts:

• Can I borrow the full amount and an extra 25% too?
• Nationwide brings back 125% LTV mortgages
• The fixed rate mortgage is king again
• Home Equity Lines Pulled
• UK mortgage crunch

Apparently the answer to this question is yes.  CNBC is reporting that home ‘owners’ who refinance their mortgages through loans backed by Fannie and Freddie will be able to borrow up to 125% of their homes’ value (hat tip Marshall Auerback).  That’s not a typo: we’re talking no-money down and 25% cash back.  Sign me up.

Homeowners refinancing their mortgages through loans backed by government agencies will be able to borrow up to 125 percent of their homes’ value under new regulations enacted Wednesday.

The rule changes, part of the government’s attempts to restore housing affordability and stem the foreclosure crisis, apply to loans backed up by Fannie Mae and Freddie Mac.

Previously, homeowners could borrow up to 105 percent of their home’s value. The new loan-to-value ratio is set up at 125 percent in a further effort to address those mortgage holders who owe more than their homes are worth.

"By expanding refinance eligibility, we can bring relief to more struggling homeowners more quickly,” Treasury Secretary Timothy Geithner said in a statement.

Is this sitting well with you?  Doesn’t this seem like the reckless lending which got Fannie and Freddie nationalized? Well, if you were wondering whether Obama, Geithner and Summers were trying to reflate the economy by bringing back the bubble, I don’t imagine you will find better proof.

Apropos borrowing 125%, you will recall that over a year ago I was wondering why U.K. mega-lender HBOS wasn’t writing down more assets because they were a recklessly lending – you guessed it – 125% loan-to-value.

Looking through old e-mails, I read an article from the FT in 2006 that surfaced claiming that HBOS (Halifax Bank of Scotland)were poised and ready to go offer loans for 125% of value. That’s right, HBOS thought it a good idea to cover 95% of the house price and loan another 30% over appraised value unsecured as a personal loan.

Now that the UK has joined the housing bust, one must ask where are the massive writedowns that have to be sitting on HBOS’ books? Why aren’t they looking to do another rights issue like RBS? I fully expect some pretty horrific things coming from HBOS as the housing crisis heats up in Britain.

We know what happened there: HBOS would have gone bust after Lehman had Gordon Brown not foisted it upon Lloyds. And Lloyds was a bank that subsequently was almost fully nationalized despite having a relatively clean balance sheet – all because of its merger with HBOS and HBOS’ reckless lending.

Now that the U.S. government is underwriting similar policies on this side of the pond, shouldn’t we expect things to go seriously pear-shaped here too?

Addendum: just in case it isn’t clear, this measure is intended to keep banks from taking writedowns.  A homeowner now 20% underwater can borrow the full amount of the original loan even though the house is worth 20% less than that amount.  The home ‘owner’ stays in the house.  The bank gets its regular payments (and a nice re-financing fee to goose earnings in Q3).  And no one defaults. It’s all good, right?

Second addendum: Yves Smith, who also got the same e-mail, notes “in most states, a purchase money mortgage is non-recourse, but a refi is. So some borrowers will put themselves in worse shape it they take up this offer.”  Check out her post here.

Related posts:

• HBOS versus Freddie and Fannie
• Treasury Considers Plan to Halt Home Price Slide
• Where’s HBOS?
• Consumer loan delinquencies paint bleak picture
• Is the new affordable FHFA loan program predatory lending?

I happened upon an article about shops being closed in France that highlighted a larger issue about cultural attitudes in the U.S. and Europe regarding work, leisure and material wealth.  I would like to share some thoughts with you on these issues because I think they are significant in regards to savings, debt and other issues at the heart of the recent economic bubble and meltdown.

Shops closed? How 19th century.

First, the blurb on French shops posted by Jay Newton-Small on Time Magazine’s political blog Swampland.

Michelle Obama has unwittingly caused a national French debate over working on Sundays. It seems the First Lady wanted to take Sasha and Malia shopping while there: the problem was virtually every store in Paris is closed on Sundays. There is a ban in France, a Catholic country, on working the day God rested. Embarrassed, Prime Minister Nicolas Sarkozy personally called a few stores and asked them to open especially for the Obama ladies. Sarkozy has since introduced a law, expected to be voted on in the National Assembly on July 6, to allow shops in touristy areas to remain open on Sundays. In an article entitled, "If You Have to Work Sundays, It’s Michelle Obama’s Fault," Sarkozy, roughly translated, argues: "Is it normal that when Mrs. Obama wants to visit French stores with her daughters on a Sunday, I have to make a call to have them opened? Everyone in President Obama’s entourage was present, great. Who then had to explain to them why we are the only country where, even in Paris, everything is closed on Sunday?" A spokesman for the Communist Party responded saying Sarkozy "crossed the line" by invoking Michelle Obama. Vivre le shopping!

In America, shops are open every day, often well into the night when most people are at home with their families.  This is especially true in America’s big cities, especially in the northeast and west.  Clearly, Michelle Obama has been living that lifestyle and was unconscious of how different it can be in Europe or even in other parts of the U.S.  It is admirable that the First Lady spends so much time with her children. However, in this case, every hour extra she gets to go shopping with her daughter is one hour less that the people working in those shops have with their own children.

So, why the cultural divide here?  Religion is certainly part of it in the Midwestern and Southern America and in France – hence the allusion to France’s being a Catholic country.  But, Germans also frown upon opening shops on Sunday as well and they are not all Catholics, though many are.  I would say much of the difference has to do with culture.

Europe equals leisure while America equals wealth

A few years ago, three economists (including a brilliant former classmate of mine, Bruce Sacerdote) produced a paper called “Work and Leisure in the U.S. and Europe: Why so Different?” Below is the abstract. (emphasis added)

Americans average 25.1 working hours per person in working age per week, but the Germans average 18.6 hours. The average American works 46.2 weeks per year, while the French average 40 weeks per year. Why do western Europeans work so much less than Americans? Recent work argues that these differences result from higher European tax rates, but the vast empirical labor supply literature suggests that tax rates can explain only a small amount of the differences in hours between the U.S. and Europe. Another popular view is that these differences are explained by long-standing European "culture", but Europeans worked more than Americans as late as the 1960s. In this paper, we argue that European labor market regulations, advocated by unions in declining European industries who argued "work less, work all" explain the bulk of the difference between the U.S. and Europe. These policies do not seem to have increased employment, but they may have had a more society-wide influence on leisure patterns because of a social multiplier where the returns to leisure increase as more people are taking longer vacations.

Translation: Europeans worked more than Americans just four decades ago, but now work less. Thus, they are taking more of the benefits of increased wealth since that time in the form of leisure over material gain than do Americans.  In a nutshell, Americans are more materialistic than Europeans.

Now, you can argue why Americans work more.  The economists make the case for unions as the driving force behind this dichotomy.  That’s an argument for another day.  My focus here is on the fact that cultural differences have developed such that Americans prefer to work many more hours in order to accumulate wealth than do Europeans.

For example, productivity levels in the United States and Western Europe are not that far apart.  The 2008 OECD Factbook as the following quote:

In 2006, GDP per capita in OECD countries ranged from over USD 39 000 in Ireland, Luxembourg, Norway and the United States to less than USD 17 000 in Mexico, Poland and Turkey. On average, income levels were about 70% of that of the United States, Norway is a notable exception with its GDP per capita 14% above that of the United States.

Relative to the United States, most OECD countries had higher levels of GDP per hour worked than GDP per capita because their levels of labour utilisation were substantially lower than in the United States. This owes to disparities in working hours but also, in several countries, to high unemployment and low participation of the working-age population in the labour market.

Europe is just as productive as the U.S. But, clearly Europeans are choosing to work less than Americans.  Think store closings on Sunday in Paris.

The asset-based economic model

The result of America’s drive to work more has been an asset-based economy driven by debt. In America, and similarly in other Anglo-Saxon countries like the U.K., debt and savings are viewed in many parts quite differently than they are in places like Germany.  In the Anglo-Saxon model, people talk about things like efficient markets and wealth accumulation with almost religious fervour. Work is certainly prized as means of accumulating wealth. But, so too are debt and asset accumulation.

That leads to a greater reliance on markets and debt.  Look at any measures of aggregate national debt to GDP and you will see the U.S. and the U.K. at enormous levels over 300%.  The same is true in terms of market capitalisation levels.  The U.S. and the U.K. are much higher in terms of publicly listed companies as a percentage of GDP than, say, Germany.

German politicians disparage this as the Anglo-Saxon economic model – and since it is an election year in Germany, we are bound to hear more of this than usual. I call this the asset-based economic model.  The goal is to accumulate as much wealth as one possibly can by buying as many assets as one can, through income (hard work) and debt (mortgaging future income).

I find all of this a bit like a rat in his cage chasing a hunk of cheese.  After all, there are only so many hours in the week to divide between family, leisure, work and sleep.  And, there is only so much you can borrow against future income. At some point, lenders figure out they have lent more than you can possibly earn and pay back.

And that’s the message here and now, isn’t it? We have seen a massive credit bubble which has taken debt levels to unimaginable proportions – all in the quest for more material wealth.  My guess is that the pendulum, having swung too far in the one direction, is headed back the other way.  While risky debt-financed binges seemed the road to riches in the asset based economy, the conservative new normal will be savings.

My hope is that this new normal not only ushers in a world where high debt and low savings are frowned upon.  I also hope we see a re-allocation of time and energy away from work and wealth accumulation and toward other more important things like family and leisure.

Related posts:

• Barack Obama ushers in a new era in America
• The U.S. is exporting unemployment with ‘Buy America’
• Remittances to Eastern Europe to slow dramatically
• Twenty wealthiest towns in America
• Europe is in for a rude awakening

Alan Blinder, David Leonhardt, and Alan Auerbach talk about deficits.  Leonhardt had a well-regarded piece in the New York Times on the issue linked below.

There are two basic truths about the enormous deficits that the federal government will run in the coming years.

The first is that President Obama’s agenda, ambitious as it may be, is responsible for only a sliver of the deficits, despite what many of his Republican critics are saying. The second is that Mr. Obama does not have a realistic plan for eliminating the deficit, despite what his advisers have suggested.

-David Leonhardt, 9 Jun 2009

Source

America’s Sea of Red Ink Was Years in the Making – David Leonhardt, NY Times

Related posts:

• America’s Fiscal Train Wreck
• Fiscal policy limited in the UK and the US
• A conversation with Pete Peterson on Charlie Rose
• The $1 trillion deficit: has Bill Gross gone crazy?
• A conversation about Prop. 8 with David Boies on Charlie Rose

PIMCO’s founder Bill Gross is out with his latest monthly missive.  It makes for interesting reading, especially in regards to the captains of finance and their desire to stay rich using other people’s money.

I remember as a child my parents telling me, perhaps resentfully, that only a doctor, airline pilot, or a car dealer could afford to join a country club. My how things have changed. Now, as I write this overlooking the 16th hole on the Vintage Club near Palm Springs, the only golfers who shank seven irons into the lake are real estate developers, investment bankers, or heads of investment management companies. The rich are different, not only in the manner intoned by F. Scott Fitzgerald, but also in who they are and what they do for a living. Whether some or all of them are filthy is a judgment for society and history to make. Of one thing you can be sure however: over the next several decades, the ability to make a fortune by using other people’s money will be a lot harder. Deleveraging, reregulation, increased taxation, and compensation limits will allow only the most skillful – or the shadiest – into the Balzac or Forbes 400.

Gross goes on to reflect that the U.S. is not keeping pace with the rest of the world in terms of producing Forbes 400 wealth, the obvious takeaways being that the U.S. is declining relative to the rest of the world and this spells trouble for the megarich as much as it does for the average American.  Obviously, this has great significance for the fortunes of the U.S. government and its ability to stimulate the economy with deficit spending.  Gross was on record saying the sell-off in U.S. government paper was a direct result of doubts regarding the U.S. government’s solvency, something Willem Buiter is also analysing regarding the U.K. government.  Gross has this to say about the fortunes of the U.S. government (emphasis his):

To zero in on the U.S. of A., its annual deficit of nearly $1.5 trillion is 10% of GDP alone, a number never approached since the 1930s Depression. While policymakers, including the President and Treasury Secretary Geithner, assure voters and financial markets alike that such a path is unsustainable and that a return to fiscal conservatism is just around the recovery’s corner, it is hard to comprehend exactly how that more balanced rabbit can be pulled out of Washington’s hat. Private sector deleveraging, reregulation and reduced consumption all argue for a real growth rate in the U.S. that requires a government checkbook for years to come just to keep its head above the 1% required to stabilize unemployment. Five more years of those 10% of GDP deficits will quickly raise America’s debt to GDP level to over 100%, a level that the rating services – and more importantly the markets – recognize as a point of no return. At 100% debt to GDP, the interest on the debt might amount to 5% or 6% of annual output alone, and it quickly compounds as the interest upon interest becomes as heavy as those “sixteen tons” in Tennessee Ernie Ford’s famous song of a West Virginia coal miner. “You load sixteen tons and whattaya get? Another day older and deeper in debt.” Pretty soon you need 17, 18, 19 tons just to stay even and that describes the potential fate of the United States as the deficits string out into the Obama and other future Administrations.

Later in this same piece, he opines that moving to a more balanced budget is certainly the way to end the increase in treasury yields and the prospect of enormous interest payments compounding annually to new breathtaking proportions.

The obvious solution to both dollar weakness and higher yields is to move quickly towards a more balanced budget once a sustained recovery is assured, but don’t count on the former or the latter. It is probable that trillion-dollar deficits are here to stay because any recovery is likely to reflect “new normal” GDP growth rates of 1%-2% not 3%+ as we used to have.

But, as he suggests, trillion-dollar deficits ARE the new normal indeed.  Moving to eliminate these deficits too early as Tim Geithner suggests the Obama Administration wants to do risks a 1937 outcome.  See my post “Beware of deficit hawks” to see why Japan in the 1990s and the U.S. in the 1930s suffered prolonged depressions because of deficit hawkishness.

In the end, one can only conclude that the U.S. is indeed likely to deficit spend for a considerable period and that this is going to have negative effects on its credit rating and relative standing in the global economy.  A diminished future for America is an inevitability of having lived beyond its means for far too long.  Accepting this fact is likely to provide a better outcome than resisting it as the U.K. did when its tenure as king of the hill came to an end.

Source

Staying Rich in the New Normal – Bill Gross, PIMCO

Related posts:

• The $1 trillion deficit: has Bill Gross gone crazy?
• Bill Gross: the new normal means investors should shun risk
• Gross: The new normal for “the next 10 years and maybe even the next 20 years”
• Will federal largesse be countered by state and local cutbacks?
• Bill Gross: Sell equities and buy Treasuries