Much is said about the propensity of USA to pile on public debt to try and right the wrongs of the moronic lenders of yester-year ….and the risks that entails, but private sector debt is a much bigger “Elephant” in the Jacuzzi than public sector debt.
Seven point six times bigger to be precise, that’s about the ratio that it reached in 1929 before dropping precipitously, over about ten years, to about 70% of public debt.
In a rare moment of lucidity Alan Greenspan, once remarked that a country with the luxury of its very own fiat currency always has the option of printing more money to pay its debts. That’s why US Treasuries are rated AAA, because if you lend the US Government $10 today, you can be 99.99% sure that in ten or twenty years time they will pay you back, plus interest. Of course you won’t be able to buy much with that $10 in thirty years time, but that’s another story.
Not so for private sector debt. There is only one private sector entity that can “legally” print dollar bills in USA, and that’s the Federal Reserve (although some question exactly how “legal” that is, but that’s another story too).
The “problem” of private sector debt:
Almost everyone agrees that there is too much private sector debt in USA (and in a lot of other places actually), and that’s a bit of a “problem”.
There are two reasons why that’s a problem right now; first the borrowers are having difficulties keeping up with the payments (that’s called “debt service”), and second, the collateral that was accepted by the lenders as security (in case…”horror”…the borrowers defaulted), turns out to be worth a lot less (today), than the amount of money that was lent.
The net result is that the aggregate quality of private sector debt; is a lot less than AAA, despite what the rating agencies would have everyone believe.
So there is a crisis. But “no-worries”, lots of clever schemes are being hatched to make the debt disappear.
There are three ways that “too much” debt can be made to “disappear”:
(A): The people who borrowed can pay it back with interest (that’s the traditional approach).
(B) They can decide to NOT pay it back (or more to the point not pay the interest); in which case it disappears by virtue of the collateral getting sold and the balance on the sale being written-off.
Of course it is possible to magically not write it off for some time, which is what the “Stress Tests” were all about; helping orchestrate that sort of delusional deception in the financial system in general, is one of the “vital” public services performed by FDIC and FASB.
(C): The government can step in like a fairy godmother and wave a magic wand creating money out of thin air making everyone whole again. It can do that either by raising taxes (very unpopular), by borrowing itself (i.e. selling Treasuries which is moderately unpopular), or by having its agent, the Fed, print money (moderately popular except for retirees and anyone on a fixed income).
There is currently a BIG Debate going on about how much of the outstanding debt “should” get dealt with via option (A) or (B) or (C), and in the case of (C) how much “should” simply be printed, and how much “should” be borrowed.
Regardless of how that one plays out (sadly, in reality there is often a big disconnect between what the rocket-scientist economists think “should” happen, and what actually happens), what’s pretty clear at this particular juncture is that the level of indebtedness of the private sector is likely to go down to a point at which the traditional way of dealing with it (Option (A): Paying it back (plus interest)), becomes a realistic option for borrowers.
So “where is the “magic” optimal line where the private sector as a whole can be reliably expected to service its debt?”
Well seeing as the ability of a borrower to pay back debt is typically a function of how much money he or she makes (or in the case of a corporation “it”), perhaps the total amount of money that is “made” in USA (like the nominal GDP for example), could be a good starting point for thinking about that?
Now let’s suppose, just for sake of argument, that private sector debt can bubble, just like anything else (that’s the area shaded in red). The way you create that bubble is by “financial engineering” which is a magically complicated system of communal self delusion practiced by bankers and central bankers from time to time.
If debt can be a “bubble” then according to the “Seven Immutable Laws of Bubbles” there ought to be a “fundamental” around which the level of indebtedness oscillates over a long period of time (that’s the green line).
So how can we find out where the “green-line” is?
Well there is ONE clue from the past 150 years or so in USA that can perhaps provide some “guidance”.
Theoretically (also according to the Seven Immutable Laws), the “fundamental” can be determined by taking the square root of the peak of a past bubble multiplied by the bottom of the trough that follows. For the period 1920 to 1940 that put’s the “fundamental” or optimal at about 134% of GDP.
By that logic the level of private sector debt in USA which reached about 340% of GDP, is now about 2.5 times the “optimal”, so according to the Seven Immutable Laws of Bubbles, at some point in the future it will go down, as night-follows day, to 134% divided by 2.5 = 53% or thereabouts.
That’s because at some point all of what the “Austrians” call the “malinvestments” (funded by foolish debt), need to be washed out of the system.
Or putting that another way, that’s because (also according to the Seven Immutable Laws), what goes up comes down and typically the period of time “down” (that’s the area shaded in blue), is roughly equal to the preceding period of time “up”. That’s another clue, notice how the period of “up” (above the green-line) starting in 1920 and ending in 1942 or so, is about equal to the period of “down” that followed.
Using that logic, if nominal GDP grows by 4% over the next fifteen years, it’s likely private sector debt will go down to somewhere in the vicinity of $15 trillion (currently its $50 trillion).
Or putting that another way, the economy will need to grow in nominal terms (inflation plus real), at a rate of 13.4% a year (could 134 be a magic number?), for that debt to be serviced.
Me-thinks it will take a lot of helicopters to achieve that.
There is one caveat, which is that interest rates (short and long) are (a bit) lower than they were in 1930/1940 so the debt service will be less (the straight green line ought to go up and down with interest rates). So if interest rates are kept low for the next fifteen years (a good way to do that would be to constrain nominal GDP growth so that long-term yields stay down), perhaps total private sector debt might go down to say 100% of GDP.
Regardless of where the bottom is, either way that’s a long drop.
There are signs that private sector debt has turned the corner and is starting to head down (regardless of the efforts of FDIC and FASB to hide that from the public – in case they panic); perhaps it’s time to start to…Err…panic?
What about public sector debt?
Again, taking the precedent of ONE event in the past (admittedly not a particularly reliable way of predicting the future but better than NONE), what’s going to happen over the next fifteen years, is that public sector debt is going to go up to about 130% of GDP. That’s as the government and its agent tries to “manage” things, and the well-connected get bailed out.
So if nominal GDP grows by 4% a year, public sector debt will go up to $33 trillion, and if it grows at the “magical” 13.4%, it will be $124 trillion.
This type of analysis is not exactly main-stream and it’s only “lunatics” like George Soros and Marc Faber who think that bubbles have a dynamic which is predictable. On the other hand, the track record of using this approach to anticipate where the market for things that “bubble” will go next; is, with a few exceptions, pretty good.
If debt is indeed a bubble like any other; and bubbles (once started) are predictable, then it’s likely that countries with a lot of private sector debt will grow rather slowly until the private-sector debt re-sets to a more manageable level.
In that case:
1: Inflation in the affected countries will be modest, forget about the quantity theory of money that assumes “velocity” is constant; recent events have proven conclusively that it isn’t. The reality is there is an output gap, there are no pressures on wages, and although there is plenty of money around to lend, there are not many credit-worthy individuals or enterprises who want to pile on more debt; rather the opposite. The only thing that can possibly cause inflation is imports; there is an easy solution for that, buy less imported goods.
2: Treasury yields will be constrained, regardless of how much the government borrows. That’s simply because demand for good quality debt (by pension funds and insurance companies) will be (much) more than supply; it’s worth remembering that the main driver for securitization which was creating $2 trillion of new debt in its heyday; was an insatiable demand for AAA debt. Even if you take out the arbitrage business, the demand is still there, just there isn’t any supply
3: Companies that are currently under-leveraged; will do better than ones that are leveraged; equity will rule, and return on equity demanded by anyone who has some will go up, simply because the option of gearing will be less. Equity – like real money, will command a premium, I remember the time when the “stars” of any project were the guys who could bring in the debt…no more.
4: Cap rates on commercial real estate will stay low (yields will be high), that’s a double-whammy because revenues will stay low. But it will be a while before there are bargains, because FDIC is allowing banks to “extend and pretend”, and it looks like they will be doing that for some time.
So what “should” the government do?
Personally I’m never very interested in what other people “should” do, I’m much more interested in figuring out what they will do (not the same thing at all), but I have a few remarks.
First of all I suspect that the $1..25 trillion that the Fed spent buying toxic garbage will end up costing them easily $500 billion (but that’s OK they can just print money to cover the loss). I suspect that very little of the $1 trillion that’s getting directed at Fannie and Freddie will come back, and in my opinion the practice of lending money to banks at 0% so they can buy 10-Year Treasuries at 3.5% or whatever, is a criminal misuse of public funds and the perpetrators of that scam should be put on trial and sent to prison.
With regard to the Financial Reforms crafted by Tim Geither & Co, well talk about the Maginot Line re-visited.
It’s all about being able to “fire-fight” the next time that the moronic banks manage to orchestrate a bubble. Well here’s some news, there was a bubble, it burst, the reality now is “post-bubble”, and all of that garbage needs to be washed away before there can be another one.
One thing that the government or the regulators or whoever can do which would be a positive step would be to clean up the securitization business which they have assiduously avoided even looking at (I suspect that may have something to do with the fact that they don’t understand it).
Right now there is almost no securitized debt being produced, even covered bonds (the safer German/French variety that have stood the test of time for over a hundred years) are hardly moving. The reason for that is because there is no transparency, the buyers were not and are still not provided with the necessary general and specific information that they need to price or value those instruments.
Previously the idea was that the buyers could rely on the ratings, well that has been demonstrated quite conclusively to be moronically stupid. But there has been no change in the system; what you need to value securitized debt is line by line loan data, all of it, and not just of the security you are valuing, you need line by line historical data of every loan issued by the entity that is pooling its loans into the security. That’s a lot of data, but these days they have computers, all that’s needed is (a) to specify a standard format (b) to legislate that anyone who wants to put loans into a pool, is obliged, under the law, to pass across the data, preferably post it (with names and addresses deleted), on the Internet.
That’s no different in principle from the disclosure principles that already exist for listed shares on a stock market – just it’s a different type of data.
Do that and the landing will be softer, but it will still be a hard landing. Regardless, throwing money at insolvent enterprises to “ease the pain” is just a waste of money, what’s inevitable, is inevitable, like King Canute’s tide.
By Andrew Butter
Twenty years doing market analysis and valuations for investors in the Middle East, USA, and Europe; currently writing a book about BubbleOmics. Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( firstname.lastname@example.org ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.
© 2010 Copyright Andrew Butter- All Rights Reserved
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