Why Deleveraging Is The Ultimate Outcome As The Fiscal Cliff Just Doesn't Matter

Includes: UUPT
by: Joseph Stuber

In recent weeks - going back to the middle of September - I have advocated a move away from stocks and into cash (NYSEARCA:UUPT). That call was well timed as the major indices have moved sharply lower starting the week after the Fed announced QE 3. Tech stocks have been the worst performing sector with Apple (NASDAQ:AAPL) outrunning the rest of the market.

I see that trend accelerating going into the end of the year. I still see the U.S. dollar as the best place to be in the coming months. It is a position very few investors agree with.

There are many who see recession around the corner but still feel the need to be "invested" - presumably to beat inflation. I don't see inflation occurring and, in fact, believe that deflation is the more likely near term scenario.

My view is that we entered into a deleveraging cycle at the onset of the recession and that process was never completed. The reason we didn't complete the much needed deleveraging process is that the federal government - through fiscal policy - began to spend aggressively as individuals and businesses moved in the other direction.

I think most readers understand deleveraging but fail to see the need for it or the impact it will have on asset prices. Deleveraging is a process of paying down or paying off debt. Leveraging, on the other hand, is the process of acquiring debt. The process of leveraging or acquiring debt expands the economy and drives GDP higher. The process of deleveraging contracts the economy and puts downward pressure on GDP.

The first scenario - deleveraging -- shrinks M2. The second scenario - leveraging -- expands M2. As M2 shrinks the dollar gets stronger relative to other assets. It's a pretty straightforward accounting transaction. If you pay off a note at the bank the balance sheet is reduced in two accounts.

First, the cash comes out of the depositors account (a part of M2) -- a bank liability -- and the bank loans account - an asset -- is reduced by a like amount. That is what happens in a deleveraging economy and it is not inflationary and therefore safe haven investments like gold will do no better than any other asset priced in dollars. The end result is disinflation initially and deflation eventually.

So are there any other alternatives to the deleveraging scenario? I don't think so but you be the judge as we take a look at some other metrics. Specifically, I want to focus on what occurred in the years prior to the recession and what has occurred since then. We are going to take a look at two separate categories of debt - household and government - to see if we can paint a clear picture of what has happened and hopefully, draw some inference on what is likely to happen going forward.

The chart below shows what has occurred in the household category since 2006 - two years prior to the recession -- and continuing through the 2nd quarter of 2012. The data in the charts to follow comes courtesy of the Federal Reserve.

The chart below reflects three categories of the household debt growth rate - total debt, mortgage debt and consumer debt. For those who were paying attention to this back in 2006 and 2007 it was clear that we were moving into troubling times.

We actually slipped into recession in the 3rd quarter of 2008 and the mortgage debt growth rate bottomed out in that same quarter. What's interesting about the chart is that the debt growth rate trajectory began to move sharply lower well ahead of the recession. After peaking at just under 15% in the 1st quarter of 2006, the mortgage debt growth rate began a rapid descent turning negative in the 1st quarter of 2008.

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The impact of this rapid deceleration of debt showed up in the unemployment and GDP numbers as unemployment began to climb and GDP began to fall at roughly the same time the mortgage debt growth rate turned negative in early 2008. The charts below reflect the period of time leading up to the recession and continuing through the 3rd quarter of 2009 when we finally moved back out of recession.

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A process of deleveraging began in 2006 as evidenced by the chart above and progressed to a point by 2008 where it created a systemic risk to the banking system. We will discuss this further in a minute but for now let's take a look at how we managed to barely avert complete economic collapse. The chart below shows a dramatic upward shift in the rate of growth of government debt -- climbing by more that 30% -- in the 2nd quarter of 2008. That sharp upward spike was the result of a bailout of the nation's banks financed by the taxpayers.

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For those who have forgotten, let me refresh your memory. It was a frantic and frightening period in our history that involved rare collusion between Congress, the Administration, the Federal Reserve and the major private sector banks. Hank Paulson -- the Secretary of the Treasury under George Bush -- led the charge and what evolved in record time was a public bail out of the banks.

The Troubled Asset Relief Program -- or TARP -- was a $700 billion program that authorized the purchase -- through use of public debt - of assets and equity (to bolster bank capital) to stabilize the private sector banking system. It was a dramatic and controversial program that moved through the approval process with amazing speed.

I join with many who see Congress as dysfunctional and fiscally irresponsible most of the time and the current attempt by Congress to patch together some sort of "fiscal cliff" resolution is just the sort of thing that reinforces that opinion. That said, we must give credit to someone for TARP and I guess Congress deserves at least a portion of the credit. It was a much needed and necessary program that allowed us to avert a major catastrophe and I fully supported it then and do so today.

However, the problem was not solved back in 2008. The damage was clearly mitigated and we should all give thanks for that but we still have a lot of work to do to restore the economy to health again. Specifically, we still have a lot of deleveraging to do. This next chart compares the dollar amount of outstanding debt held by households with the amount of government debt.

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Here's the problem. The federal government has borrowed at a rate not seen since World War II and yet the total outstanding household debt remains at 2006 levels. That massive borrowing by the government was supposed to prime the pump. What we wanted to happen was an expansion of private sector debt. Had that occurred M2 would have managed to expand beyond the dollar level of the Federal Reserve injections creating a modest inflationary situation.

Inflation drives asset values higher as the supply of money outruns GDP. Despite what central bankers suggest, it is just this inflationary environment that their policy initiatives are designed to create. Central banks around the world are attempting to devalue their own currencies which monetizes debt and drives asset prices to levels where leveraged assets don't pose a serious risk of loss to the holders of the debt in the event of default.

One might take a look at the chart at the top of this article reflecting household consumer debt and conclude that I am wrong and we are borrowing and expanding M2. After all, total consumer debt has climbed steadily since bottoming out in 2009. Some say this is bullish as consumer confidence is improving. I would say the opposite is the case.

The rate of growth of consumer debt has moved from a negative 5% to plus 5% but there is nothing in the GDP numbers or M2 velocity that suggest this increase in consumer debt is the result of increased confidence that will lead to more aggressive spending and drive GDP higher. To the contrary, it suggests that people are incurring debt to buy necessities and not paying those debts off at the end of the month.

That conclusion is further supported by the chart below showing the growth rate - or lack thereof - of disposable income over the last six years.

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One can argue that none of these metrics suggest the problems are beyond resolving if we just get to work. I will remind you that we have been "getting to work" since the recession with all the fiscal and monetary tools available. We are talking roughly $7 trillion in borrowed money being added to government spending. Keep in mind that is not the total amount of government spending - it is just that portion that is financed with debt. We have also flattened the yield curve and brought the front end to near zero. Add to that a little less that $3 trillion in monetary stimulus through QE and it's hard to conclude that our leaders haven't tried.

Now Congress is faced with a decision - can we afford to extract a mere $600 billion from the economy with tax hikes and spending cuts that were agreed to a little over a year ago. Probably not but it won't matter anyway. No doubt something will be done or maybe not but it just won't matter how the "fiscal cliff" is resolved. Whether we deal with the deficit by ratcheting it back $600 billion or just $200 or $300 billion doesn't' constitute a difference that matters.

The process going on in Washington in recent weeks is nothing more than political posturing ---an attempt to skirt the issue by blaming the other side. The truth is the economy -- as fragile as it is - is not able to withstand whatever "Grand Bargain" compromise that Congress comes up with. The only way we stay in positive territory going forward is to continue on the same path we've been on - just keep borrowing a trillion or so every year and sending out unemployment checks and there is a real chance even that won't work any longer.

As Congress ponders the "fiscal cliff" and the consequence of their decision keep in mind that approximately 20% of the nation's mortgages are still underwater four years after the "Great Recession" ended. Also, consider that seasonally adjusted household debt remains at about the same level it was at the end of 2006.

We are a nation that is still plagued with a leverage problem. We either need to increase leverage by expanded borrowings and in so doing, increase M2, which leads to inflation as the Fed has attempted to do or decrease borrowings through a process of further debt reduction. We've failed in creating the former - increased leverage - which leaves us no alternative but the later - decreased leverage. This will occur as natural market forces finally override the less natural artificial stimulus that has failed to jump start an economy still dealing with the aftershock of the "Great Recession."

Consider that the collateral securing mortgage debt obligations is still significantly undervalued and not sufficient to pay off the debt through sale of the collateral. At the present time approximately 85% of these underwater loans are being serviced in a timely manner but that will change quickly if we enter recession. The truth is the sheer weight of the debt in both the public and private sector has prevented any meaningful economic recovery.

As Congress demonstrates their complete disregard for keeping a promise by trying to conjure up a new way to break yet another agreement - in this case -- the "sequestration cuts" to spending, and others, on the Republican side of the aisle are promising to break their commitment to America by reneging on the pledge they made to not raise taxes, one wonders - what, after all, did we expect.

It is time to replace optimism and hope with a pragmatic and businesslike approach that deals with the excesses as efficiently and quickly as possible. If only we could take the matter of political expediency off the table I suspect Congress would manage to do the right thing.

The solutions aren't going to be easy nor will they be popular. The American people won't understand and the consequence could well be political death. That's not the point though. At times we have to make decisions in life that we don't want to make. Our own personal experiences inform us of that truth.

Perhaps we should take a page from the Paul Volcker playbook and cancel ZIRP. In so doing we would rapidly complete the deleveraging process as increased carry costs would force the liquidation of overleveraged assets. Those left standing would find all assets selling at bargain prices and begin the process of reviving the economy as a real "risk on" climate would surface and drive GDP growth and begin the process of returning to full employment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am short a group of tech stocks, financial stocks and crude oil. I am long the VIX.