U.S. Is Playing Financial Dominoes

Capital structure is relevant.  Promises are significant.  Contracts are definitive.

This will be short , but I have no end of friends asking me how bad it is out there.  First I tell them my opinion is a minority opinion.  Second, I tell them that debt-laden economies are inherently inflexible.  Third, I tell them that when the banks are compromised, ordinary monetary policy is useless, because there is no way to make a bank that is worried about its solvency lend more.  Fourth, even extraordinary monetary policy may not work, as the Fed tries to target lending markets, and finds that they can absorb bad assets, but can’t readily recycle them.

The aggregate capital structure of the economy is not a matter of indifference.  If there are many debt claims, and firms with debt finance other firms via debt, who finance other firms via debt, etc., then we set up a bunch of financial dominoes, where a disturbance can knock one down and carry others with it.

This is why the total debt to GDP ratio matters so much.  Economies stop functioning when they have high levels of embedded debt and a slowdown hits.  That is where we are now, at levels of Debt to GDP that exceed those of the Great Depression.  Until we get that ratio down from 350% down to 150%, normalcy will not return.  Air is leaking out of the debt bubble, and the ability to reflate is not there, because the market value of the assets have sagged to such a level that even a zero Fed funds rate will not raise the market value to the levels where the assets are booked.

People are not reliable; they sin; they default.  Economic systems that are primarily equity financed are better able to deal with the nature of man, because they have more flexibility.  Economic systems that are more heavily debt financed face more problems when someone cannot live up to his promises, because it means that others relying on the performance may not be able to live up to their promises also.

Things are different now.  In past economic cycles, there were sectors of the economy that could be stimulated by the Fed lowering the Fed funds rate.  But now, because of too many fixed commitments, there is no sector of the American economy that can absorb more debt, and stimulate everyone else.

Thus the task of levering up falls to the Federal government.  But will they be able to honor all the promises that they have made?  Given that they control the printing press, the answer is yes in nominal terms, but no if in inflation-adjusted terms.

Comments

[wdhalgren:]

The most important part of your article is the last sentence. The fed, in conjunction with other central banks, can and will reflate the global asset bubble. They prove it every day. We are undergoing coordinated global debasement of fiat currencies that will render the accumulated mountains of debt (along with any accumulated currency savings) worthless.

Short long term government debt, buy gold, copper, oil. Borrow money, do not lend money. Spend, do not save. The fed has chosen its path, ignore the message at your peril.

2008 Nov 10 10:10 AM

[Jason Rines...:]

America is not powerless to fix the economic mess. It is a two fold attack:

1) Cut spending - several areas which are mostly painful such as benefits but there is much corruption baked into the system. Start with the corruption and fraud, such as the $32 B in fraudulent claims in the Healthcare system where only four total cases where prosecuted in 2007. Work backwards from there into the benefits themselves that are non-sustainable. SS seems OK but Medicaid and Medicaire need to be overhauled. Investigate and prosecute those in the financial system that perpetrated fraud as well. There are hundred of examples of 'grey' areas that were immoral, but not illegal. However, there are dozens of cases that seem outright fraudulent in the financial sector. Exposing the layers of fraud also get us down to understanding the real numbers involved. Can't fix what you don't know and investors that have already taken a bath won't come back into the market without an understanding of risks going forward. Beginning prosecutions would help bring a little confidence that at least another global swindle won't happen in our lifetimes.

2) Spend like mad to replace imported goods, especially oil. While the U.S. shouldn't cut off trade but accelerate it, the US must produce and export goods that the world needs. This includes metals and food in the short and medium term. Infrastructure spending on roads and bridges is OK but everything the government can do to induce and encourage private equity jumping in to sectors like alternative energy, telecom, Internet are important to sustainable job creation. Education reform and reinvestment by both government and private equity are important as well.
3) Be upfront to all Americans going forward. The truth is very ugly indeed but it was worse for Americans to be told for the last two years the fundamentals were strong in this economy, that the chance of recession was 25%, blah blah blah. If someone like me knew by July of 2007 that the economy was in dire jeapordy then surely we could have educated the people to prepare a bit sooner. Educating the public without setting off panics is a craft, one this government had no skills at doing. Government must learn how America's economic engine worked in the past, studying what worked and failed during such times. We don't have to reinvent the wheel, although some major nuances such as global interconnectedness come into play in this particular downturn. Ben Bernanke knowing the Great Depression but Congress and Administration clueless is a recipe for the disaster we now see.

2008 Nov 10 10:51 AM

[dlaw:]

Look at the numbers the author is proposing and you'll see that they are ridiculous.

We're going to pay down more than $20 trillion in debt? That's "normalcy"???

Well, the answer is simple, then, we will NEVER get to Mr. Merkel's "normalcy". He might as will just right "I understood the economy of 50 years ago, but I don't understand the present one. Until we get back to the one I understand, I don't know anything."

Or, more simply put: "I don't know anything."

2008 Nov 10 12:21 PM

[Smarty_Pants:]

"But will the [Federal government] be able to honor all the promises that they have made? Given that they control the printing press, the answer is yes in nominal terms, but no if in inflation-adjusted terms."

An astute point.

Sure, you will get your Social Security payment. If you're lucky you can buy a cup of coffee with it.

wdhalgren is right. Borrow what you can afford to pay back. Don't lend. Avoid hanging on to cash for very long. Buy tangible things that will last, productive ones if possible.

For the long term: 'stuff' will maintain its value better than money. Act accordingly.

2008 Nov 10 12:39 PM

[iknoknot:]

agreeing with the author and comments:

Equities may have a stuff-like book value, but they're clearly at the mercy of a market filled with agendas driven by extreme leverage and panic. Not good 'stuff' to buy right now. Too many unknowns and very volatile.

Consider 'stuff' that can be bartered. consider 'stuff' that supplies things you are known to consume (e.g. solar-panels to make your electricity and warm your water). Consider tools for productivity as 'stuff'. Hell, consider 'stuff' that simply makes your life better for a while - it's probably gonna get tough out there for a while. Paying that all back with inflated dollars seems prudent...

If I were loaning money, I'd be raising interest rates, knowing what those future dollars are likely to be worth.

a good read - thanks,

--ikk

2008 Nov 10 07:34 PM

[investor88:]

David's article on domino effect is a good description of the current storm. The lender of last resort is government but this is no panacea as some medicine as side effects as David pointed out.

2008 Nov 10 10:16 PM

[David Martin:]

A fine analysis as usual.
I am a bit more doubtful though about the inevitability of inflation, as the deflationary forces are so powerful with the frantic deleveraging occurring.
My best guess would be ongoing deflation, no matter how hard central banks push on the string, followed perhaps by hyperinflation as all the money that has been printed hits in a tidal wave.

2008 Nov 11 09:06 AM

[axelrod608:]

<Things are different now. In past economic cycles, there were sectors of the economy that could be stimulated by the Fed lowering the Fed funds rate. But now, because of too many fixed commitments, there is no sector of the American economy that can absorb more debt, and stimulate everyone else.>

I think of this in different terms. I like to think of it in terms of sustainability. In the 1930's, 1/3 of all Americans still lived on small family farms and were accustomed to rowing all or most of their food. They were not involved in the credit sector. Also, back then the US was the world's greatest exporter of oil.

Yes, every sector is maxxed out on debt. Trying to to stimulate credit markets is like CPR on a corpse. But the real issue is sustainability. Today, almost all Americans are absolutely reliant on consumer stores for everything. We NEED to shop. And as the dominoes fall, our access to consumer staples will deteriorate.

I do not see the US government having the necessary and sufficient resources to backstop the current debt load. As much as it will hurt, and the misery it will create, we MUST get our failing businesses to shed debt in bankruptcy. It is the only alternative that will allow a portion of the economy to survive intact.

It will wipe out pension funds, investment funds, etc., but it will leave a slimmed down economy with profitable businesses. The world that Alan Greenspin created must collapse. The only real question is what we want o come out of it. If we keep going the direction we're in, China, Japan, Saudi Arabia will own the US. Is that what we really want ?

2008 Nov 11 10:18 AM

[Mowog:]

Japan is financially powerful, but it too is in serious debt with wasteful spending, corrupt and inept politicians, an aging population, and ever fewer children (among whom more are refusing to work). Japan will not be taking over the US. China's Communist system has promised much to its people; with the one-child policy, it too faces ugly demographics. Saudi Arabia has an exploding population of young people who refuse to work (that's what Pakistanis and Yemenis are for), unless it's for the government, thus parasitic jobs; low oil prices reduce government spending and jobs, which makes young men angry.

2008 Nov 11 10:19 PM

[Kunst:]

"That is where we are now, at levels of Debt to GDP that exceed those of the Great Depression. Until we get that ratio down from 350% down to 150%, normalcy will not return."

What are you counting in that 350% of GDP (3.5 x $14 trillion, so about $50T)? The official federal debt is pushing its $11T limit, around 80% of GDP. I have heard numbers as high as $65T for federal debt including SS/MC liabilities. Other levels of government have debts, as do households and corporations. What are you including in that 350% of GDP?

2008 Nov 12 12:43 AM