Excessive Systemic Debt: The Primary Cause of Our Current Crisis

Includes: DIA, QQQ, SPY, VEU, XLF
by: The Market Flash

I don’t know about you, but as a citizen of the United States and a believer in free markets, I find the economic and financial performance of the United States during the last four months shocking. The occurrences of the last four months have strong men and women going home at night and saying to themselves “What the #&%$# happened”. I think I now know “What Happened”. It has been hinted at in Seeking Alpha blogs, published in The Economist magazine as an article buried in the back, not the cover page, but it has not been fully recognized on the cover page of a major magazine or newspaper anywhere that I am aware of. A cover page that says “This is what caused our current economic mess” is what I think most people are interested in.

Look at the graph below (from this Seeking Alpha article - I’m not sure I agree with the article but the graph is what I want you to see) and ask yourself what is striking about it.

What is striking about this graph is that the last time the U.S. had a Debt to GDP ratio close to the Debt to GDP ratio in 2008 was in 1932. I’m not saying we’re going to have another Depression, but it is obvious from the graph that severe economic dislocation happens when the Debt to GDP ratio goes above 300%.

You can talk about bank regulators falling asleep at the switch, you can talk about Countrywide selling any lousy mortgage contract they could to Fannie/Freddie, you can talk about Wall Street greed, but the United States steadily building up debt levels for consumers and corporations (I’m not sure if the graph shows government debt or not) to unsustainable levels is the primary cause of the 2008 financial and economic tsunami. Too much debt was incurred by too many economic players, and its corresponding de-leveraging process is causing real economic problems in terms of falling aggregate demand (think car sales) and unemployment.

There is an excellent David Merkel article that discusses this, although I have to say that the title of his article ("We Have a Debt to Discharge") masked the true importance of what he was saying.

This quote summarizes his main point:

The Great Depression ended when the Debt to GDP ratio dropped below 150%. When enough debts were extinguished by payoff or default, the system could once again be normal.

What is the take away for investors in this? ETFs for indexes, like SPY, DIA, QQQQ, and VEU, and almost every other long investment have suffered badly during the last year. This Total Credit Market Debt to GDP ratio is something to pay attention to and one should get very nervous if it goes over 300%. Seeing the Debt to GDP ratio get back to more normal levels should be an indicator that Main Street is recovering. Ned Davis Research seems to track Total Credit Market Debt to GDP, but I don’t know if it costs money to access the credit information or not.

Another irony in all this is that the government bailout that is the supposed remedy for all our problems will be financed by borrowed or printed money. I’m not hearing any politician say that bailout should be financed by cutting the defense budget by 4/5 ths, or giving up Medicaid. It makes one nervous.

Disclosure: The author has been long too long SPY, DIA and QQQQ