Fighting the Wrong War

“Generals are always fighting the last war.” Certainly this was true in Vietnam for many years. More recently we tried to refight Desert Storm in Iraq, without understanding that we were headed for another Vietnam.

But what about the economists? Are they subject to the same failings? Most certainly the answer is yes. We have now spent the last year fighting the Great Depression, when the current problem results from a very different cause. True the Great Depression followed the pricking of a stock market bubble, much like the worldwide equity bubble we experienced from 2002-2007. Yet there is one factor in the current market that is materially different from the conditions of the late 1920s that precipitated the Great Depression of the 1930s.

You have likely seen the chart below from Ned Davis Research sketching the history of leverage in the United States economy.

Leverage (Total Debt/GDP) peaked in the 1930s at ~2.6 x Gross Domestic Product. Leverage in the current economy peaked at 3.6 times GDP in 2007-2008. So what’s the difference? The difference is that there is no indication that, in the aggregate, the boom of the late 1920s was caused by a massive leveraging of the economy. From 1923 through 1930, leverage ranged from 150% to 170% percent of GDP. On the other hand, in the current era from Q3 1998 to Q2 2008, a period similar in many ways to the boom times of the 1920s, leverage increase from ~2.6x to almost 3.6x. The massive spike in leverage to GDP from ~1.6x in 1930 to ~2.6x in 1934-36 resulted not from a credit bubble, but from the rapid decline of incomes and output while debt remained relatively constant.

The current down cycle is being driven by a phenomenon different from the forces that led to the Great Depression, i.e. a massive overleveraging of the American, and more broadly, the world economy. How did this happen? Starting in the 1980s we learned new ways to create leverage. The then relatively recent invention of the credit card began to reach full blossom and consumers became empowered to “buy now pay later” at a previously unheard of rate. Similarly, the development of various securitization tools enabled the creation of new funding vehicles that drove a variety of markets, starting with home mortgages, but extending to all aspects of consumer, business and commercial real estate finance.

Mortgage securitization, which came into full flower from 2002-2006 with the invention of CDOs and credit default swaps, is now well chronicled. Less well understood are the mechanisms by which much of the rest of the economy became, in effect, a giant fractional banking system. The technology that drove mortgage securitization led to the ultimate securitization of “predictable” future cash flow streams from all aspects of the economy. Not only were future consumer and business income streams securitized through pooling of credit cards, car loans, commercial real estate, equipment leases, etc., truly exotic products began to appear, such as securitizations of movie and music residuals. In 1972 the concept of royalty streams from Ziggy Stardust being securitized by Wall Street would have been thought even weirder than the music.

The net impact of all the securitization and borrowing was to monetize future cash flows in order to make them spendable and investable in the present. This fueled a boom that has now clearly proven to be false. It appears that even the rapid growth major cities such as Phoenix and Las Vegas may have been fueled primarily by a housing boom built on the expectation of further growth in the future. Now the time has come to pay the piper. We are living in the future from which we borrowed in an earlier time. Now is the time to generate the excess cash flows that were leveraged so cavalierly during the boom.

It’s frequently assumed that, since the Great Depression ended as the world ramped up for World War II and government borrowed heavily to fund the war, that a massive increase in debt fueled spending dragged the U.S. out of the depression. The facts do not bear that out. The debt to GDP chart above indicates another mechanism at work during the period which may have been equally important. From 1936-1938 debt to GDP declined from 2.6x to 1.70x. Total debt to income ratios did not rise during the war years. In fact debt continued to decline a percentage of income through the mid-1950s, generally a very prosperous period for the economy. Clearly the exit from the worst of the economic malaise of the 1930s was accomplished without significant new credit creation.

There now seems to be almost unanimous agreement that future prosperity depends on the government’s ability to restart the economy’s credit creation engine. This has resulted in debt funded economic stimulus, TARP, TALF, and the nationalization of AIG, the GSEs and now Citigroup (C). Increasingly desperate calls from the likes of PIMCO for a restart of the securitization engine and other aspects of the Shadow Banking System indicate that the pressure comes not just from economists, but from the remnants of Wall Street as well. This pressure comes from a misreading of the lessons of the Great Depression. The apparent growth in leverage in the 1930s was a consequence of the economic decline, not its cause. In that scenario Keynesian stimulus made sense: fix the incomes and the leverage problem would fix itself.

In the current era on the other hand, leverage is the cause, not the result, of the economic crisis. We spent our future productive output and must now go through an extended period where we produce more than we consume. Until we wake up to this reality and develop economic theories, governmental policies and private actions to support the necessary era of capital formation and debt reduction, we are doomed to live in an era of privation where the focus remains on redistributing a shrinking pie rather than growing our way out of the problem.

Comments

[J. D. Swampfox:]

The writer says it very well: "The apparent growth in leverage in the 1930s was a consequence of the economic decline, not its cause. In that scenario Keynesian stimulus made sense: fix the incomes and the leverage problem would fix itself. In the current era on the other hand, leverage is the cause, not the result, of the economic crisis." Write offs and a focus on real production that new savers need - that's the prescription...

Mar 04 06:52 AM

[Crocodilian:]

It is painful and awkward when disaster can be summed up as neatly as the author's formulation:

"The net impact of all the securitization and borrowing was to monetize future cash flows in order to make them spendable and investable in the present. This fueled a boom that has now clearly proven to be false."

But its true. But the problem is-- there's no obvious solution. The author is spot on when he describes what is clearly _not_ the solution: more of the same.

"We spent our future productive output and must now go through an extended period where we produce more than we consume."

Again, nicely put. Having spent some portion of our then-future wealth yesterday, we must pay it back today, or renege on the IOU that someone is holding (and that "someone" is often us -- viz Social Security Trust Fund).

We have experienced a period of massive debt build up, followed by a massive debt paydown once before in our history. In the period 1940-1975, we first massively increased the debt (to fight WWII), and then slowly paid it down from 1946 to 1976 (debt fell from %120 of GDP to %30 of GDP in that period).

How did we do it? Mostly much higher tax rates. Throughout the 1950s when the debt was falling fastest, the top marginal rate was %90 (this was under a Republican Administration, interestingly). Higher tax rates have the effect of discouraging consumption (and given the very generous way investment deductions were structured in the 1950s, of encouraging investment).

But what's worth noting is that today's doom scenarios of inflation, repudiation, were not part of the agenda. Its also worth noting that in the 1946-1975 scenario, it took thirty years of reduced consumption to pay for four years of war. If there is anything that is certain, it is this:

"There is no quick, easy, flip-a-switch-and-ever... solution to our economic problems. Many years of consuming stuff with money that we did not have will have to paid for by many years of reduced consumption"

Mar 04 07:13 AM

[Aristophanes:]

Securitization is a means of obscuring risk. Therefore the process adds risk. Ban securitization, especially of mortgage backed securities and force banks to carry loans on their books. Canada does this and its bubble is miniscule compared to the US, with almost no oversupply of housing.

If the need is to rebuild credit, then use tried-and-true methods of risk assessment, not these broken supermodels of the banking system.

Mar 04 07:21 AM

[kelm:]

Excellent article. I have maintained on SA and to my readers that it is TOTAL debt that is what impairs an economy, not simply the federal debt.
Now, take the above chart, then take the federal Debt vs. GDP chart that everyone quotes to say "see it was worse at the end of WWII" and stare deeply at them to realize how the deficit argument has been distorted. Then recognize that as we bail out companies, states, individuals, etc the debt on the TOTAL chart is inexorably migrating onto the Federal debt chart.

The author is correct, there is no clear answer to the problem but adding more debt is certainly not the answer. Unfortunately the hallmark of a real solution is pain. Grinding, gut wrenching economic pain for a few years, everywhere and for everyone but that is not a solution 21st century America can yet accept.

Mar 04 09:10 AM

[Ferdinand E...:]

Brilliant article. Well worth a long seminar, and I don't mean in a storefront university. Why a 'long' seminar? Because I am not sure that the last paragraph is completely correct.

Mar 04 09:18 AM

[robert.b.fe...:]

The author is spot on financing debt with more debt is definately untennable. In private life bankruptcy is the end result causing pain in your life for some years to come. In the government realm it means devaluation of currency, massive inflation and ultimately default causing pain for every one for some years to come.

Mar 04 09:53 AM

[OldLimey:]

Falling demand is a symptom not the cause of this recession. What we have is a balance sheet recession. Easy access to mispriced credit allowed the world to inflate the liability side of its balance sheet and this fed through to various, sequential asset price bubbles. Asset prices are now reverting south, leaving liabilites sitting high like a mesa in a weather-eroded plain. The solution is clearly not to try to reflate asset prices with more cheap credit in an effort to restore the status quo ante. Regretably, by treating a leverage problem as a demand problem, our leaders are in all probability dooming us to a double-dip downturn. If this is correct, heaven alone knows what the second leg of the 'W' will be like. Great article - thank you.

Mar 04 01:47 PM

[patio:]

I too applaud the author, fine job.
If only our politiicians had the smarts and guts to articulate this to the populous. Americans are tough, we can handle the truth, but our "leaders" on both sides of the aisle won't do it. But we can right our own houses, as many have mentioned.

Mar 04 02:38 PM

[Crocodilian:]

On Mar 04 09:10 AM kelm wrote:

> Excellent article. I have maintained on SA and to my readers that
> it is TOTAL debt that is what impairs an economy, not simply the
> federal debt.
> Now, take the above chart, then take the federal Debt vs. GDP chart
> that everyone quotes to say "see it was worse at the end of WWII"
> and stare deeply at them to realize how the deficit argument has
> been distorted. Then recognize that as we bail out companies, states,
> individuals, etc the debt on the TOTAL chart is inexorably migrating
> onto the Federal debt chart.

This is a very good point. Private debt at the end of WWII was low, and savings rates were high-- that's a notable difference between where we were then, and where we are now.

But private debt isn't "automatically" public debt, the "migration" as you call it is continuing, is disturbing, but there can and should be "haircuts" in the process. $1 o f private debt in a bad company should not equal $1 of public debt.

What's happening, disturbingly, is that the private debt is migrating -- and the equity is being wiped out. That's effectively what's happened at Citi . . . equity gone, debt still in place. Same at the GSEs.

I can't disagree with you on the point that this is disturbing, and one must make estimates of total debt. Even taking the GSEs and Fannie and Freddie on the the Federal balance sheet, you still end up with debt at%120 of GDP. That is alarming, but that's the level, roughly at the end of WWII.

Mar 04 03:26 PM

[plumstupid:]

As it appears there is a consensus here regarding a need to change the economic system one must ask to what do we change?

Mar 05 04:37 AM

[John Slater:]

I am not suggesting a change to the system. We've got a pretty good system that has driven two hundred years of economic prosperity in the United States. It's called the free market.

The market has been trying hard to correct the excesses described in my article, but the powers in DC and New York have devoted Trillions of Dollars of our money to keep the market from working. I don't believe in Darwinian capitalism; the country long ago decided to provide a safety net for its citizens.

What's different this time is that the power structure has decided to provide a safety net to the major financial interests who are presumably smart enough to make their own decisions and to take the consequences when they are wrong. Bondholders of Citibank, AIG, et. al. have no legitimate claim to federal protection and subsidy, but all of the bailout plans seem calculated to protect them.

What's really going on here is a chapter in the battle between Jeffersonian and Hamiltonian democracy in America. With apologies for oversimplification, Jefferson believed that America would prosper by putting power in the hands of the people with a wide dispersion of power. Hamilton believed in an aristocratic system run by the best and the brightest, with power concentrated in government and power elites closely aligned with government. In the world of finance Jefferson would have supported a large number of small banks with no massive concentrations of capital. Hamilton supported creation of the Bank of the United States.

In the present era, the Hamiltonians seem to be in ascendancy in both political parties. While overall the smaller banks appear to have done a better job of managing risk than the major national banks, the government continues to support the national banks to the detriment of the regional and community banks. In my view this is a formula for disaster both for our economy and our democracy.

On Mar 05 04:37 AM plumstupid wrote:

> As it appears there is a consensus here regarding a need to change
> the economic system one must ask to what do we change?

Mar 05 07:52 PM

[plumstupid:]

Forgive me but there hasn't been 200 years of economic prosperity. Several recessions and depressions including the current one reduce that number significantly. I'm happy to hear you don't condone Darwinist capitalism. You realize of course that you are in a very small minority. Therein lies the problem. Therein lies the requirement for a codified rejection of capitalism. At its essence its fatally flawed. For one to win another must lose. I question the acceptance that boom bust cycles are a good thing. One would hope we've evolved further than that.

Mar 06 01:13 AM

[John Slater:]

For all its pain, in a historical context the Great Depression is just a blip in terms of real per capita income, which grew from $1000 in 1800 to ~$40,000 today. (see charts at www.visualizingeconomi.../ and at mjperry.blogspot.com/2...) In the long run, the current episode will be no different, so long as we don't destroy the engine that has generated the prosperity.

My concern with the system is that we are now trying to build is a form of state capitalism, which has not proven to be a great formula for social justice in the past (consider the history of the Krup family in Germany in the 1930's and 1940's).

Mar 06 10:30 AM