There's No Easy Solution for Debt

Includes: AGG, DIA, SPY
by: Lollapalooza

There’s good news and then there’s bad news. Which do you want first? The bad news is there’s likely much more pain coming from the global debt bomb. The good news is that humans are very resilient and will adapt to the environment. To understand the nature of the debt problem, it helps to view money and debt differently. When money is viewed as stored energy, the big picture reveals why there is no easy medicine for our debt pain.

All living things need to consume energy to live. However, all living things must first spend their energy in order to get more for continued survival. Things can only survive if more energy comes in than goes out. Accordingly, the more energy that can be stored, the higher the standard of living is.

Energy is spent through labor or investing in order to earn more money, or stored energy, in return. Money is simply an accepted standard of exchanging stored energy. When money is earned, it is really the receiving of someone else’s energy. Earnings (energy) are then exchanged for others’ energy through the purchase of their goods and services, which, in turn, are a result of their spent energy.

That sounds complicated, so why go through all the trouble? This is done because specialization allows for more efficient use of our collective energy. Specialization tends toward perfection and we enjoy a higher average standard of living than we would if we were isolated and entirely self-reliant. All that was needed was a commonly accepted medium for exchanging specialized energies, and—poof! That’s how people enjoyed exponential growth in standard of living over the past few hundred years. However, in order to reap the benefits of specialization, there has to be cooperation—liquidity of energy.

Debt is simply borrowed energy. Borrowing energy makes sense only if more energy is returned for its use. Borrowed energy spent unwisely has to be paid back from future energy. In other words, standard of living has to come back into a sustainable balance according to how efficiently energy has been used. Only a limited amount of energy can be borrowed before lenders realize how inefficiently it is being used and they turn off the spigot.

The correction in standard of living can come in the form of debt deflation, where all of the marginally leveraged go bankrupt. It can also come from inflation, where those will be left behind whose income and assets do not keep up with the levels of cost of living and asset inflation. Correction can come from higher taxes, which has an effect on real purchasing power similar to inflation. It can also come by reducing spending and being as efficient as possible. The ultimate solution is likely to be a combination of all of these. But as long as two plus two equals four, the correction in the average standard of living is inevitable.

Continuing side effects from the debt bomb are likely because of its magnitude. It really was a perfect storm. The extremely high interest rates and inflation from the late 1970s to early 1980s provided a high platform from which to start a two-decade slide in interest rates and inflation. This was a major tailwind for increasing levels of debt. Much of the debt expansion was sustained by a wave of baby boomers that were reaching their peak productivity and earnings potential, which gave the appearance of sustainability. The situation reached a crescendo in 2007 with dangerous leverage on some of the world’s largest asset classes, upon which uncollateralized derivatives were leveraged with help from Wall Street.

This confluence of forces working in the same direction, what Charlie Munger calls the “lollapalooza effect,” was built upon a two-decade debt explosion. That in itself is not necessarily bad. However, much of this borrowed energy was not spent productively. Much of it was spent on consumer goods, entertainment and “fluff.” Too much fun was being had, so energy continued to be spent on things of little or no real value.

The probabilities were low to have that many powerful forces working at the same time toward expanding leverage. Because of that, it’s only rational to believe that the full price of this behavior has not yet been paid. Not that the current downturn hasn’t been painful, but the correction thus far doesn’t appear to reflect the magnitude of the run-up. Although the long-term looks as promising as ever, the next five to ten years are likely to be lean, depending on which medicine we choose for our debt pain.

Disclosure: No Positions