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, ABMC (17 clicks)
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Much has been said about the propensity of the USA to pile on public debt to try and right the wrongs of the moronic lenders of yester-year … and the risks that that entails, as private sector debt is a much bigger “elephant” in the jacuzzi than public sector debt.

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It is seven point six times larger to be precise; that’s about the ratio that it reached in 1929 before dropping precipitously over the last ten years, to about 70% of public debt.

In a rare moment of lucidity, Alan Greenspan once remarked that a country with the luxury of its very own fiat currency always has the option of printing more money to pay its debts. That’s why US Treasuries are rated AAA, because if you lend the US Government $10 today, you can be 99.99% sure that in ten or twenty years time they will pay you back, plus interest. Of course you won’t be able to buy much with that $10 in thirty years time, but that’s another story.

This is not the case for private sector debt. There is only one private sector entity that can “legally” print dollar bills in the USA, and that’s the Federal Reserve (although some question exactly how “legal” that is, but that’s another story too).

The “Problem” With Private Sector Debt:

Almost everyone agrees that there is too much private sector debt in the USA (and in a lot of other places actually), and that’s a bit of a “problem.”

There are two reasons why that’s a problem right now; first, the borrowers are having difficulties keeping up with the payments (that’s called “debt service”), and second, the collateral that was accepted by the lenders as security (in case …”horror”… the borrowers defaulted), turns out to be worth a lot less (today), than the amount of money that was lent.

The net result is that the aggregate quality of private sector debt; is a lot less than AAA, despite what the rating agencies would have everyone believe.

So there is a crisis. But “no-worries,” lots of clever schemes are being hatched to make the debt disappear.

There are three ways that “too much” debt can be made to “disappear:”

(A): The people who borrowed it can pay it back with interest (that’s the traditional approach).

(B) They can decide to NOT pay it back (or more to the point not pay the interest); in which case it disappears by virtue of the collateral getting sold and the balance on the sale being written-off.

Of course it is possible to magically not write it off for some time, which is what the “Stress Tests” were all about; helping orchestrate that sort of delusional deception in the financial system in general, is one of the “vital” public services performed by FDIC and FASB.

(C): The government can step in like a fairy godmother and wave a magic wand creating money out of thin air making everyone whole again. It can do that either by raising taxes (very unpopular), by borrowing itself (i.e. selling Treasuries which is moderately unpopular), or by having its agent, the Fed, print money (moderately popular except for retirees and anyone on a fixed income).

There is currently a BIG Debate going on about how much of the outstanding debt “should” get dealt with via option (A) or (B) or (C), and in the case of (C) how much “should” simply be printed, and how much “should” be borrowed.

Regardless of how that one plays out (sadly, in reality there is often a big disconnect between what the rocket-scientist economists think “should” happen, and what actually happens), what’s pretty clear at this particular juncture is that the level of indebtedness of the private sector is likely to go down to a point at which the traditional way of dealing with it (Option (A): Paying it back (plus interest)), becomes a realistic option for borrowers.

So “where is the “magic” optimal line where the private sector as a whole can be reliably expected to service its debt?”

Well seeing as the ability of a borrower to pay back debt is typically a function of how much money he or she makes (or in the case of a corporation “it”), perhaps the total amount of money that is “made” in USA (like the nominal GDP for example), could be a good starting point for thinking about that?

Now let’s suppose, just for sake of argument, that private sector debt can bubble, just like anything else (that’s the area shaded in red). The way you create that bubble is by “financial engineering,” which is a magically complicated system of communal self delusion practiced by bankers and central bankers from time to time.

If debt can be a “bubble” then according to the “Seven Immutable Laws of Bubbles” there ought to be a “fundamental” around which the level of indebtedness oscillates over a long period of time (that’s the green line).

So how can we find out where the “green-line” is?

Well there is ONE clue from the past 150 years or so in USA that can perhaps provide some “guidance.”

Theoretically (also according to the Seven Immutable Laws), the “fundamental” can be determined by taking the square root of the peak of a past bubble multiplied by the bottom of the trough that follows. For the period 1920 to 1940 that put’s the “fundamental” or optimal at about 134% of GDP.

By that logic the level of private sector debt in USA which reached about 340% of GDP, is now about 2.5 times the “optimal,” so according to the Seven Immutable Laws of Bubbles, at some point in the future it will go down, as night-follows day, to 134% divided by 2.5 = 53% or thereabouts.

That’s because at some point all of what the “Austrians” call the “malinvestments” (funded by foolish debt), need to be washed out of the system.

Or putting that another way, that’s because (also according to the Seven Immutable Laws), what goes up comes down and typically the period of time “down” (that’s the area shaded in blue), is roughly equal to the preceding period of time “up.” That’s another clue, notice how the period of “up” (above the green-line) starting in 1920 and ending in 1942 or so, is about equal to the period of “down” that followed.

Using that logic, if nominal GDP grows by 4% over the next fifteen years, it’s likely private sector debt will go down to somewhere in the vicinity of $15 trillion (currently its $50 trillion).

Or putting that another way, the economy will need to grow in nominal terms (inflation plus real), at a rate of 13.4% a year (could 134 be a magic number?), for that debt to be serviced.

Me-thinks it will take a lot of helicopters to achieve that.

There is one caveat, which is that interest rates (short and long) are (a bit) lower than they were in 1930/1940 so the debt service will be less (the straight green line ought to go up and down with interest rates). So if interest rates are kept low for the next fifteen years (a good way to do that would be to constrain nominal GDP growth so that long-term yields stay down), perhaps total private sector debt might go down to say 100% of GDP.

Regardless of where the bottom is, either way that’s a long drop.

There are signs that private sector debt has turned the corner and is starting to head down (regardless of the efforts of FDIC and FASB to hide that from the public – in case they panic); perhaps it’s time to start to … Err … panic?

What About Public Sector Debt?

Again, taking the precedent of ONE event in the past (admittedly not a particularly reliable way of predicting the future but better than NONE), what’s going to happen over the next fifteen years is that the public sector debt is going to go up to about 130% of GDP, as the government and its agent tries to “manage” things, and the well-connected get bailed out.

So if nominal GDP grows by 4% a year, public sector debt will go up to $33 trillion, and if it grows at the “magical” 13.4%, it will be $124 trillion.

Disclosure: No positions