Wednesday, February 4, 2009

This Issue Is Debt! Too Much of It!

Going forward…the primary issue the world is going to have to face is debt…lots and lots of debt. Debt is clogging the blood vessels of the world financial system!

And the proposal to get us out of this dilemma?

Create even more debt!

If the problem is too much debt then the economy has to go through the pain of working this debt off…and this is called a debt/deflation. As people and companies and government reduce the amount of debt on their balance sheets they withdraw from the spending stream…and save…exactly what people and companies and governments are doing at the present time. But, removing spending from the spending stream reduces the demand for goods and services, causes firms to cut people from their employee rolls…and creates a downward spiral in economic activity. The economy engages in cumulative behavior and gets deeper and deeper into a hole.

This is what the people and the government want to avoid…if possible.

The Obama stimulus proposal is a way to get us out of the current economic crisis.
(There is another way that I will discuss below.) Basically, it is an attempt to inflate our way out of all the debt that exists. The Federal Reserve is doing its part in trying to pump up the amount of cash that exists within the system. But, creating money in this way takes time for the inflation to work its way through the system because it must go through banks and other financial organizations. And, this system, right now, seems to be functioning at a very low level.

Keynes saw this problem in the 1930s and proposed a way of getting around the banking and financial systems…create massive amounts of government expenditures and put this spending directly in the economic system…financing the deficits with government debt. Then, as the economic system starts to turnaround and pick up steam…the banking and financial system will pick up some steam and provide the “kicker” to create the inflationary environment needed to reduce the real value of the debt that had been built up…including the debt the government deficit spending just added to the pile.

Therefore, the first way to reduce the amount of debt that is outstanding in the economy is to create more debt so as to un-clog the banking and financial system…create an inflationary environment…and watch the “real value” of the debt decline.

This is a long term process and has several problems to face along the way. One of these is the question of how much spending should the government undertake? The issue here is about what the “multiplier” of government spending really is. I treated this in a post on January 26, 2009, titled “What will be the impact of Obama’s stimulus plan, Another question has to do with the process of enacting the stimulus plan into law. This I treated in a post on February 2, 2009, titled “the Obama Stimulus plan: Why I’m Concerned”,

However, the ultimate issue relates to the amount of debt that is outstanding…in the United States…and in the world. If the amount of debt HAS to be reduced…and it must be reduced in order to get the economy functioning again…then, following this approach, inflation must take place to reduce the real value of the debt. The danger with this plan is that if inflation is not cut off at some time in the future, the incentives in the economy will be to return to a “go-right-on” and “business-as-usual” approach to living. That is…we will be right back where we were around the middle of this decade, where leverage was good and more leverage was even better, especially within an inflationary environment where things need to be kept “pumped up”! If this happens, we will still be addicted and still have the “monkey on our backs.”

Another way to reduce the amount of debt outstanding in the economy is to basically “write down” or “re-write” the debt and not create any more through an enormous fiscal stimulus plan like that proposed by the Obama administration. This would involve a massive restructuring of existing business balance sheets…both financial institutions as well as non-financial institutions. Insolvent institutions…including the auto companies…need to be recognized as such. In effect, existing shareholders in these companies have lost their investment…so much for good governance and oversight. Bondholders will have to accept an exchange…taking “new” debt at, say, 75% or 50% of the current face value…or preferred shares for the debt they hold…or taking an equity position in the company…maybe even warrants.

These exchanges would have to be negotiated…but the bondholders would have to understand that, as things now stand, the companies are insolvent and they could get nothing if the restructuring does not take place. Plus, the companies or the bondholders…or the public…really does not want the government to take over these institutions. We do not want state-run companies…financial or non-financial…because the fate of the nation would be much worse with a nationalization of industry than it would with an imposed “re-structuring” of the balance sheets of these businesses…financial and non-financial.

In terms of the consumer…a similar thing would have to take place. The major concern has been related to the housing sector and mortgages. But, we are now seeing a massive wave approaching of defaults on credit cards, car loans, and other types of debt that the consumer has taken on. Similar to the re-structuring of the business sector, the balance sheets of consumers must be re-structured. How we do this cannot really be discussed in this short post, but the idea would be that organizations that have extended credit to the consumer sector will have to take a haircut on the amount of debt that is owed by each consumer and the terms of repayment will have to be restructured in order to make the probability of repayment of the debt realistic. Again, this re-structuring would have to be negotiated…but we are talking here about much lower costs than would accumulate if there were more foreclosures and bankruptcies…more lawyers’ fees…and more costs all the way around. And, this could be done in a much shorter period of time than if all these bad assets had to be “worked out”.

I have given two extreme solutions to the problem of the debt overhang. The fundamental crisis is connected with the fact that there is too much debt in the system. For the system to work this dislocation out we would have to go through a period of debt-deflation. The two extremes presented here are, first, the Keynesian approach which is to inflate the economy and reduce the real value of the debt, or, second, to impose a debt-restructuring on the economy which would allow for a negotiated reduction in the debt loads of all economic units in the system.

People will really not be happy with either of these extreme solutions…or, for that matter…any combination of the efforts. But, once one loses their discipline, as the United States and the world did in the 2000s…there are no good solutions available to get out of the hole that has been dug. All people can do is to “take their medicine” and vow not to let such a situation ever occur again. However, looking back at history, one cannot be very confident that we will maintain our discipline once we get over the crisis.

I would like to make just one more suggestion. There is only one real change I would like to see to the regulatory structure…for both financial and non-financial firms…and that is the imposition of almost complete openness and transparency of the business and financial records of companies. Whatever a company does…it should be open to its owners…and to anyone else that might be interested.


zephyrprime said...

The keynesian method cannot work because it relies upon debt creation to generate inflation. Thus, you are digging a deeper hole while trying to dig yourself out of a hole. Your other idea is eminently logical. I doubt it would ever be enacted. Unfortunately, we will probably have to "work out" our excesses. During the great depression, debt loads were only reduced by enough people defaulting on their home and farm mortgages and speculators defaulting. There was no orderly decline. Japan has enjoyed an orderly private debt reduction in recent years but unfortunately, it's public debt has risen to offset it.

( A Techie) said...

Hi... i was just searching "economics and finance" on google blog search and picked up your blog...

This post was really able to enrich my knowledge on this issue.. thanks...

I am totally new to this field but i still feel that second method is much more logical ... and by this way , Govt. can punish both financial institutions and consumers for their actions which lead to this situation ... don't know write or wrong but i felt this way ...