Wednesday, June 16, 2010

Unfortunately, Debt Must Be Repaid

Fitch Ratings Ltd. is releasing a report today that points up the problems of having too much debt. Restructuring the debt of a person or a family (or a business), even when government programs help to formalize and regularize loan modifications, is not a “magic wand” that resolves the issue of debt overload.

Using data from the Obama administration’s Home Affordable Modification Program, Fitch reports that “the redefault rate within a year”, of the loans that are modified, “is likely to be 65% to 75%”. This information comes from the Wall Street Journal article, “High Default Rate Seen for Modified Mortgages,” “Almost all of those who got loan modifications have already defaulted once.”

The failure rate is likely to be high because “most of these borrowers were mired in credit-card debt, car loans and other obligations.” That is, when a person or family (or business) goes into debt they go into debt “across the board” and do not just limit themselves to one kind of debt or one type of lender.

And, the Treasury Department says, that those given loan modifications under this program have a “median ratio of total debt payments to pretax income” that is around 64%. “That often means little money is left over for food, clothing or such emergency expenses as medical care and car repairs.”

The good news is that the results of the program indicate that around one-third of the loan modifications make it through the first year. This is looked on as “good” by the Treasury Department and by a Fitch representative.

This is the reality of debt creation during a period that can be referred to as a period of credit inflation. At times like these, more and more people, families, businesses, and governments take on more and more debt until it gets to the point that the debt loads become unsustainable in some sectors of the economy.

Thus, to the first point, people and families take on mortgages, as well as “credit-card debt, car loans and other obligations” until, the second point, their “ratio of total debt payments to pretax income” becomes too large. Then, any increase in total debt payments, like a re-setting of the interest rate on a mortgage, or a reduction in pretax income, due to being laid off a job, puts the borrower into a situation in which debt payments cannot be made. Defaults occur, and a foreclosure…followed by a bankruptcy…may follow.

The “macro” government response is to provide fiscal and monetary stimulus to make sure people stay employed and to inflate incomes so that debt loads (debt payments relative to pretax income) decline. This is the Keynesian prescription!

The problem with this solution is that in a period of credit inflation, as incomes and prices continue to increase, debt loads continue to increase. If the government buys people out of their debt burdens by fiscal stimulus and monetary inflation, people (and families and businesses) don’t adjust their behavior to become more financially prudent. They just keep on, keeping on. This is another case of moral hazard.

Even worse, given the belief that government will continue to “bail out” those who have taken on too much debt, we find that those that have taken on too much debt generally go even further into debt. Take a look at what has happened over the last fifty years of credit inflation and this type of behavior is observed everywhere.

The Keynesian prescription of fiscal and monetary stimulus to keep unemployment low and debt burdens manageable only exacerbates the problem over time. That is, governmental efforts to sustain prosperity over time just postpone the consequences of dealing with the debt loads that are built up during these time periods.

Keynesian economic models, with the exception of the maverick Keynesians like Hy Minsky, don’t include the credit or debt aspects of economic activity. As a consequence, they ignore how people (and families and businesses) manage their balance sheets over time. In essence, these models ignore the very real fact that ultimately, debt must be repaid and cannot just increase without limit!

Over the past fifty years we have seen people and families and businesses and banks and governments take on more and more debt. Inflation has risen at an average compound rate of about 4% from 1961 through 2008 so that it has paid people to increase financial leverage, take on more risky assets, and finance long term assets with short term debt. And the federal government has underwritten this inflation by increasing its gross debt by around 7.7% per year for this period of time and the Federal Reserve has caused the base money in the economy to rise by 6.2% per year. The M2 money stock measure rose at a compound rate of 7.0% per year. All roughly in line with one another.

The Fitch report is presenting us with a picture of what happens when debt loads get “out-of-hand”…when there is just too much debt around.

The current response of the Federal government? Official federal government forecasts of the cumulative fiscal deficits for the next ten years runs around $9 to $10 trillion. Some of us believe that the deficits will run more in the neighborhood of $15 trillion. In terms of monetary policy, the Federal Reserve has placed $1.1 trillion in excess reserves in the commercial banking system. The leadership of the Federal Reserve expects us to believe that they will be able to reduce the amount of these excess reserves to more normal levels without the reserves being turned into loans that will expand the money stock measures by excessive amounts. (Just a reminder: excess reserves totaled less than $2 billion…note, billion and not trillion…in August 2008 before the big injection of reserves into the banking system took place.)

For one more time, the federal government is betting that by stimulating the economy and putting people back to work in the “legacy jobs” they were laid off from and by re-inflating prices and incomes that debt burdens will be reduced and we can get back to “spending as usual”. If the federal government is successful, the day in which debt loads are reduced will be postponed…once again!

However, the credit inflation causes other things to change. Over the last fifty years we have seen that in every employment cycle, fewer and fewer people are re-hired in the “legacy jobs” from which they were released. Under-employment, not just un-employment, rises and this puts more and more pressure on incomes. The ratio of debt payments to pretax incomes rise for these people. Right now, I estimate that roughly one out of every four or five potential works is under-employed, the highest level since the early 1950s.

Second, the steady inflation of the past fifty years has resulted in a larger proportion of the capital stock being un-productive. As a consequence, capacity utilization in industry has fallen to post-World War II lows. As we have seen in each business cycle during this last fifty years, less and less of this capacity is used in each recovery. This results in a drag on employment and income.

Eventually, debt must be repaid and debt loads must be reduced. The Fitch report highlights this problem. It is something that all of us should keep in mind in the upcoming months. If the situation with respect to under-employment and capacity utilization don’t change the debt loads will get even heavier.

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