Monday, June 20, 2011

Read My Lips! Too Much Debt!

People and businesses leverage when an economy expands over an extended period of time.  The last major period of leveraging in the United States occurred over the past fifty years beginning in the early 1960s.  This was a period of sustained credit inflation that resulted in an 85% decline in the purchasing power of the dollar. 

People and businesses de-leverage when the economy reaches an unsustainable level of debt and that de-leveraging can take a substantial period of time. 

Research by Carmen Reinhart of the Peterson Institute and her husband Vincent Reinhart of the American Enterprise Institute has suggested that “excessive debt could be corrected only by a long period of deleveraging.” (See the article “Running Out of Road” in the June 18, 2011 copy of The Economist, pages 77-78.)

De-leveraging also means, in aggregate, that increases in lending (debt creation) will not become too buoyant during the restructuring of balance sheets. 

Consequently, de-leveraging will tend to reduce the multiplier effect of any fiscal stimulus program and the creation of more debt through fiscal stimulus will only add an additional burden on the economy that is trying to get its balance sheet back under control.

The desperate hope to counter this de-leveraging is to flood the financial markets with liquidity and pray that the printing of money will somehow stop the de-leveraging and make debt acceptable once again. Hence, QE2!

A caveat here: there are a number of large companies that came out of the Great Recession with their balance sheets well in hand.  For example, Microsoft was one of these companies.  Many of these companies have issued debt over the past year or so to build up cash reserves to acquire other companies that have been overleveraged and are not in such good financial shape. This generally represents a separation in the market between large organizations and all others.

Thus, the only way this de-leveraging will be overcome is by reducing the real value of the debt through a period of credit inflation like the one experienced over the past fifty years.  Otherwise, the debt levels are not sustainable.  Efforts to bail out the people, businesses, and governments that have issued too much debt will only postpone the problem.  The debt levels will have to be reduced sometime…now or in the future. 

The debt loads that people, businesses, and governments are carrying seem to be un-sustainable, even with the very, very loose monetary policy.  For example, household liabilities have declined by a little more than $600 billion since the recession began in December 2007, but the total amount of household debt still totals a little more than appeared on the household balance sheets in the second quarter of 2007. 

Household debt at the start of 2011 is almost double the amount of household debt that existed at the start of the year 2000.  This represents a compound rate of increase of more than 8 percent per year.  One could argue that this rate of increase is not sustainable given that over the long haul the real economy grows only slightly more than 3 percent per year.

Total business debt shows roughly the same pattern.  This debt has declined by a little more than $160 billion from the start of the recession to the first quarter of 2011.  However, the current total is around the same level it was in the third quarter of 2008 indicating that in total, businesses have not accomplished a great deal of de-leveraging to this point. 

And, the debt problem is also entangled with the ability of people and businesses to unravel their situations through foreclosure and bankruptcy proceedings.  Foreclosures take time.  If people or businesses are in foreclosure but these foreclosure proceedings take longer and longer to work out, the economic units involved in the proceedings will be more or less relegated to the sidelines in terms of any additional borrowing or spending. 

An instructive article appeared on the front page of the New York Times yesterday. (“Backlog of Cases Gives a Reprieve on Foreclosures,” “In New York State, it would take lenders 62 years at their current pace, the longest time frame in the nation, to repossess the 213,000 houses now in severe default or foreclosure, according to calculations by LPS Applied Analytics, a prominent real estate data firm.
Clearing the pipeline in New Jersey, which like New York handles foreclosures through the courts, would take 49 years. In Florida, Massachusetts and Illinois, it would take a decade.“
And, this problem is not easing.  In May 2011, total foreclosures in the United States totaled 1,736,724.  Six months earlier the total was 1,682,499.  And the number of sales has declined reflecting the back up in the whole foreclosure process. 
Personal bankruptcies are down but are still running near record rates of 1,450,000 to 1,500,000 per year.  In 2010 there were only 56,425 business bankruptcies, down from 60,851 in 2009.  For the first three months of 2011, business bankruptcies are running around a 50,000 annual rate, far above the figures for the rest of the 2000s.
And, this doesn’t even get into the problems connected with the debt of state and local governments. 
Debt loads must be reduced sometime…in one way or another.  People, businesses, and governments are still carrying too much debt.  And, more and more federal government debt does not really help the situation.  A good portion of the debt must be repaid.
This is the drag on the economy.  And, until a lot of this load is worked off…in one way or another…economic growth will remain weak. 
Why hasn’t this gotten the notice it should in all the discussions going on? 
Because almost all of the economic models used to predict economic activity do not contain information on debt levels and leverage.  The reason is that debt levels and leverage levels are quite subjective over time and depend upon what governments are doing and what people believe to be acceptable.  These decisions vary from cycle to cycle and are extremely hard to model.  Furthermore, as the Reinhart’s have argued, there has not been a sufficient amount of data available to adequately study the influence of debt on economic activity.
My conclusion from this information is that the major problem facing the western countries now is that there is too much debt outstanding.
And, when I look at how the system is working off this debt I can only conclude that there is still a long way to go before people, businesses, and government get to levels of debt that are sustainable.  Even QE2 does not seem to be shaking these economic units from their desire to rebalance their balance sheets.  There is just too much debt still in the system and it doesn’t need more.

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