[THS] !!!! The Market Ticker: 2009 Labor Day Ponderings....
vignes at wanadoo.fr
Mon Sep 7 14:26:50 CEST 2009
[An excellent analysis of the economic crisis, technical but penetrating - see url above for two graphs, if necessary]
The Market Ticker
Commentary On The Capital Markets
Sunday, September 6. 2009
Posted by Karl Denninger in Macro Economics at 14:12
2009 Labor Day Ponderings....
After a bit of prodding I decided to go back and expand a bit on the "Weekend Chart
To Ponder" posting.
Be warned: this is a far more esoteric undertaking than the previous, and may make
your eyes glaze over. Nonetheless I believe it is important, as it sets forth some
"boundary conditions" that, when analyzed against current economic trends and
behavior, are likely to lead you to inescapable (and perhaps ugly) conclusions.
Expanding this chart was particularly difficult to do because The Fed doesn't make it
easy to find the data I was looking for - specifically, total outstanding borrowings on
mortgages. Their "Flow of Funds" report shows changes, but that's not sufficient - I
need total numbers outstanding. Fortunately The Census Bureau keeps track of that
data - albeit with a bit of a lag (they don't have 2008 yet.)
Just to reiterate for those who didn't catch this up front - these numbers are
expressed as percentage changes and are all per-capita.
The latter is important and often ignored - a rising population of course can support
a larger (total) amount of credit outstanding, but at the same time it mutes GDP
growth. That is, if you have 100 million people in the nation and double it (to 200
million) GDP doubling doesn't actually improve anyone's lot in life - the per-capita
GDP is the same. Ditto for total incomes, and total debt - rising debt is bad, but only
if it is rising per-capita.
Many people have asked why I didn't include inflation in these numbers. There are a
number of reasons, the most-important of which is that it doesn't matter when one is
comparing against incomes. There is also the problem of defining inflation - exactly
what do you include and what do you not? Government statistics are notoriously
inaccurate - for instance, they did not define the rise in house prices from 2003-2007
as "inflation", since they use a thing called "owner's equivalent rent" in the
computations - a farcical measure for the majority of Americans, since the majority
own their homes. Then there are what are called "hedonic" adjustments; the
simplest explanation of "hedonics" is that when steak becomes too expensive the
government substitutes hamburger, since both are meat and contain protein (yeah,
We can fight over "inflation" numbers all day and all we'll generate is heat, not
enlightenment. The easiest way to avoid doing that is to compare against what
matters when it comes to debt - that is, income.
Because the servicing of debt requires income. The greater the outstanding debt
(per-capita) in regards to income, the closer "the wall" gets to the consumer.
So with that, here's the chart (click on it for a bigger copy):
Now let's agree on a few things, shall we?
First, there is a "critical level" beyond which all debts will default - without exception.
That point is where the carrying cost exceeds income. For example, if you have a
$100,000 mortgage and $9,999 (or less) in income, if the interest rate is 10% every
such mortgage will default since you can't pay $10,000 with $9,999.
A direct comparison of this sort is, however, a ridiculously optimistic scenario.
"Money income", as defined by the Census Bureau, includes all money earnings
before taxes (Census definition) and excludes non-cash benefits (that couldn't be
used to pay debts) such as food stamps and housing subsidies. It also excludes
capital gains and losses (we can argue over whether it should, but it does.)
Note, however, that taxes are not included, and for essentially all employed persons
there is an explicit tax hit (even if you have zero federal income tax) for Social
Security and Medicare, never mind state taxes, property taxes and other forms of
tax, all of which reduce income available to service debt.
Second, before you can service debt you must have the basic necessities of life.
Chief among these are of course food and shelter, the latter often being a big source
of that debt too (mortgage debt in particular.) Therefore, we must subtract out of
your income the cost (per-capita) of the basic necessities of life. We'll define this as
the Federal Poverty Threshold; since the average household is 2.59 people (per the
US Census again) this places the per-capita requirement for basic necessities of life at
($14,540 / 2.59) (arithmetic average of the 2 and 3 person poverty level divided by
actual average household size) or $5,614 as of 2007. This must be subtracted from
the per-capita income of $26,804 (for 2007) knocking the actual income available to
service debt (in the best case) back to 1998 levels, when it first crested $20,000, or
500% of baseline.
Third, all forms of debt are additive. That is, you can't compute the percent interest
necessary to force 100% default rates just for mortgages unless mortgages are the
only form of debt out there, and clearly they're not. When you try to "blend" the
numbers you again run into the need to make assumptions that make it impossible to
set an accurate "must default" level.
Finally, we must add in the costs associated with the income and debt you are trying
to service. This is often ignored and yet it can't be - the cost, for example, of a
vehicle (including insurance, gasoline, repairs, etc) to get to work, if you live where
mass transit is unavailable between your home and office, is an unavoidable expense
that must come out of income before anything is available for debt service. The
impact that this has on an individual varies greatly.
Does this particularly enlighten us on the promise (or peril) going forward for
Not really, but it does give us a framework to start thinking about whether what
we've been doing to "address" the recession since 2007 can possibly work.
Now let's think for a moment about the actual "default function"; that is, how
outstanding debt compared to income actually results in defaults (or not) in a real
system. I would argue that it is most like the rational function f(x) = 1/x where x is a
positive number representing the "displacement" from "zero hour", or the maximum
debt possible to be sustained, and y is the default percentage with infinity
representing 100%. The "zero point" is where debt service (if all debt) is impossible
with current income (that is, interest due exceeds current after-tax and after-
(If you're wondering what a graph of this function looks like, here's an example)
That is, once we get a reasonable distance away from that "zero point" the change in
default rate for a given displacement is rather small. This behavior is what leads to
booms during loose lending periods - reasonably large changes in income and debt
levels do not immediately lead to large changes in default rates - so long as we're a
"safe" distance away from the "zero point."
But this behavior is deceiving, because the change in default behavior is in fact
parabolic, not linear, as one approaches the "zero point." As debt continues to build
in the system the ratio gets closer to the zero point for (x), and as that occurs the
default rate starts to rise - first slowly, then much more rapidly for a given excursion
toward zero. What's worse is that the act of default forces the equation the wrong
way, since defaults tend to cause bankruptcies of both borrowers and lenders, and
thus business failures - and the latter results in unemployment (thus driving per-
capita income down.)
So, you say, this is all a nice bunch of arm-waving, but what does it mean? (Are
your eyes glazing over yet?)
On that point we can reach some conclusions. We know, for instance, that unlike all
previous recessions since the 1930s this one began with consumer defaults on
subprime loans. That is, we began to approach the zero point through the dramatic
increase in debt outstanding and the most-marginal borrowers were unable to make
This in turn caused the cessation of origination of these loans and the construction of
homes that were enabled by them, which forced people out of work both in those
lending and building enterprises (thus forcing per-capita income downward.)
That in turn drove us even closer to the zero point, and the damage began to move
up the scale. Higher-quality borrowers began to default - first on ALT-A loans and
then prime loans, and the defaults spread into other areas of finance including credit
cards and commercial real estate.
The Fed and Government, in response to this trend, flooded the system with liquidity
in an attempt to drive down borrowing costs (that is, to get the interest component
down so "the wall" was further away.)
Did it work?
No - because the banks, rather than being forced to admit their losses and come
clean, were instead permitted to hide them. They took this "cheap money" for
themselves and instead of lowering interest costs for consumers, moving the default
function in the desired direction, raised them on consumer debt, forcing the default
function the wrong way!
The government in turn stepped up its borrowing and replacement of actual income
with subsidy, since the interest rate for government borrowing did indeed go down.
This prevented an all-on implosion at that instant in time.
But did it fix the problem?
Because the debt is still out there and the ability of the government to continually
borrow more money forever to use in these subsidies for the purpose of halting the
shift to the left in the debt/income default function does not exist.
Oh sure, government can do this for a while - and it has. But not forever, and yet
"forever" is what is required, until and unless those debt levels go down or income
levels go up to get us back into the "safe" zone of the default function.
Yet the government's actions in fact move the curve the wrong way over time! That
is because government borrowing is in fact debt that ultimately must be paid for out
of individual income. While it is "cheap" borrowing it has not (and doesn't) replace
the high-cost debt that is causing the problem - it is simply a means of attempting to
subsidize the current payment required to keep the default from happening "right
now" (as in this month.)
We are doing the wrong thing because government and The Fed have misdiagnosed
(either intentionally or not) the cause of the recession and thus whether their tonic
can be effective.
During an ordinary inventory-led recession where excessive credit is not the
triggering cause (rather, it is over-capacity in the economy) the tonic applied is
useful, because stimulating demand causes the slack to come out. It also causes
debt:income ratios to expand, but remember the default function - so long as you
are a good distance away from the "zero point" this has little cost in terms of
increasing the actual number of defaults. It does, in each and every case, shave the
safety margin. We've gone through multiple recessions (all the way back to the
1970s) where we had lots of safety margin, and as a consequence this "tonic"
seemed the right medicine for the job.
The problem is that we never forced the contraction of borrowing and thus never,
over more than 30 years time, caused the safety margin to be rebuilt!
When you are in a recession that is occasioned by getting "too close to the sun" -
that is, too close to the zero point - such policies are a disaster, because there is no
safety margin left - you have in fact entered the parabolic zone of defaults, where
anything that ramps the debt/income ratio at best masks the problem for a period of
time and at worst can drive you into the maw of what amounts to a singularity - the
implosion of your economic and monetary system.
I believe the evidence is clear and in fact irrefutable - we are in this mess because
we reached the parabolic portion of the default function - in fact, we just touched
the edge of it.
As such what the government and The Fed have done is exactly backwards and is
only going to make the inevitable pain that must be taken worse.
In 1933 Roosevelt devalued the dollar to get out of this death spiral. He was able to
do so because the dollar was linked to gold, and thus he could simply sign a
document and change the exchange rate, at the same time banning private
ownership of the metal (and thus preventing the market from immediately
counteracting his devaluation and rending it meaningless.) Today all currencies are
fiat and this option is not available - should it be attempted via massive money
printing (doing so would require The Fed to literally print the entire asset base
underlying the credit system in the US - somewhere on the order of $20+ trillion
dollars!) the outcome would be an instantaneous ramp in energy costs (and all other
imports) by more than 1,000% and the immediate collapse of both our economy and
all banks, including The Fed itself, since wages would not and cannot increase by
that same 1,000% in a global economy.
We must force the outstanding credit levels down to sustainable levels. This will
cause a huge number of bankruptcies, especially among the financial "heavy hitting
firms" on Wall Street and the pension and insurance funds of Americans as the true
"value" of their so-called assets are exposed.
The problem is that there is no alternative - we squandered the ability to rebuild our
safety margins over the previous 30 years, and now we're into the maw of the
parabola with no remaining margin available to exploit. The longer we wait to do the
right thing the worse the outcome will be, and if we wait too long we will lose our
nation - literally.
History has shown that the 2000-01 recession "avoidance tactic" of more than
doubling outstanding consumer credit in mortgages and increasing it by 60% in
other debt while income only rose 23% during the same period bought us seven
years of delay and a collapse far worse when we hit the wall - unemployment only
reached 6.3% during the 00-01 recession (in 2003) while we are now at 9.7%
(officially) and climbing. Consumer spending and defaults were a non-factor in 00-01
- today they are the feature of our recession.
Today we simply have no more "forward debt capacity" in our economy.
This is not conjecture or belief - it is hard fact and has been proved by the structure
of the current recession.
Attempting to use even more lending - that is, credit - to "pull us out" of this
recession is not only doomed to fail it will drive the default equation closer to zero.
We must stop this madness and the accumulation of damage that must be taken in
our economy before we find ourselves in a monetary and fiscal gravity well from
which we are unable to escape.
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