Posted on: Thursday, July 8, 2010
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Debt is Still the Major Problem and Deflation is the Painful Solution
Velocity Is the Key
Selected Debt/GDP 
H/H Credit Market Debt 
The Cycle of Deflation 
Public and Private Debt 
Consumer Confidence 
New Home Sales 
Money Supply 
Money Supply & Monetary Base 
Total Credit Market Debt/GDP 

We understand that we have discussed the debt problem in this country for what seems to be forever, but we can't stop talking about it now that the debt is clearly the catalyst for the latest stock market downturn.  Debt is discussed by the pundits on financial TV also, but in almost every case the discussion revolves around government deficits relative to GDP or government debt relative to GDP.  They are constantly comparing the U.S. government debt to every other country in the world (especially Portugal, Italy, Ireland, Greece, and Spain-PIIGS).  We believe that the government debt should be taking a back seat to the private debt which is much larger and must eventually be deleveraged. 

The private debt is about 6 times larger than our government's public debt; about 4 times larger than our government's gross debt (including the government debt used to fund our Social Security shortfall);  and about 2.5 times the gross government debt plus the total state and local debt.  Household debt alone is equal to 96% of GDP; private domestic nonfinancial debt is 183% of GDP; total credit market debt is 357% of GDP (see first chart Selected Debt Measures as a % of GDP).  Please note that the only form of debt that isn't rolling over is the government debt.

We have been predicting for over 3 years that the government debt (including public, gross, and state and local governments) will increase substantially, while the private debt (all forms) will roll over and decline substantially.   In round numbers total credit market debt is $55 trillion and government debt is $15 trillion, leaving private debt at approximately $40 trillion.  We have drawn debt cones (see 2nd chart-debt cones) to illustrate the concept.  We believe the government debt will rise towards the $30 trillion level while the private debt will drop towards the $20 trillion level.  This coincides with the Cycle of Deflation (next chart) which we authored years ago.

This debt scenario is bad enough, but when you take into consideration the unfunded liabilities that we are saddled with in the future-- with social security, medicare and medicaid, you can add another $80 trillion onto the $50+ trillion of total credit market debt today.  By the time the baby boomers retire, the 40 million residents presently over the age 65 will rise to 72 million.  We are talking about a large number of relatively unhealthy people who will live well into their 80s.    These are facts that are being disseminated to the masses now and if that doesn't scare the younger population that will have to pick up this burden I don't know what will.  

Most bears on the stock market are fearful that the Administration and Fed are printing far too much money and this will result in potential runaway inflation. We, on the other hand, do not think the results of the Fed's balance sheet increasing through quantitative easing (QE) will result in inflation in the next few years, although it could very well be a serious problem further down the road.  We believe the private sector debt will continue to decline (deleverage) regardless of what the Fed and Administration do to attempt to jolt the economy. 

The reason that the attempt at money printing to juice the economy will not work, in our opinion, is that the whole private sector is frozen due to the fear of losing more money.  Corporations are continuing to build up cash positions and individuals are afraid of taking risk in this environment.  The latest economic releases verify our opinion that the private sector is losing confidence.  Corporations are afraid to take on more employees---we gained only 33,000 jobs in the private sector in May and just last week reported a disappointing gain of 83,000 jobs in the private sector. It would take average monthly increases of over 130,000 jobs just to keep up with the average gain in the labor force. Last week the Conference Board reported that the Consumer Confidence index for June declined to 52.9 from 62.7 in May.  New single family home sales collapsed 32.7% from April to a record low rate of 300,000 (see the next two attached charts).  There are estimates of about 10 months of shadow inventory of foreclosed homes currently off the market and not included in the national inventory.  The national inventory of homes available rose to 8.5 months supply in May.  Today it was announced that demand for mortgages to buy homes dropped 2%.  It was the 8th weekly drop in the 9 weeks since the credit for home buyers expired on April 30th.  We just recently wrote a comment dealing with the potential for a second dip in housing prices on June 10th titled "The Dire Outlook for Housing".  

The Fed believed that Quantitative Easing (QE) would stimulate the economy much more than it did.  QE includes all of the measures the central bank takes to increase the monetary base, hoping that this translates into increased money supply.  However, in the current credit crisis QE is not working as well as the Fed and Administration expected.  While it has succeeded in jump-starting the monetary base it has failed to increase the money supply or velocity (the ratio of economic transactions to the money supply).  Thus, while the banks now have the ability to make new loans, not enough qualified borrowers are interested in borrowing money, and banks are not willing to loan money to anyone that is not a credit worthy borrower. What we need to stimulate the economy is "velocity" which measures the rate at which money in circulation is used for purchasing goods and services.  The velocity of money is computed by dividing the nation's output of goods and services by the total money supply (circulating currency plus checking account deposits).  Velocity of money is also influenced by interest rates.  When rates are low, people hold more money in cash, when rates are rising, they put more money in interest paying investments. 

When velocity is low the nation essentially winds up in a "liquidity trap" which is a situation where monetary policy is unable to stimulate the economy either through lowering interest rates or increasing the money supply.  This was the condition that Japan found itself enveloped in from 1989 to present.  We expect the same problem in this country and hope (really hope) to be wrong.  If we are lucky we will be able to go through the slowdown we expect (or double dip) and repair the household balance sheets enough to grow out of this mess in less time than it is taking Japan.   


Recent Articles:
7/8/10   Debt is Still the Major Problem and Deflation is the Painful Solution
2/25/10   The Cycle of Deflation
1/25/10   The Total Debt Relative to GDP Trumps Everything Else
11/12/09   Debt Dynamics Will Hold Back Economy
9/30/09   “FUMBLE--ITIS”
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