The Nature of the Beast: A Look at the Ongoing Debt Crisis
Much of the rage these days has been about “how to get businesses to spend.” Watching CNBC, one would easily conclude that we are in the midst of a supply side slump, in which businesses curtailed production due to uncertainty in policies from Washington.
With the US Chamber of Commerce unleashing a wave of negativity on the present policy landscape, I think it’s important to take a step back and look at what is fundamentally taking shape in our economy. Economics has become so politicized to the point that discourse has become detached from the source of the problem. Let’s analyze where we are and where we came from in an apolitical manner, focusing solely on the simplified economic elements.
What is the problem?
In a nutshell, the problem is debt. We are in the middle of a rolling credit crisis. It all started with the private sector accumulating far too much debt–the leverage ratios in the financial and residential sectors reached unprecedented heights–and has now transitioned into one in which the US government has accrued a substantial fiscal debt. The following chart, borrowed from Steve Keen’s Are We “It” Yet paper (definitely worth the read for those who enjoy more advanced economics), offers a great illustration of exactly what has transpired. As you can clearly see, when the lines representing finance and business turn downward, the government’s line accelerates upwards.
Once the first shock (sub-prime trouble started in 2006 and heightened throughout 2007) hit debt markets, the shock sent ripples throughout US debt markets. When Lehman Brothers collapsed in September 2008 and AIG required a bailout just to meet its collateral requirements, debt markets completely froze and finance essentially came to a halt.
In the meantime, as the financial sector of the economy collapsed, and the unemployment rate rose, the cycle of defaults and increasing unemployment continued to accelerate in pace. Demand in the economy took a shift to the left.
In the short-run, the aggregate supply is a vertical line, as production capacity itself is static. One can clearly see that when demand shifts left, both price and total production also take a corresponding shift to the left. This is rather different than your typical post-Great Depression recession. In fact, it is the first time since the Great Depression that we have seen such a shift.
What this means for monetary and fiscal policy?
When aggregate demand takes a leftward shift the remedy called for is different than what has worked in other recent recessions. In the past, cutting interest rates would induce firms to increase production, as a supply-side recession led to a shortage in production. We saw this play out as the Fed rather quickly moved interest rates to the zero bound, and sure enough there was no uptick in economic activity. Fiscal policy, on the other hand, could be implemented to fill some of that “demand gap” that results from a shift in aggregate demand, and this is exactly why our government pursued a stimulus plan.
The common thread through all of this is that the problem started as one of too much debt in the private sector. As a result, demand for dollars increased–demand for dollars is equivalent to saying that firms and households cut consumption in order to save and/or pay down debt. Debt was (and is still) getting capitalized far faster than the money supply was increasing. Essentially, we are in the midst of a massive debt to equity conversion in the private sector. In order to soften the landing, the government lent a helping hand and took on more debt itself so that the private sector could afford to capitalize. And perhaps most importantly, Helicopter Ben Bernanke unleashed a massive wave of quantitative easing and drastically increased our money supply in order to accommodate the increasing demand for dollars.
Where are we now?
Well now, the government’s deficit has expanded rather quickly. This is not a bad thing. Meanwhile, private sector balance sheets have continued to improve, to the point where people are now complaining that companies have too much cash. This too is not a bad thing. The next step is to get us into a position for demand to start increasing in the private sector. Clearly there is demand for investment (as opposed to consumption goods), as is evidenced by the fact that even since the Federal Reserve stopped purchasing mortgage backed securities, interest rates on 30 year mortgages continue to plunge to new record lows: demand outweighs supply in that market.
Why is that? Well what bank wouldn’t want to lend when they could borrow from the Fed at next to no interest and lend that money out at about 4.5%. That’s a healthy profit margin right there! The problem is that demand for mortgages is incredibly low, as over levered households are in no position to take on more debt in buying new real estate (hat tip to Hedgeye for the chart):
Is investment light right now? Sure it is, But, while we’re not seeing investment in increased production capacity, we are seeing investment in increased productivity. Companies are spending large quantities of money investing in the new technology infrastructure. Intel’s (NASDAQ: INTC) earnings highlight this trend on the supply side, as does Federal Express’s (NYSE: FDX) on the demand side. Intel beat on account of increased demand from the cloud computing trend, while Federal Express invested in improving the company’s efficiency infrastructure.
We need to add a little more context to what is going on. Business cycles are just that–cycles. There are peaks and there are troughs, but all in all, changes take time. Subprime “popped” in 2006, totally crashed in 2008 and bottomed in 2009. That was a good three years of negativity there. We are just through year one of the recovery in equity markets. Anyone who expects the economy back at full capacity at this point has some sort of agenda. It’s just impossible and unrealistic. The key is to remain cognizant of where we came from and where we are, and to continue implementing effective policies to mitigate the deflationary pressures coming from households and financials and to encourage investment in innovative ideas.
In April we were all clear and May-June the world was ending. There are inherent emotions that contribute to the fluctuations of market prices. As investors and traders, it’s important to look at this through an unemotional lens. The market will do its thing (check out Ben Graham’s Mr. Market to get an idea), and the economy will do its own thing. Now is one of those times to take a step back and put things into perspective.
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