Debt Bubble

In general Americans are poorer today than they were at the turn of the century in 2000.

Since that time average household income is up about 14% but big ticket items like housing, college, health care, cars ate up much more.

In order to keep up we borrow and debt is at an all time high.  This is actually what one would expect as the population increases, but per capita debt has also risen significantly.

So a modest increase in income offset by significant increase in debt does not equate to a great economy.

It equates to a economy that is at risk.

The increase in debt is possible because we have seen interest rates kept artificially low.

Similar to previous periods when the economic elements get our of kilter, there is usually a dramatic adjustment.

That adjustment is needed to bring debt and incomes into balance.  It could be inflation, deep recession or something unpredictable, but these type of out of balance situations are not sustainable over the long term.

We have a debt bubble and it will pop.

Just when is the question?

Statistics and Reality

People like o look at statistics and believe they reflect what is actually happening and they do in a certain way.  However take a simple statistic I saw the other day saying a certain company was having its best year since 1990.  Well it was about the stock price and that company's stock had virtually collapsed in the last year.  It recovered from the lows and had therefore a big percentage increase.  Of course the company was doing much better years ago and the percentage increase did not make up for the fact that the stock was around 20% of its one time high.

The same is true with the statistics about the economy.  Unemployment is low, true, but workforce participation is low.  Wages are increasing, true, but from lower bases.  Wages are for most working people no where near where they once were.

Things not accurately measured in statistics, at least not the economic ones are the other risky changes to most Americans.  Pensions have been eliminated at many companies and while they offer self investment plans, many don't participate because it means a lower paycheck.  Issues with social security add a degree of uncertainty to many people.

Health insurance is also a high risk for many even if they have coverage now.  Its in danger or the contributions required keep increasing.  Sure the stock market is up but working class Americans are generally not big shareholders, except maybe in a company 401K if they participate.

Housing is up, but not at the level is once was and many young people have onerous student debt to contend with.  The reality is see is that most people struggle to make ends meet and dig themselves deeper into debt to afford some nice things.  Some are doing much better than that.

Is the economy as good as the statistics say?  Well the statistics are correct, but the reality is just different.  An increase of a few percent in average wages is not changing anybody's life.  A secure future and secure health care would.

Price pressure

One of the things that seems to have changed is the sensitivity of the consumer for goods and services to changes in price. While obviously, price was always a factor in making decisions about whether to buy something or not, when demand was higher, it wasn't the main factor since many consumers felt the desired product or service might get more expensive or become unavailable if they didn't make a quick decision.

As demand fell off a cliff last year and prices plummeted, consumer's have taken a different attitude, feeling that the product or service will be available and that there is stronger likelihood that it will be cheaper if they wait. This change in sentiment is clearly going to put pressure on businesses and you see things like Coach coming out with a more affordable line of product to cater to the new consumer.

This attitude is also impacting the length of time products remain in use. Where many people felt that they needed to get a new car every few years, many are now postponing that decision and driving slightly older cars. This had led to a shortage in the used car markets. Now, I sometimes see this change characterized as a switch to cheaper products, such as store brands. However, while some of that has happened, it is more accurate that consumers want the products they have been used to buying at a lower price point.

Brands that in the past tried to maintain certain price levels are being put under a lot of pressure to provide consumers with deal. Of course, we have seen how business has been able to restore profitability by cutting costs. I believe it will be quite a while before prices will go back to what they were, since consumers have learned they can demand better value for their dollar.

This is flowing down the supply chain. I hear analysts talking about the risk of inflation as the dollar declines and things like foreign oil go up in price. However, companies that try to pass increased costs through to the consumer are going to have a hard time of it. I believe they will be spurred to find cheaper alternatives or ways to reduce costs in other areas to maintain low prices.

With all the extra capacity we have, inflation is a very unlikely event for at least two years, if not longer. In fact, deflation is still a more likely scenario.

Money Supply

In a simplistic view, the amount of the deficit is seen as increasing the amount of money in the system and therefore leading to inflation. This view is only true if the money theoretically created gets into circulation and is greater than the amount of money that leaves the system.

Money is created in part by banks making loans. Based on the reserve requirements, banks can lend more money than they have in deposits. The idea behind this is that they have enough in reserve to meet demand while increasing liquidity in the system.

What should not be forgotten is that a lot of money has left the system, based on increases in reserve requirements, the failure of both banks and private (shadow banks) lending organizations and the tighter credit requirements. Further, the value of one's assets represent money available to the system to the extent that the asset valuations exceed current debt. To have an increase in the money supply we would need more money created than has disappeared.

Considering how greatly asset valuations, particularly in home values, has fallen this represents a tremendous decrease in the money supply. As foreclosures have increased, the reserves to cover these foreclosures must be replaced or the total lending has to be decreased to maintain reserve requirements.

In 2008, about 11 trillion dollars of wealth was lost in the United States. This means an amount between 3-4 trillion dollars and 11 trillion dollars left the money supply depending on reserve requirements. The total deficit in no way is able to replace that amount of lost money.

There is less money in circulation than there was two years ago.

Inflation?

Now that most earnings have been reported and the better than expected earnings have caused some optimism, we will most likely spending the rest of August drifting lower in the Market.

There is a good reason for this. There are still significant issues that need to be monitored and as various groups and analysts point them out they will tend to keep money on the sidelines and induce profit taking.

We still have high unemployment and many foreclosed houses as well as underutilization of our economic capacity.

The adjustment to a smaller economy is still ongoing. During the recession the economy has contracted by about 15%. Under even the most rosy scenario, the growth rate will take years to regain that amount. In fact in the non-Government sector the contraction has been even greater.

This slack in the economy will continue to force lower prices as companies compete by being more efficient and productive and trying to grab market share. The first area of growth for most companies may very well be in exports.

One area that shouldn't be a concern for this economy is inflation. It will take many years before the demand will push prices up. Now, the value of the dollar may decline in respect to other currencies and imports may get more expensive, however, it will be very hard for these price increases to be passed on to consumers, forcing companies to continue to improve efficiency.

Bottom line is that supply and demand are the fundamental rule for pricing and we have much more supply than demand and will have it for quite some time.

Inflation - Deflation?

There are still many who predict the United States and its citizens are doomed to undergo a major depression because of the tremendous debt and the Government intervention in the free market system. Dire predictions like these have been made many times before but in times of severe economic contraction they get a lot more attention.


There are competing doom scenarios, one that predicts severe inflation and one that predicts severe deflation. Now both end up with quite dire forecasts and it sort of reminds me of a Robert Frost poem Fire and Ice.

We have been experiencing deflation recently, although it is not fully represented in the CPI. The June CPI shows an overall decrease of -1.4 year over year. A lot of this reduction is due to the change in oil prices and it would have been much worse if the Medical and Services areas didn't continue to have price increases. The oil prices from last year are clearly a short term phenomena and do distort the index. However, I think most of us feel that whatever the official statistics show, the actual cost paid for many things is significantly less than it was one or two years ago. Consumer spending is down significantly and with less demand, the price curve goes down.

Now in order to combat weak demand and potential deflation, the Fed has lowered interest rates and the Government has increased deficit spending. This takes us to the inflation scenario, one in which proponents of monetary theory believe the increase in money supply can take us no where else.

It does seem that considering supply and demand, an increase in the money supply without a corresponding increase in demand will lead to a lower price for the dollar and therefore inflation. Of course this assumes the real money supply has increased, which may be debatable considering the higher reserves held at banks and loss of wealth (i.e. money) due to the drop in housing and equities.

So would either deflation or inflation be disastrous? Depends on ones definition of disaster.

Concerning deflation, one can look at Japan which has been in a deflationary period since the mid 1990s. There was some belief that it was starting to emerge from it, but recent events call that into question. The main problem with deflation is that economic activity slows, borrowing becomes difficult as debt becomes more expensive over time and economies tend to stagnate. However, looking at Japan over the period of deflation, does not indicate that society as a whole collapsed, and the standard of living for most Japanese had been maintained at respectable levels.

As far as inflation goes, there are a number of examples of ruinous inflation, perhaps most notably the Wiemar republic. Inflation there completely devalued the Mark, led to the fall of democracy, the rise of Nazism and ultimately World War 2. Now, other countries have also had sever inflation without having a World War as a result. Inflation makes everything seem more expensive and is particularly hard on those who live on fixed incomes. It certainly makes foreign imports more expensive but makes domestic exports cheaper leading to improvements in the balance of trade. Clearly, the rate of inflation has a lot to do with the ultimate impact. If prices grow at a slow to moderate pace it is not particularly problematic. It would be sudden and rampant inflation that would cause the most disruption. The other factor, is if inflation is expected, people demand higher returns to offset the expected devaluation of the dollar, causing borrowing to get more expensive and driving down the market p/e ratios.

Now, in our current scenario, we have seen the economy contract by about 15% over the last 4 quarters. This drop in demand is what has caused the recent deflation. It seems that the stimulus and cheap money policies may be bearing fruit and demand is starting to increase. However, we know that there is significant slack in the economy related to labor and commodities that would offset any significant inflationary trends.

Now, if the dollar continues to fall internationally, it makes American products cheaper and foreign products more expensive. It is possible that increased exports can reduce the slack in domestic consumption and lead to an increase in production, potentially fueling the inflationary fires.

So what will it be? It seems that we are at the bottom of the price reductions and that as demand starts to increase we may see modest price rises. Of course, it will take awhile for these prices to return to pre-recession levels and if we make significant progress in areas such as renewable, domestic energy sources, we may find the amount of dollars going outside the country significantly reduced. We also know that Americans are saving more, and those savings are reducing the amount of money in actual circulation, just as the increased bank reserves are.

So inflation is not guaranteed. I would like to think that as the economy picks up we take an intelligent approach to deficit reduction and debt retirement. The biggest challenges there include the cost of foreign energy and health care. I am pretty optimistic about both of these and think its time we fixed them.

Demographics

If you think about the future, and I only mean the fairly close future, there are a number of things that are going to happen because of Demographics. The "Baby Boomer" generation has been aging and is reaching retirement age. Now, the sad fact is many of them counted on a retirement based on the money in their 401Ks and homes. A lot of this money has vanished. Real estate especially will take years to return to values it attained in 2007. The stock market is also unlikely to get to levels from that year for a while.

This generation, which has to a large extent been the primary engine in the economy for the last 60 years is now faced with a situation forcing them to try to save. Further, as the grim reality of their situation has sunk in, some will have to work longer, assuming there are jobs for them.

They are going to put demands on health care, and social services that were easily forecast but which are going to be worse as their own resources have diminished. Many of them have seen any traditional pensions they may have expected endangered, companies that at one time promised life time health benefits have either gone out of business or are scaling back the benefits.

The one strength this group still has is tremendous political clout. While to a large extent many of them spent much of their lives living independently, as they find themselves unable to provide for themselves economically, they are likely to demand that the Government do something.

This probably means that budget deficits will continue to grow and the National Debt increase. There is no magic solution to this demographic issue. The other known problem is that the number of workers paying taxes to support this group as they retire and need services is proportionately smaller than it has been in our history. For the next few decades, unless we have a massive immigration of young people, the ratio of people above 60 to those under will set records. As long as we rely on an income tax to finance our social services, we will have a significant problem.

We may see a change in the American lifestyle, and we may be already seeing it, where generations return to living together to reduce expenses. That is one of the reasons that the housing stock in existence is probably excessive and will exceed demand for a good number of years.

They are also going to spend less money. First, they have less. Second, as they age, some things they spent money on will become insignificant to them. Of course they will still buy consumables but some of the industries that relied on them wanting things newer and better will suffer. If we see fewer households there will be less demand for major appliances, automobiles, lawn maintenance equipment and any other items that are discretionary. Spending will not disappear, but demand will decrease and profit margins will be squeezed.

The economy will adjust, but it will become more fundamental. If we do some smart things, such as reform the tax system, increase immigration, and reduce dependence on foreign oil, we can mitigate much of this.

However, the amount of reduced demand that the demographics predict is probably going to mitigate any inflationary pressures for years to come.

Deflation

Two years ago if you wanted to buy a house the amount you would have paid would certainly be higher than the price you would pay today. If you wanted to put gas in your car, you would have paid as much as $2 more than today. In most retail stores, while there were items on sale, the sales were neither as broad nor as deep as they would be today. It is also likely that the salary or starting pay you could get would be higher than you could get today, however there are a lot of variables there.

So have we experienced Deflation? One of the things that is worrisome about deflation is that since the currency is worth more, debts become more expensive. Also, since prices are declining there is a disincentive to buy since there is an expectation that whatever it is you want to buy will be cheaper tomorrow.

This may sound sort of like the situation facing us today, yet you hear a lot of talk about the return of inflation because the Government is creating money. Is it really? When the bank reserve requirements increase, you are taking money off the street. If you don't replace this money somehow, you have less money, not more. So is more money being created than has disappeared?

When you consider the idea that the Government is creating money, some seem to think they just turn on the presses and print a bunch. They actually create money by borrowing with a promise to repay. The money created this way can be considered as a "dilution" of the money supply but that is only true if the amount of money in use is greater than it was before the borrowing. It should also be noted that when banks use assets to loan money at multiples of those assets, they also either create or remove money from circulation. So is the value of those assets go down and therefore less loans can be made, there is less money. In fact, as we move more and more to electronic transactions, the need for money to ever get printed diminishes.

So, if we have had trillions of assets lost because of falling valuations in housing, stocks, inventory and commodities, isn't that a whole lot of money that went out of circulation since the banks had to reduce loans and replace the lost assets used as the basis for future loans. Has the Government borrowed enough to replace all this lost money? One problem in measuring this is that the money supply measurement that would be meaningful here includes the value of the assets on the banks books. While it looks like it has increased, that depends on whether the bank assets are properly valued. Since we dropped the "mark to market' rule it is more likely these assets are valued at hopeful amounts. This is of course why the reserve requirements have been increased, and is assets recover value, the hopeful valuations may end up being correct, but it is doubtful to me that there is really more money available.

I think worrying about inflation right now is a bit premature, we should be worried about deflation.