We Have a Debt to Discharge
There is a common error with contrarian investing. It is not a question of identifying things that people believe that are wrong, but finding things that people rely on that are wrong. Reliance is the critical component. I don’t care about what people think if they don’t have any skin in the game. When someone relies on a certain result happening (or not happening), then there will be series of behaviors that happen as what he believes in fails, from intensifying the bet in the early phases, to throwing in the towel in disgust at the end.
I’m going to take this idea and twist it a different way tonight. One thing that the Democrats and Republicans (except Ron Paul) agree and rely on is that they know how to avoid a repeat of the Great Depression. The textbook answer is:
- Easy Money
- Fiscal Stimulus
- Don’t Raise Trade Barriers
Ben Bernanke learned this as a young college student, and built it up in his Ph. D. dissertation. He has the same moral certainty about this that George Bush, Jr. does about fighting terrorism. And, I’m going suggest that Bernanke, and most of the political establishment (which hasn’t really changed in the last few days) are wrong.
What is a bubble? My definition: a bubble is a self-reinforcing cycle where monies invested obtain a negative return in aggregate over the long haul. It is characterized by significant borrowing at low rates to invest in already appreciated assets in order to profit from a momentum-driven market. When cash flow is insufficient to pay the interest to finance the bubble, the bubble pops, and a self-reinforcing bear market ensues. When that bear market encompasses most of the financial system, we call it a depression.
What is a depression? A severe recession where the banks are impaired. In an ordinary recession, lowering the Fed funds rate can stimulate the banks to lend. Not so now; the banks are licking their wounds, and letting profits grow by financing at lower rates, and sucking in bailout cash to shore up their balance sheets against future real estate lending losses.
The Great Depression ended when the Debt to GDP ratio dropped below 150%. When enough debts were extinguished by payoff or default, the system could once again be normal. Virtually none of the efforts of FDR focused on eliminating debts; in my opinion, he lengthened and intensified the Depression by not encouraging the liquidation of bad debts. And now we do the same thing. We perpetuate the misallocation of resources by trying to keep house prices high, by bailing out institutions that should go through the bankruptcy process. This fails to convert bad debts into equity in newly solvent businesses.
All the US government is doing is creating a bigger bubble. What will happen when the Treasury auctions fail, or, stretch the yield curve so wide that there is panic. We don’t want our financial institutions to fail, so we are willing to wager the creditworthiness of the nation in order to save them. I don’t like that bet. Many empires have died choking on debt. Is the US to be next?
When I wrote articles opposing the bailout, I did so because I did not think it would work, and that one-off conservations/liquidations would be preferable, but not optimal. Optimal to me would be using the bankruptcy code on a expedited basis, wiping out junior capital, and making senior capital take haircuts.
But in the present, we contemplate borrowing to bail out all manner of problems — bail out homeowners, automakers, banks, insurers, guarantors, etc. The end to this phase will come when the creditors of the US write off their prior lending, and decide not to throw good money after bad. I have no idea when that time will come, but the dreamy schemes of politicians aiming to solve every financial hurt will help to force such a time to happen.
November 7th, 20087:52 am at
Great post David! Especially spot on with:
“All the US government is doing is creating a bigger bubble. What will happen when the Treasury auctions fail, or, stretch the yield curve so wide that there is panic. We don’t want our financial institutions to fail, so we are willing to wager the creditworthiness of the nation in order to save them. I don’t like that bet. Many empires have died choking on debt. Is the US to be next?”
Ive been discussing this as well on urbandigs and that the new age slowdown will likely bring with it the end of the treasury bubble. I think this is part of the endgame here as govt bails out everyone, and doesn’t let the weak fail for fear of systemic risk or impact to our economy/jobs. Next up are automakers. I doubt they will let them die, go into bankruptcy, restructure and come out stronger without any bailout or rescue.
Even the introduction of ultra short treasury ETFs is telling.
Did you see CDS on US 10 yr treasury lately? We do not need a default, we simply need the markets to question the credit worthiness of US treasuries and you will see yields surge, especially at high end. How will that affect the slowdown? It will exacerbate it!
November 7th, 20088:43 am at
Down one road lie a period of deflationary contraction and restructuring. Down the road of serial bubbles lie inflation and possibly hyperinflation, which will ultimately lead to the deflationary adjustment.
What happens depends on policy and the market is ever policy dependent: http://www.blogger.com/posts.g?blogID=816559531110064247
November 7th, 200810:39 am at
Great post, I think you said it well.
But, IMHO, Bernanke knows exactly that. The problem is that if housing asset prices decline to a more fair value then banks are left with a 500b-1t hole in their balance sheets. If, on the other hand, there is 20-30% inflation, then the balance sheets are saved.
I think Bernanke wants to create inflation without spooking the markets. That will give the nominal lift to asset prices. As long as our creditors don’t back out, we’ll be OK.
November 7th, 200812:00 pm at
Mr. Merkel-
The views you express in this post are consistent with some of the policy views of Andrew Mellon, Secretary of the Treasury under President Hoover. In the wake of 1929 stock market crash, Mellon believed that excessive credit creation and unsound lending were behind the bubble. Mellon favored the liquidation of failed banks and institutions (no bailouts), balancing the Federal budget, and returning to the gold standard at pre-war parities. this was conventional wisdom at the time. As the depression deepened, the Hoover Administration became progessively less doctrinaire.
Encouraging liquidation had very unpleasant consequences in 1929-1932.
November 7th, 200812:06 pm at
Great post.
I would add that the chambers are empty too.
No HELOC cash, tougher to get debt, and no stock market gains to prop up the economy. That is why I feel we are headed to a more severe recession. Those are all things missing, that existed during the past couple of downturns.
The only chamber with something left is government, but that one will go dry by February.
November 7th, 200812:13 pm at
Arthur, anon — Debt liquidation can’t be avoided. Hoover and FDR prolonged and intensified the pain of the Great Depression. Had they let it progress without interference, the Great Depression would have been over in no more than five years.
Look at Japan — they have stretched a popped asset bubble into a two-decade long morass. We are doing the same thing now, but starting with a worse balance sheet as a nation. Japan had room to borrow; FDR had room to borrow. We don’t.
We can take the pain in a few big doses and return to normalcy sooner, or a bunch of little doses that will leave us floundering for a generation.
November 7th, 200812:31 pm at
“rthur, anon — Debt liquidation can’t be avoided. Hoover and FDR prolonged and intensified the pain of the Great Depression. Had they let it progress without interference, the Great Depression would have been over in no more than five years.”
YES YES YES YES YES
Their is no way out of the box. People take a half truth and make a full truth out of Mellons comment. Mellon’s way was the fast way out of the pain. Extremely intense. Buy pain, sell time feeling it.
Floundering indeed. .Gov risks itself as an entity in founding fathers form by continuing/accellerating the road it currently takes.
November 7th, 20084:30 pm at
I hear both sides of the argument. Another highly respected voice I also listen to is David Rosenberg of ML. David M. and David R. are both very concerned with the situation, but come to different end states (say in 2010) based on (I think) a different view of how much debt the US can take on without significant consequences. And we all know the US has debt capacity – but how much? David M. what is your opinion regarding the incremental debt capacity of the US where the current layering on of addition debt results in a certain probability of a ‘tipping point’ as you suggest. If you can, quantifying this or pointing to how one could approach quantifying this would be a great aid.
Without this quantification I feel in the middle of a unprovable ‘beliefs’ debate.
November 7th, 20085:19 pm at
what is your email?
November 7th, 20085:44 pm at
A bubble can also be defined as a reversal of the usual interaction of price with supply and demand. Ordinarily rising prices increase supply and reduce demand. In a bubble, expectations of continued rising prices instead reduce supply (hoarding) and increase demand (speculation). It isn’t necessarily the case that they always pop when cashflows don’t cover interest, as interest can be capitalized in bubble conditions. Bubbles pop when expectations change.
The key determinant is expectations, and expectations are temporal. A sudden spike in price will be seen as an anomoly, whereas a more persistent rise plays on the normal human tendency to linear extrapolation, and this requires time to become embedded.
The same is true on the flip side. If expectations of declining prices become embedded, there’s a risk of an anti-bubble. Again though, the formation of the anti-bubble requires two conditions; that lower prices bring lower demand and increased supply, and that this becomes embedded in expectations. Current policy is obviously designed to avoid the first condition. If it succeeds, no anti-bubble will form. If it fails, the passage of time risks causing the second.
As for the debt, we need to remember that what’s happening now isn’t so much the creation of new debt as the transfer of debt from private to public hands. It’s an open question at this point if and to what extent private debt expands once the immediate crisis is past.
November 8th, 20082:08 am at
It is listed here: http://alephblog.com/contact-us/
November 8th, 20082:32 am at
There is a future, in the past, that does not rely upon the accumulated Debt that is at the heart of the cascading monetary disorder.
http://www.safehaven.com/article-11769.htm
Monetary Reform: Gold And Bills Of Exchange
by Antal E. Fekete
Address before the Civil Society Institute at Santa Clara University, November 3, 2008
How wonderful that it was presented at my MBA alma mater, Santa Clara Univ.
November 10th, 20081:50 pm at
Choose your poison – -
The correction will come and at a price. We talk about strategies while what is at stake is survival.
As the World Wide Economic slowdown increases and the heat turns up on the middle and working classes, we all will be facing some ugly possibilities.
Economic solutions don’t always work as with political realities. Enjoyed the posts and agree that world governments would love to create enough inflation to bail the real estate assets out of the hole they are in.
Sorry, don’t think that will happen this time around, you have all heard the saying, “pushing on a string” this what the Fed appears to be doing.
James Monachino