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Comstock Partners on Deleveraging (Not for the Fainthearted)

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Comstock Partners has a new newsletter out, and it makes a cogent case that there is no pretty way out of our over-leveraged mess. The disheartening bit is not only the narrative but a series of charts. One, on debt to GDP, show that it has risen in the last year (debt was roughly $49 trillion as of last year, it is not $52 trillion this year). So we have had a lot of economic pain with NO reduction in aggregate indebtedness, This isn’t simply shifting private debt onto the public balance sheet (in effect); this is actually an increase in the underlying pathology.

That debt to GDP chart is controversial, because the comparability of older data to current figures is debatable. But the key message is that debt to GDP shot up after the stock market fall in the Great Depression due to the collapse in GDP. And while large scale deficit spending did help pull the economy out of the rubble, it was also accompanied by large scale debt reduction, via bankruptcies and bank failures (not pretty, mind you) and restructurings. But in this time around, there is perilously little in the way (yet) of restructurings of underlying debt. That does not bode well for recovery.

From Comstock Partners (hat tip DoctoRx):

We are in the process of deleveraging the most leveraged economy in history….this deleveraging as a major negative that will weigh on the economy for years to come and we could wind up with a lost couple of decades just as Japan experienced over the past 20 years. It is true that Japan didn’t act as quickly as we did but our debt ratio presently is much worse than Japan’s debt ratios throughout their deleveraging process…

This seems to us to be a “mini bubble” of stocks reacting to an abundance of “money printing” by governments all over the world since stocks are rising worldwide. Of course, if the U.S. doesn’t recover there will be no worldwide recovery since the rest of the world is still dependent upon the U.S. consumers’ appetite for their goods and services (despite the so called growth of domestic consumption in China and India). We, however, don’t believe that the U.S. massive stimulus programs and money printing can solve a problem of excess debt generation that resulted from greed and living way beyond our means. If this were the answer Argentina would be one of the most prosperous countries in the world….
Most investors believe the bailouts, stimulus plans, and quantitative easing will lead to inflation. In fact, almost all of the bearish prognosticators are negative because of the fear that interest rates will rise once the inflation starts to work its way into the economy. They point to the doubling of the monetary base which they believe will soon lead to rising prices as more dollars are created chasing the same amount of goods. We, on the other hand, are not as concerned about the doubling of the monetary base because we believe the excess money will need the money multiplier and increases in velocity in order to increase aggregate demand and eventually inflation. As long as velocity (turnover of money) is stagnant we expect the increases in the monetary base and all the quantitative easing will lead to a stagnant economy and deflation until the consumer goes into the same borrowing and spending patterns that was characteristic of the 1990s through 2007.

Yves here. This point echoes a Gillian Tett piece today. Back to the newsletter”

Remember, over the past decade (when we believe the secular bear market started) the total debt in the U.S. doubled from $26 trillion in 2000 to just over $52 trillion presently (peaking a few months ago at $54 trillion). This consists of $14 trillion of gross Federal, State and Local Government debt and $38 trillion of private debt. We expect the private debt to continue declining in the future as the deleveraging of America unfolds, while the government debt will very likely explode to the upside as the government tries to slow down the private deleveraging by helping out the entities and individuals in the most trouble with debt (such as over-extended homeowners).

We wrote a special report in January of this year titled “Substituting Debt for Savings and Productive Investment” in which we explained why the U.S. economy historically prospered because of hard working Americans saving a substantial amount of their income which was used for productive investment. Unfortunately, all of this changed over the past few decades and got worse over the past decade. In fact, we stated in the report that it took $1.50 of debt to generate $1 of GDP in the 1960s, $1.70 to generate $1 of GDP in the ’70s, $2.90 in the ’80s, $3.20 in the ’90s, and an unbelievable $5.40 of debt to generate $1 of GDP in the latest decade. Over the past two decades, while most investors thought this trend could continue indefinitely, we have been warning them of the catastrophic problems associated with this ballooning debt….

We expect the total debt in the U.S. to decline during the deleveraging period directly ahead, with the government debt exploding while the private debt collapses. The private debt in Japan was almost the reverse of the U.S. where most of our excess debt was in the household sector and most of the excess debt in Japan was in the corporate sector. The debt to GDP figures in Japan were not easy to come by from the typical sources until the mid 1990s and had to be estimated, but should be pretty close to the numbers used above. Our sources on the above Japanese debt figures came from Ned Davis Research and the Federal Reserve Bank of San Francisco. NDR’s report, “Japan’s Lost Decade– Is the U.S. Next?” have great statistics and information and the Fed’s report “U.S. Household Deleveraging and Future Consumption Growth” is well worth reading.

The Fed study charted the peak of the debt related bubble of the stock and real estate assets in Japan in 1991 (1989 for stocks and 1991 for real estate) and overlaid it with the peak of U.S. debt associated with the same assets in 2008. They concluded that if we are able to liquidate our debt at the same rate as Japan we would have to increase our savings rate from the present 6% (artificially high due to the recent stimulus paid to households) today to around 10% in 2018. If U.S. households were to undertake a similar deleveraging, the collective debt-to-income ratio which peaked in 2008 at 133% (H/H debt vs. Disposable Personal Income) would need to drop to around 100% by 2018, returning to the level that prevailed in 2002.

If the savings rate in the U.S. were to rise to the 10% level by 2018 (following the Japanese experience), the SF Fed economists calculate that it would subtract ¾ of 1% from annual consumption growth each year. We did a weekly comment about this very subject on June 25 of this year and came to a similar conclusion. In that same report we showed that from 1955 to 1985 that consumption accounted for around 62% of GDP. Because of the debt driven consumption over the past few years at the end of March 2009 consumption accounted for over 70% of GDP. If the percentage dropped to the normal low 60% area of GDP it would subtract about $1 trillion off of consumption (or from $10 trillion to $9 trillion)….

We expect that the U.S. deleveraging will follow along the path of Japan for years as real estate continues to decline and the deleveraging extracts a significant toll from any growth the economy might experience. We also expect that, just like Japan, the stock market will also be sluggish to down during the next few years as the most leveraged economy in history unwinds the debt.

The newsletter also has some charts (not in the text, you need to click on them…..I figured I’d send the curious over there).

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  1. Richard Kline

    I'm broadly in agreement with the Comstockers on their major contentions here. To me, the metastisization of $ denominated debt over the last generation has been the great destabilizing force in the world economy. Yes, there are other major problems; this is the driver against which other forces are guaged and engaged. And as these analysts do, one must look at both public and private debt and the composition of each to get the real picture; any single data point can mislead. There were noises last Fall and the year before when this issue was broached that because 'the public debt was so low' in relation to GDP expanding it substantially was no cause for alarm. As if that private debt didn't weigh in or would mystically sublimate itself into divine ichor. Well as we see now, more public debt is leading to more total debt; some surprise, what?

    The Comstockers also make a good point when the speak of the disabled multipliers for the mass of Fedbucks put in motion leading to low velocity, and consequently to no demand pressure on prices. It will be very difficult for prices to rise when consumer spending as a whole continues to decline at a significant pace, which is presently the case in the US. Wages appear to be showing declines, and that, too, constitutes a major brake on inflationary accelerators. While I am much concerned about the inflationary consequences of more debt issuance and strategies of quantitative easing, I don't expect a typical inflationary spiral to get much traction.

    The pressure of all this extra lolly from the queasig strategy is more likely to go sideways in some fashion, which makes one worry about systemic events. For example, I consider the rise in equities more nearly pathological than normal market function. Money has to go somewhere so even while there is no recovery to be seen, nor likely to be had, money pushing equities up for the sake of momentum plays is a not unlikely outcome of too much funny-money looking to materialize itself in come asset class. The sick part in all this is that the money being used to chase equities is significantly the result of public debt issuance shunted back to the big financials as guarantees and swaps: we borrowed this money, and took it to the casino for another go round. In the worst case, one gets a bubble, as is the likely result in China from a siminlar process. What one does _not_ get is any of investment, growth, profit, or employment. That is, the debt-created bumpf for the queasing strategy largel goes sideways in speculation rather than pumps the real economy in some fashion.

    —And the thing to really fear is simply that the Powers That Be in the US have no strategy for even reining in that debt, none whatsoever. What cannot be built to the sky either crumbles or turns turtle. That is the future the present course guarantees for us, and it is likely much nearer than one would think. To speak of deleveraging we have to start to reduce debt, and that has not yet even begun; in fact, the reverse. We are rearranging the loading of a listing trawler with a sieve-like hull—so we can load more on. As I said, a systemic reordering of such an arrangement seems likely, and such would be sudden, dramatic, unpleasant, and exceeding difficult to recover from.

  2. Andreas


    thanks for the interesting blog.

    But I have problems to find the charts in the newsletter you mentioned. Your link to the curious links only to the article. And no links there.


  3. MarcoPolo

    “We, on the other hand, are not as concerned about the doubling of the monetary base because we believe the excess money will need the money multiplier and increases in velocity in order to increase aggregate demand and eventually inflation. As long as velocity (turnover of money) is stagnant we expect the increases in the monetary base and all the quantitative easing will lead to a stagnant economy and deflation until the consumer goes into the same borrowing and spending patterns that was characteristic of the 1990s through 2007.” – Comstock
    This bull about money multipliers – subterfuge. Inflation is not prices! We have had inflation for the past 15 years. Bringing on supply gangbusters while wages and demand were stagnant kept prices (CPI) low and masked that inflation as growth. Deflation is not contraction either. Or, change the terminology if you choose, but be consistent. Hate to appear such a Friedmanite, but he did as least have this much right.
    The dangerous part of creating all this money is that it may eventually come back here to be spent sending asset prices, commodities and interest rates to the moon. Then you will see contraction. Crude oil is already tightly & inversely correlated to $ exchange rates. Expect to see more of that in other commodities. Andy Xie had an article earlier this week in which he worried about China’s exposure to a rising $. (Did I see it here?) Not in our future.
    The danger is a falling dollar. A falling dollar endangers all of our business models. Global trade will fall still further. There will be inflation & shortages of even the silliest things as with the 70’s wage/price controls.
    The only solution is to deleverage. Take our medicine. Unlike Comstock I don’t see that in our future either. You can’t deleverage by transferring private debt to the public. The Keynesian instinct is to inflate. To repudiate is not to deleverage. So…look out! We’re fighting the last war. The one in which we didn’t have the world’s reserve currency and in which we benefited (or would have benefited) from a weaker dollar.
    “Over the past decade when the secular bear market started” – in what? Not t’s. But it’s coming.

  4. Richard

    The only thing I would disagree with is the comment about "bailing out" homeowners" as I think that program is essentially a political cosmetic, a courtesy bow by Democrats to their left. Calculated Risk has a great chart showing that the great wave of foreclosures is still going up to peak and is not breaking. To the extent the program has any purpose at all, it is to provide another tax subsidy to the banks (my Dad told me to be banker and I should have listened to him. It takes a real skill to run an institution into the ground when the Gubmint lends you money at 0% (or simply gives it to you outright) and you can lend it out at 6%. I think I could do that and collect a $50,000,000 bonus for my genius. But I digress.) Barry Ritholz, I believe quoting David Rosenberg, calls the modification program "extend and pretend." I don't know if you do favors for folks keeping them in homes where they must pay monthly mortgages along with other costs of ownership that are almost twice the rental cost for the same house where they have no equity and no prospect for having any equity in those homes for decades.

    Capitalism, to steal from Churchill's aphorism on Democracy, is a terrible, wasteful system, excpept when compared to the others. In the U.S. today we look at trillions of dollars of wasted investment (I could say showing that when it comes to waste, Government can't hold a candle to the private sector, but many Government policies over the last generation have interacted with private decisions to create this mess). The wasted investment of dead malls, empty offices, and now vacant homes built to excess over the last thirty years will make David Byrnes's song remarkably prescient "Nothing But Flowers."

    The groupthink in the business elite over the last 30 years was that the way for a company to prosper was to outsource as much production to low cost labor countries and reimport and market to the wealthy U.S. consumer mass market. Beginning this decade business realized that the internet and fall in communications costs by a 1000% in a generation would allow them to shift back office functions to labor low cost countries. Even where jobs were not shipped overseas, or where low cost illegals were not used to substitute for labor in the U.S., the threat they could be has kept the lid on U.S. wages in this decade which even before the current Great Recession had grown less then inflation during the period from 2000 to 2007. With the recession the decline in income has accelerated, cushion only by Government transfer payments. According to the most recent statistics on income in June income fell by 4.7. The wage deflation feeds the asset price deflation since folks have less income to service their debt. The business model falls apart as the wealthy mass market ceases to exist as U.S. median incomes descend to the median levels of developing countries with good educational systems, or at least good enough to turn out millions of English fluent graduates.

  5. Leo Kolivakis

    "If the savings rate in the U.S. were to rise to the 10% level by 2018."

    >>This would spell disaster for the U.S. economy. I do not see it happening because people simply cannot save when they have bills to pay and debt to pay off. Deleveraging will mean weak growth for many years, but people have to remember that savings are also influenced by the stock market and housing market. If the latter finally recovers and the former grinds higher, then they will save less and consume more (wealth effect). The risk of debt deflation comes from the employment outlook. If unemployment keeps rising, then the risks becomes all too evident. However, even though I expect unemployment will continue to rise, i see the pace of deterioration abating considerably as the US economy slowly recovers.



  6. Siggy

    Inflation isn't simply too much money chasing too few goods. What if the extinguisment of debt is offset by increases in the quantity supply of money? What happens then? Prices tend to stagnate. What the private sector has to do is to extinguish all debt that cannot be serviced. What the public sector has to do is assist the private sector in the extinguishment/repudiation of of that debt that cannot be serviced.

    The current level of excess reserves is suspect in that the rate of absolute new lending is incredibly low. Were it not so low, the velocity of money would be significantly higher than it now is. That suggests that banks are still carrying a substantial quantity of debt at excessive prices. Now that is inflation in and of itself.

    Now deleveraging leads to lower prices because the extinguishment of debt is effectively a reduction in the quantity supply of money. A lower quantity supply of money leads to lower prices; i.e., increased purchasing power.

    The Comstock piece is very much on point and its view into the future suggests that we are a very long way from dealing with our current excesses.

  7. Jesse

    They make good points.

    This is a bit undermined by their bearish stance since roughly the Nixon administration. (exaggeration for a joke, but not a big one.)

  8. Doc Holiday

    What happened to voodoo economics? The charts here say more than I can (in this coppy/pasted tidbit):

    Inflation was non-existent in the second quarter, with the GDP deflator flat and taking the YoY trend down to 1.5% from 1.9% in the first quarter. (We have seen out of the diffusion indices, such as the Chicago PMI, that pricing trends are in reverse.) This lack of pricing power along with sustained negative volume growth, dragged nominal GDP down at a 0.8% annual rate and -2.4% on a year-over-year basis, which is something we haven't seen since the fourth quarter of 1949. And, what should matter most for stocks and bonds is nominal GDP — price multiplied by volume. Indeed, Charts 1 and 2 illustrate the case — the rate of change in the S&P 500 (Chart 1) and the rate of change in bond yields (Chart 2) ultimately track the trend-line in nominal GDP growth.

    What this says to me, is that Cash For Klunkers is going to reduce inventory and increase the cost of cars, increase the wages needed for production, increase the cost of technology for production, increase the demand for other shit and thus cause gut wrenching inflation and economic flatulence and flaccidity.

    Although The Obama Car Bubble is a great idea (as a theory) — not unlike Kennedy's boondoggle race to put stuff on the surface of the moon (before the Reds) will it really help get the economy turned around and be as exciting and fun as Bush's Ownership Society? Will a car bubble be as sustainable and will a car bubble be a better use of taxpayer money, versus a public transportation bubble that might actually help society change its travel behavior. We are careening wildly towards a time when this recessionary period will be looked upon as being a wonderful jobless recovery (on paper) but, …. so who, so who, so who will be buying these cars and driving to school for the new jobs that are not needed? What jobs are needed besides daytrading, selling cars, selling foreclosed McMansions and serving $5.00 cups of coffee and of course, yes, yes, yes, we friggn need crap loads and bus load s of cute nurses with starched white hats and cheerful smiles as they try to remember their algebra and all that other stuff that never sank in after high school — not that I'm suggesting that there is a nursing bubble, but that has crossed my mind and does seem to fit in with car sales and education, so I guess I am barking up the wrong tree and apologize for taking too long to say so little about nothing.

    FD: I'm losing my will to do this anymore…

  9. Anonymous

    Hey Doc Holiday, don't lose your will. The incentive to spew textual white noise like we do may come and go but not the will, please.


  10. sharonsj

    Please remember that average Americans aren't necessarily out there buying up expensive and useless toys. Everyone I know uses credit cards because they simply do not have enough money to get what they need to live, myself included. I am on a limited income and too handicapped to go out and earn enough to pay all my bills. And I think there are huge numbers of people in my situation.

  11. skippy

    Ahh! How quaint we have technical/market recovery backed by trillions of future tax dollars (if there are any future tax dollars in sufficient quantity's to slate the beasts thirst).

    Mean while the little people are swimming in the heads loped off at the temple top, in order to garner their economic gods favor. One class of people (market priests) sacrificing their fellows of lower status only to maintain their pathological identity. Its getting morose watching their attempts, justify the belief in the gods of their construct. The harder they try, the sooner its wanting will be exposed.

    Skippy…"Ours is a world of nuclear giants and ethical infants. We know more about war than we know about peace, more about killing than we know about living" – General Omar Bradly.

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