Tuesday, December 19, 2006

Diminishing Returns or,
Eating The Sardines (cont.)

So far we have seen that in the US:
  1. Total debt/GDP is extremely high (330%).
  2. Debt/GDP is rising at an unsustainable rate (25% per year).
  3. The economy has a debt "dependency" - it is hooked on debt to keep asset prices rising.
Today I examine if this asset bubble economy is economically sensible and viable.
I look at three standard financial ratios:

a) Leverage or gearing, i.e. the ratio of total debt to the value of assets
b) Return on assets (ROA), i.e. the ratio of annual profit to the value of assets
c) Return on equity (ROE), i.e. the ratio of annual profit to net worth (assets minus liabilities)

In the case of a nation the closest equivalent to "profit" is GDP; however imperfect it may be in measuring true economic conditions, it is suitable for comparison purposes. It is also important to note that although these ratios are widely used in evaluating the financial health and performance of businesses, their absolute numbers are not directly comparable. For example, a leverage of 30% may be perfectly fine for a corporation but onerous for a nation.

With that in mind, the first chart below shows the ratios of:

a) Total debt to the combined assets of all US households and businesses (i.e. leverage) and
b) GDP to combined assets (ROA).

(All data come from the Federal Reserve "Flow of Funds Accounts of the US ")

Notice how leverage has increased while ROA has declined - debt has increased and the price of assets has gone up, but the economic "profitability" of assets has declined. This is very significant: the economic return we get out of assets is going down even as we borrow to create more of them or, more likely, as we inflate their value and borrow against them.

Another measure we need to look at is the marginal return on assets, i.e. the change in GDP divided by the change in assets (Δ GDP / Δ Assets) or how much more GDP we get for an additional increase in the value of assets. Not surprisingly, this has been coming down as well.

The one remaining financial ratio is Return on Equity, in this case GDP divided by Net Worth, charted below. (Keep in mind not to directly compare apples and oranges, in this case the 40% national ratio to a corporate ROE which is typically 10-15%. )

What is useful to observe here is that this "national ROE" ratio has been stuck at the same level despite the rapidly expanding application of debt capital. This is a very strong indication that debt has been taken on to finance purchase of consumer items and passive assets (eg real estate and portfolio investments), instead of adding to productive capacity in the form of plant and equipment.

From the foregoing (plus previous posts) it becomes plain that the US has created a debt/asset bubble that is failing to produce proportionately higher tangible economic benefits, as measured by standard financial analysis ratios. This means that we are experiencing diminishing returns.

In "sardine" terms, the can has been opened, the fish has been tasted and found to be plain ordinary sardines - despite the exorbitant price paid.

So what is Zebediah to do? Can he get his money back?

Stay tuned.