Saturday, December 30, 2006

Bubble Implosion
Household debt represents 131% of disposable income, up from 95% in 2000 and just 65% in 1990 (see chart below). The debt has been taken on to maintain a reasonable standard of living in the face of slow income growth versus zooming costs for healthcare, education and energy. The debt burden has become so onerous that it has to go away - somehow. But how?

Two things will happen simultaneously, in my opinion:
  • A significant cutback in consumer spending.
  • A destruction of debt through foreclosures and bankruptcies.
American consumers are already spending more than they make (negative personal savings rate) and cannot sustain more shopping without additional income. The effects of a cutback will be felt from mega-emporiums in Topeka, to truckers and container ship companies all the way to China - which is now home to the greatest manufacturing overcapacity bubble in history. The Chinese have built factories expecting torrid export growth for the next 5-10 years. Manufacturers there operate on razor thin margins and are dependent on high volume for profit. When growth turns to stagnation there will be massive factory layoffs and shutdowns. A vast swath of the nascent middle class will disappear faster than a will o' the wisp. Can China switch to selling its wares to the domestic market? Perhaps for a portion of the manufacturers this is possible but the rest will simply disappear and the country overall will stagnate for at least a decade or more while American consumers attempt to rebuild savings. But enough about China...

The American Debt/Asset Bubble has been blown so large and for so long that its deflation is a given if only because current incomes cannot sustain higher home prices and more debt. The pervasive creation of no money down, interest only, negative amortization etc. exotic loans to "sub-prime" borrowers was just the last hurrah, the last landing at the top of the debt ladder. The process is now working in reverse with defaults rising fast, taking home prices down and cutting demand as even credit worthy potential buyers pull in their horns. This self-reinforcing downward spiral will only stop when all the bad debt has been washed away. The effects will be felt everywhere; from mortgage brokers, to banks and servicing companies, all the way back to the malls of Topeka where it will link and amplify the reduction in consumer spending.

The two processes will merge into one mega-cycle of debt-liquidation and lower consumption until household finances are repaired. There will be a long, rolling recession that may be somewhat ameliorated by the Fed lowering short interest rates, but that will not suffice to convince lenders to loan to already overextended borrowers. Money supply will contract, the dollar may strengthen vs. other currencies and commodity prices will drop - precious metals included. This is the classic deflationary cycle - one that many people are unfortunately not familiar with, believing instead that debt liquidation will result in massive inflation.

A past comment by Mr. Bernanke about "cash helicopters" (before he was Fed Chairman) has been grossly misunderstood by some to mean that the Fed will create hyper-inflation in order to destroy debt. In fact, Mr. Bernanke was describing a hypothetical last-ditch attempt to get an already moribund deflationary economy back into its feet by brute-forcing money supply growth - not what should occur in the initial stages of a slowdown.

To summarize

The Debt Bubble is the natural driving force and a by-product of the stock and real estate asset bubbles created in lieu of income growth since solid, well-paying jobs disappeared for the middle class. All three bubbles will deflate in tandem, probably back to the debt-to-income percentage levels of the early 1990's. In today's dollars this means a wipeout of at least $6 trillion in household debt. How about assets, then?

The current assets/liabilities ratio for households is 5/1; if this were to stay the same, the implication of a $6 trillion debt liquidation is for assets to plunge by $32 trillion. This is unlikely to happen; rather we will see the assets/liabilities ratio move back to the 1990's level of 6.5-7/1, implying a drop of asset values of $22-25 trillion, always in today's dollars.

What will this mean in terms of real estate and equity values? I will deal with that in tomorrow's post - sort of a New Year's prediction...


  1. While I agree that deflation will be the out come to this debt bubble I wonder about the liquidity that is being pumped into the US market and leveraged up by the private equity and hedge funds speculating in everything and spun by the MSM as all is well in the market.
    I think the crashing and pull back of the American consumer will be the trigger to start the unwinding spreading to areas outside of housing. Washing away this debt will be a killer! Just the housing stock overhang now and the amount of construction in process is daunting. Is the game now inflate or die?
    Seeing that this boom had to end, six months ago I cut all expenses that were not really needed so that I could live on 50% or a little less in income and am building up more in cash in reserves. I am in construction and have been through these times before but I think this time will be worse. I do have a broad skill base and have been putting money into my "means of production" also all of my work has been word of mouth thru the years and I feel I produce work of value. I do have debt due to life choices and unforseen problems but I feel they are serviceable and will be free in less than 2 years, 1 if I get lucky. As an average Joe this seems the best I can do at this time but am adding to the deflation spiral.

  2. Dear Anonymous,

    Thanks for your insight. It is exactly this excess "liquidity" that is the problem. "Money" (i.e. liquidity) is created by printing or borrowing. The process is obviously very valuable to a modern economy - but if the price of assets funded by borrowing gets too high vs. the return one gets from them (eg rent, dividends, interest) then trouble looms. This is where we are today.

    Inflation is not going to solve the problem, as I have explained in previous posts. Maybe ultimately we will have to create inflation in order to exit from a deflationary spiral (ie let fly Bernanke's proverbial cash helicopter) but that is far in the future.

    In the meantime, getting out of debt and increasing savings is crucial, in my opinion. But you don't need me to tell you this - it has always been true!

    Best Wishes for a healthy and happy New Year.

  3. Wonderful blog, mysteriously accurate so far.

  4. What would the equasion formula be for a Bubble collapsing at the speed of light?

    Thank you,
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