Tuesday, December 4, 2007

The Smoking Debt Gun

The reason why so few good books are written is that so few people who can write know anything - Walter Bagehot (1826-1877).
Then again, there are those few who do know something and do write good books.

You may have noticed the new "Readers Recommend" link on the right, above the "Hellasious Recommends" list. Many readers suggest excellent books (and videos) in the comments section; it would be unfair for me to take credit by including them under my own recommendations, so I made this new link available to showcase them more properly and fully.

Please feel free to make recommendations and I shall make every effort to include them, given space and time considerations.


I have frequently (an understatement) pointed out that what is needed to get us out of the mounting debt crisis is more earned income, not more or cheaper debt. The chart below clearly shows how we got into the current mess: since the early 1980's earned income grew ca. 3% annually, while household debt grew much faster (click to enlarge). In order to maintain the lifestyle familiar to them as citizens of the richest and most powerful nation in the world, Americans had to borrow.

No one put a gun to their heads, of course... or did they? I believe someone did, and even pulled the trigger. Let's look for the smoking gun, then...

Data: FRB

I mentioned college loans a couple of days back ("The Bobby McGee Moment"). The college I graduated from now charges $45.000/yr for tuition, room, board, books and fees. Add everything else, and a student and his parents are staring at $50.000 per year minimum. By comparison, my freshman year there cost ~$8.000; that's a compounded increase of 6.30% per year. This is not an isolated case: as the chart below shows, tuition inflation has been running at double the official CPI rate for decades. More importantly, as we see from the first chart, it is much higher than the rise in wages.

Tuition Inflation in the USA (Chart: FinAid)

In the case of a college education, therefore, the smoking gun is quite obvious: tuition and related costs grew so much faster than earned income that parents and students had to borrow. The same can be said of at least two other major expense items: housing and medical care. In the past 25 years the median price of a single family home rose at a compound rate of 6%; medical care services by 6.5% - both much more than wage earnings. How could a family cope with such cost increases vs. their earnings, if not by borrowing?

As could be expected under the circumstances, saving evaporated - there was simply not enough money left over to save. After hovering around 10% for 15 years between 1970-1985, the personal saving rate commenced a relentless drop that brought it all the way down to zero. It even turned negative for a while, an occurrence of dis-saving not seen in the US since the Great Depression.

Personal Saving Rate (Chart: FRB St. Louis)

Certainly there were many people who went overboard: cheap and easy debt allowed them to engage in conspicuous, extravagant consumption. I do not need to repeat the stories... But I think they are the exception, not the rule. When the history of the Great Debt Bubble is told many years from now, they will be footnotes to add color, not the story itself. Because, as Robert Heinlein wrote: People who go broke in a big way never miss any meals. It is the poor jerk who is shy a half slug who must tighten his belt .

The smoking gun that forced American families into debt has been identified: rapidly rising costs for big-ticket essential items like housing, medical care and education, even as earned income grew by much less. So who pulled the trigger and who are the (multiple) victims? That's the topic for tomorrow's post.

Totally unrelated P.S. : Abby's Baaaa-ack.

Abby Joseph Cohen of Goldman Sachs and 1999-2000 stock bubble infamy, just came out saying that the S&P 500 will climb to a record 1,675 by the end of 2008, extending the longest stretch of annual gains since the 1980s.

She is one of the best contrary indicators in the strategist camp. Back in 2000-01 I made a point of shorting every time she came out with a bullish hoo-hah. I think she stayed bullish until 2003 and then turned bear. Just in time.


  1. Great post. This is the key issue, you really sorted through the noise. These multipart posts have become like cliffhanger serials.

    Jason B

  2. Does anyone know what the position limits are for index ETF options like the russell?


  3. How about Financial Armageddon (http://www.amazon.com/dp/141959608X)? I think Sudden Debt readers would find it interesting, especially the chapter on derivatives.

  4. re: position limits

    go to... www.theocc.com

    choose: Market Data, Position Limit Data and then the date for the report on all position limits.

    Read the WARNING on the page before you click the date - Limits change often.


  5. My health insurance bill will now go up to $1750 a month from $1500 for a family of four. They are basically saying don't have insurance. Maybe in the future we will all be reduced to being homeless and eating canned beans.

  6. Dear Anon/medical insurance,

    If you want to see how the rest of the world deals with medical insurance, go see Moore's SiCKO. I think u can get it on DVD.

    You will get VERY VERY angry.


  7. Sorry, dude, they are stupid, and like sheeple they are being led to the slaughter.

    You can always rent; you don't need a fancy house, rent a condo. Can't afford that then don't have kids.

    Nobody needs doo-dads either so save for healthcare. Everyone should be able to assume that the shit will hit the fan at some point.

    Education is the only one which is "unavoidable", grant you that one. Not a whole lot of choice there.

    All of this is socialist posing for really bad choices made by really dumb people. That they were marketed this crap is not an excuse.

  8. After your 'Janis' post a couple days ago, and this one today, I feel compelled to respond.

    This fall, I completed the relocation of my family from New England to Florida. While there were personal reasons (proximity to family), from a financial standpoint there were three factors:

    1) Substantially lower in-state tuition rates at public universities (approximately $3.6k/yr vs. $10-12k/yr in New England).

    2) The availability of reasonably priced health insurance via HSA's.

    3) My realiztion that the housing market is insane, followed by the urge to 'cash out' and rent in the short term.

    #1 will allow my children to pay for college out of pocket, #2 has allowed me to work as a contractor while I consider full-time opportunities, and #3 provided sufficient liquidity to make it happen.

    With no debt, and cash on hand, these actions are possible. My goal is to ensure my children do not start life with a debt load.

    I have come to the realization that zero debt=freedom while debt=servitude. I hope to make more feel the same.

  9. "rapidly rising costs for big-ticket essential items like housing, medical care and education, even as earned income grew by much less."

    This happened even as women went back to work in record numbers to augment family income.

  10. Great work! You get The BIG PICTURE Right and Simple.

  11. "Money is much too serious a matter to be left to central bankers" - from Milton Friedman's book Money Mischief.

    Looking for a smoking gun? Try negative real interest rates for several years, used primarily to support a FIRE sector and allow the political establishment to simultaneously cut taxes and increase spending.

    A PC would do a better job at growing the nation's money supply than politically appointed bureaucrats on the FOMC. At least it would be more impartial.

  12. Yes I saw Sicko. I hate Micheal Moore , but that was one of his more entertaining movies. I don't agree with him though, I found out that his hospital in cuba only treats diplomats and foreigners. I'm sure normal cubans get a hospital that looks more like what you'll find in India. I'm kind of torn though here I am paying $1750 a month in health insurance, but it's not like I would rather pay $1750 in extra taxes for the insurance. Money has to come from somewhere.

  13. re insurance vs. Universal health system

    That $1.750/mo. pays for a lot of "Mr. In-Betweens", from the insurance agent, all the way to the money manager investing the insurance money and the shareholders getting the dividends...and let's not forget everyone's beloved professional class... the tort lawyers (apologies to OkieLawyer)

    How much of the savings could be better spent, say subsidizing higher education?


  14. " Anonymous said...

    Sorry, dude, they are stupid, and like sheeple they are being led to the slaughter."

    Here we have the ideologue, telling us the way the world should be rather than responding to reality. You are superior to the hoi polloi, they deserve destitution if they can't muster their way through the sophisticated (corrupt) economic and political system like you clever guppies.

    "All of this is socialist posing for really bad choices made by really dumb people. That they were marketed this crap is not an excuse." By "marketed" are you also referring to how our recent trillion-dollar-plus military misadventure was marketed? How bout Citi's lobbying (payola) for the bailout of their financial misadventures--marketing too?

    By "socialist posing" are you including the socialist transference of wealth to the energy, agriculture, and transportation industries? Didn't think so.

    Let me see if I get the logic. If you give special tax breaks or tax revenues to Exxon, ADM, or Haliburton you're a good capitalist, but if you support the highest level of education and health care for all of your citizens you're an evil socialist.

  15. Your first graph shows a DECREASE in the rate of debt accumulation. But what about the TOTAL amount of personal debt - has this peaked?

    Debt carries a legal obligation to repay both the principal and the compounding interest. If wages/incomes stagnate the ability to service the existing debt is constrained - so how will the debt be repaid? Issue new debt!!

    One of your contributors mentioned the possible role of Central Banks in this debacle. They are definitely at fault. They adamantly refused to regulate the creation of massive amounts of credit by the non-banking sector.

    Re: your reading recommends:

    Bernstein's, Against the Gods is easy to read, informative and you are left with the distinct impression that investing is as 'safe' as betting at the racetrack!
    It has an excellent research-grade, reference bibliography.

    Brian P

  16. Great blog. This question is off topic but hopefully useful:

    If writers of CDS were to default en masse (not implausible given that HF's put up little capital), then presumably the notional value of those contracts would magically appear on the I-banks' books (as they are counterparty).

    So if you were an I-bank recipient of $100 billion in notional CDS, how would hedge it?

    It seems given your earlier posts that the optimal hedge would involve buying equity puts.

    Do you think this equity hedging is going on now? Is it the most likely transmission mechanism between the credit market crash (which has already happened) and the equities markets?

  17. As for anonymous saying that hospitals in Cuba look like those in India. Well . . . have you been to Cuba? Have you been to India? Well . . . I have, and those in Cuba on average are considerably better than those in India.

    So, once you get out of your ideological skin about Cuba, perhaps you could offer something constructive.

  18. Anonymous of 4:32 p.m.:

    You really have to wonder when millions of people suddenly began to make the same "stupid" mistake. Did the obesity epidemic arise because millions of people spontaneously lost their character and will to eat moderately? No. People in a society are subject to structural forces, and when they start to do new, "stupid" things in large numbers, it makes no sense to pin everything on the individuals. It takes some sophistication to understand the implications of debt, particularly when one constantly hears respected authorities like Alan Greenspan touting the virtues of expanded credit opportunities for ordinary people. Over the past several decades, how many people have been aware of the increasingly tenuous financial situation of the majority of the U.S. population? When people are told that buying on credit is good for them and good for the economy, and clever strategems are used to make it (seem) easy and painless, and almost no one in a position of authority warns them of the danger, of course they will get into debt. That's not stupidity. That's sociology.

  19. note the decline in income in 1980. Anyone recall who became president that year . . . which lead to increased privatization, deregulation, etc., through the 80's and right through the 90's? Might the shift in balance of 'power' between capital and labor, i.e. the decline in income, be related to the privatization, deregulation, etc?

  20. I found out that his hospital in cuba only treats diplomats and foreigners.

    Where did you "find this out"?

  21. Much of the increased cost of health care is due to improvements in quality (or at least quantity) of care. There are new treatments available for a lot of conditions, and there are a lot of new conditions being defined.

    (A few years ago I never heard of Restless Leg Syndrome, now thousands of people are taking expensive prescription meds for this "disease". There a lots of examples of things your garndparents would have just accepted as a normal, non-medical part of life that now need to be exhaustively evaluated and treated.)

    Of course, added to this is the aging population, defensive medicine, etc, but improved quality is a BIG part of this.

    On the other hand, is higher education really that much better than it used to be? Can improvements even begin to justify cost increases much higher than inflation.

    I think that higher education is more expensive primarily because the schools charge what the market will bear. And the system has presented the consumers with more available money (student loans with 30-year terms and adjustable payments, etc). The more aid that is available, the more the schools can jack up tuitions; and the more tuitions rise, the more Congress is concerned about the struggling middle class, and the more money is made available for loans. Add other freely available funds (home equity withdrawal, etc) and you pretty much have a bubble recipe.

  22. Anon. said: That's not stupidity. That's sociology.

    Second that. Here's a famous example:

    Ed Bernays was hired in 1928 to turn women into smokers (and cancer and heart disease victims). Until then female smoking was social taboo and even illegal in some states. The tobacco moguls were foregoing profits from 50% of the population.

    What did Berneys do? He consulted a psychoanalyst and linked the nascent womens' rights movement with the right to smoke. "Torches of freedom", he called them. Movie studios were paid to have flappers smoke on screen, etc. etc.

    BANG. Profits zoomed.. Brought to you by the science of manipulating the public.

    The PR industry thinks this one of their greatest accomplishments. They even have it prominently showcased in their Museum of Public Relations online.

    Go to:
    www.prmuseum.com and look under Berneys.

  23. Well said, Marcus.

    Many people who were born on third base grow up thinking they hit a triple.

  24. Hellasious,

    You are one impressive name dropper. Edward L. Bernays is someone who we would do well to study. He not only wrote the seminal works in the field of Public Relations, he gave it its name. And being the double nephew of Freud, he was no stranger to psychology.

    I notice that his "Pulic Relations" is back in print. About 10 years ago (around the time he died) I went looking for it in one of the largest university libraries anywhere and had to wait for it to be dug out of off site storage for seldom requested volumes. It remains the foundation of how to get people to act irrationally against their own self interest.

  25. vtdoc:

    Your comment has left me with a lot to comment on:

    In the area of health care, while I agree that there have been many medical advances and the aging population creates a greater demand on our health care system, it is also true that we have lagged behind in the creation and hiring of medical personnel to meet said increased demand. Why? I suspect to keep salaries for medical professionals in line with prior expectations. Is that the only reason? No, of course not; but it certainly contributes. So do stories like this one: Young doctors with $500,000 in student loan debt.

    Now, on the issue of student loan debt: when the Republicans came to power in Washington, they pushed private lending over cheaper government-sponsored student loans (Direct Loans).

    Yes, with the advent of the Information Age, there is a lot more necessary information to learn to stay competitive. But we in the U.S. are saddling our children's potential by debt to have them fail before they have a chance to start.

    I followed up on an editorial by Bob Herbert by adding some of my own experiences. But I particularly like something Mr. Herbert wrote:

    Tamara Draut, in her book, “Strapped: Why America’s 20- and 30-Somethings Can’t Get Ahead,” tells us:

    “Back in the 1970s, before college became essential to securing a middle-class lifestyle, our government did a great job of helping students pay for school. Students from modest economic backgrounds received almost free tuition through Pell grants, and middle-class households could still afford to pay for their kids’ college.”

    Since then, tuition at public and private universities has soared while government support for higher education, other than student loan programs, has diminished.

    This is a wonderful example of extreme stupidity. America will pony up a trillion or two for a president who goes to war on a whim, but can’t find the money to adequately educate its young. History has shown that these kinds of destructive trade-offs are early clues to a society in decline.

    Hellasious: Here is a book I recommend:

    Tamara Draut: Strapped: Why America’s 20- and 30-Somethings Can’t Get Ahead

  26. Following on in the vein of the evil Edward Bernays'(I employ the term evil only slightly tongue in cheek) wondrous achievement in snookering women into taking up smoking, see the you tube clip of late filmamker Aaron Russo discussing a conversation he once had with one of the Rockefeller's concerning who was behind the Women's Liberation movement. Hint: Keeping corporate costs down by freeing up labor.

    And allow me to second those who have put the ignominious anonymous poster, he of "they are stupid", in his place.

  27. American Health Care The typical morbidly obese patient that I have worked with comes into the hospital in respiratory distress somewhere in their late forties. They need to trached and put on a vent. In order that they will not pull out their trach they are sedated and restrained. It can take up to eight nurses to roll and clean them three times a day. Many caregivers get career ending injuries working with these patients. They need special beds with air mattresses that rotate pressure underneath to help mininmize skin breakdown. Many times they still wind up with massive wounds as their weight pushes the limit of what the beds and staff can handle. The patient typically is in fluid overload and most of their weight loss in the hospital is due to diuretics. After one to two months of getting fluid off the patient begins to be started to wean off the vent and begins to be mobilized. By now they have become severley deconditioned and have to be gotten out of bed with a crane. If they keep losing fluid and weight they take a couple of months to get back on their feet before geting ready to go home. Most nursing homes will not take these patients as they do not get paid enough to make it worthwhile. This insures that they stay in the acute hospital longer at greater cost. Most do not have insurance as they have not been working prior to coming to the hospital. . Is this the end? No becasue of their size and eatings habits they begin to skip their diuretics to prevent the mutiple times of going to the bathroom. This leads back to the hospital where we get to repeat the processs. I have heard of the bill being for some running in the millions. When else in the history of the world could this happen?

  28. I second Okielawyer's book recommendation. I remember an interview of its author on NPR when it came out. One of the searing statements went something like, "it's not that people in their late 20s and early 30s don't want all the things their parents had at that age -- marriage, children, mortgage -- it's that they can't afford them." A hard and sober truth indeed.

    I'm aquainted with a number of kids of that generation and their lives and prospects really are a function of whether they had to start out in debt from college tuition. When I'm in a cruel mood I tell them about how state university tuition in California didn't cost anything for in state students until Reagan was elected governor. The very idea is beyond their imagination. Such fantasies are for places like France.

    It looks to me like 1980 was the tipping point. That's when the boomer market rally kicked in on cue, and that's when power shifted away from labor to its lasting detriment. Since we're tossing out books I'd add Barbara Ehrenreich's "Fear of Falling"which examines the insanity of Reagan democrats. Her more recent books are excellent too if you like the kind of writing that puts a face on the hampster class.

  29. Baumol's Disease: In a paper (I think in 1969) William Baumol explained that the cost of services would rise faster than the cost of agricultural and manufactured goods. This is true of all services which are resistant to automation and agricultural and manufactured products where labor saving technologies can be applied. So stockbroking has been automated to a large degree and its price has fallen but education and medicine are hard to automate so their prices have risen faster than the average good or service in the economy. Inflation indices track that average good or service. In higher education there are a few other drivers of cost too:

    1. Demand by students for better quality dorms, sports facilities, food, computer technology etc.

    2. Decline of state financial support for state universities.

    3. At elite private universities the full tuition is born by people from wealthy families whose incomes have risen faster than the average population's. The median student gets a lot of a financial aid at those schools which has also increased over time. It's likely that the average amount actually paid hasn't risen as fast as the full tuition number.

  30. Citing SICKO which has been shown to be a cheap propaganda film filled with inaccuaricies and down right lies (like all of Moore's work) took away a lot of your credibility in my eyes. Your extreme pessimism and hatred of debt also out you as a bitter leftist. Your cluelessness on CDS as exposed by a CDS trader is another sign of you bitting off more than you can chew. You make some interesting observations but now that I see your ideological bias it is all clear.

  31. To correct one thing, Real Weekly Earnings (in constant 1982 dollars) for production or nonsupervisory workers on private nonfarm payrolls Peaked in 1972, fell 19% between that year and 1993 before beginning a sluggish rise into 2000 when they were still 14% below peak. The period since 2000 has seen this measure stagnate at best -- which, without being overly political, is to say that wage decline and stagnation has been bipartisan acceptance of a neoliberal, 'the market knows best', agenda in favor of capital.

  32. Peaked in 1972, fell 19% between that year and 1993 before beginning a sluggish rise into 2000 when they were still 14% below peak. The period since 2000 has seen this measure stagnate at best

    Hmmm, what could have happened between 1993-2000? Oh wait, I know: A Democrat was in the White House.

  33. Hellasious, that was a superb post.

    Education costs have been a heavy burden on working-class people in my generation (born '68) and afterwards.

    I have witnessed the gap widen between my peers who had full parental financial backing, and those who had lacked such backing.

    This effect will only compound over time.

    Another thing to bear in mind is what I call credentials inflation. An increasingly competitive labur market has led many people to borrow money and pile on the credentials.

    To be sure, more education can increase productivity. But especially in non-technical fields, I see many instances in which the credentials needed to obtain work far exceed the education really needed to do the job.

    Employers have their pick. Other things being equal, why wouldn't they hire someone with more credentials?

    In effect, parts of the labour market have seen a credentials bidding war for decent employment. This is a bidding war which over time, those from poorer households will tend to lose out.

    One will therefore witness the widening and hardening of social class divisions.