Variations On A Theme

In today's post I will revisit the theme of too much debt vs. earned income.


Are you familiar with Bach? Unlike most composers, if you play his piano music separately for each hand you will likely just hear random notes, frequently dissonant instead of harmonic. But put both hands together and his genius becomes apparent. Two, three and sometimes even four distinct voices are intertwined for your listening pleasure - assuming you are not tone deaf, of course.

Well, it is quite obvious that many economists and policy makers are, in fact, tone deaf to the multiple voices of the economy. And no matter that piano is scored for both hands*, they keep trying to make music by playing only the "right" hand notes: Lower interest rates, more liquidity injections, tax rebates to boost consumption. For some reason they continue to ignore the more fundamental "left" hand: earned income - which is, after all, the entire support mechanism for asset prices and credit quality.

Below is part of the score in chart form - think of it as sheet music: The top blue line (equivalent to the right hand) is household debt growth, directly related to asset prices, interest rates and liquidity. The bottom red line (the left hand) is growth in earned income. They each provide a very different tune and, just like with Bach, you need both to get the proper music going.

Annual growth in household debt (blue) and hourly earnings (red)

It is no surprise, therefore, that after repeated attempts at right-hand only concerts the economy's self-styled virtuosos (Fed and Treasury), are failing to please the audience (markets). Many previously devoted fans are increasingly perplexed and some are even looking anxiously towards the exits. The music critics in the popular media are starting to take notice.

But enough with the Bach divertimento - back to the economy.

Earned income growth trailed debt badly for 15 years, with the divergence becoming very pronounced after 1999. The economic recovery after 2001 was, thus, largely a mirage produced by debt: people did not spend money they earned, but money they borrowed. What we are experiencing now - the credit crisis - is the expected result: borrowers are swamped by debt payments they cannot possibly meet.

The shortfall between income and debt service requirements is leading to the rapid abandonment of leveraged assets, including homes, automobiles, LBOs and all manner of structured finance schemes. As assets are cast away their prices drop, leading to generalized markdowns.

Where the leverage was very high - and it was very high in many instances - a vicious cycle ensues where lower prices result in margin calls and forced liquidations, i.e. a self-reinforcing negative feedback loop: lower prices create more supply. This is the opposite of what we expect from classical "invisible hand" supply-demand curves. It is also the reason why such a virulent crisis could result in a systemic meltdown, if left to continue without proper intervention.

It is essential to realize that assets being upside-down versus their loans (negative equity) is not a cause of the credit crisis, but a result.

The root cause of the credit crisis is that many loans are too large versus the present value of the income streams of the borrowers, after living expenses.

An important corollary from this observation is that keeping wage increases low - as many economists frequently advise - further weakens this negative balance, ensuring continued pressure on asset prices in the future.

It is quite clear from the above that if a generalized crisis is to be avoided policy must be directed immediately towards enhancing the earned income of working people, i.e. increasing their after-tax wages and salaries. Some may object on the grounds that such actions will create demand-driven structural inflation. However, given the parlous state of household finances, I believe the risk of such a development is very small. With the personal saving rate at an unsustainable zero/negative range and given the proper inducements, people will elect to rebuild savings instead of spending the extra income.

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(*) For you piano buffs, there are a few lovely pieces written exclusively for the left hand. To me, the most beautiful are Scriabin's Prelude and Nocturne. Click below for the Nocturne. Ignore the cheezy balloon decor, the performance is excellent.