Balancing Rock

By: Michael Ashton | Wed, Jul 27, 2005
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For just a day, let's forget about the bombs detonating in various cities from London to Egypt, and look at the bigger picture.

Although it isn't typically part of this commentary, that segue suggests that I first start with the geopolitical picture. In my view, the War on Terror has been a success so far in that it has occupied the terrorists far from our shores. A good offense constitutes the best protection for a porous defense (just ask the Indianapolis Colts), and as much as the wars in Afghanistan and Iraq have cost I wonder if it would have cost appreciably less to make the homeland perfectly secure...and cleaning up the mistakes... even had we been willing to accept the restrictions on our liberties that it would have required. No, a good general works hard to dictate the time and place of the engagement, and while suicide bombers continue to bash our forces from time to time the simple fact is that we have chosen the battlefield we prefer: Iraq, not Manhattan. And if as a side-effect we establish a seed of democracy in the land of the Tigris and Euphrates, then so much the better.

And so - to my mind the greatest threat to our country and our prosperity at the moment is not, in fact, al-Qaeda or any of its imitators. The threat is systematic, it is internal, and is the same as has been faced by numerous economies in the past: greed, and in the case of the United States (and western nations generally) a sense of entitlement that goes along with it.

It was greed that got countless Americans in the position of shooting for the moon in poorly-researched companies and in buying real estate without understanding the costs and risks thereof. It is the sense of entitlement that prevents us from confronting the hard choices we face: to collectively, as a society, live within our means...and indeed, to live well within our means so as to pay back the profligacy of the past. This profligacy did not occur without enabling. Social Security is a disaster that has helped teach Americans that they don't need to save for their own retirement; along with Medicare and the entire entitlement architecture, it has nurtured dependent citizens. The problem is that the dependent citizens have been told that they're not dependent; that they have a right to benefits provided by the morefortunate. And, when those morefortunate don't have enough to provide to the dependents...we can simply borrow and make everyone happy. For a time.

The Fed under Greenspan has been an enabler as well, by underwriting an enormous expansion of money and credit and the institutional infrastructure that is needed to support it. And this has led to the awkward situation that, thanks to this infrastructure, it isn't at all clear how this awfully imbalanced situation gets resolved. The infrastructure has developed a self-defense mechanism much like the self-aware computers in Terminator. Play the following game with your friends: pick an imbalance, and describe how the imbalance might end. Then your friend comes up with the institutional response that avoids the "payback." You follow that by trying to come up with a way that that imbalance gets resolved. Your friend counters with the institutional response. And so on. The game ends when you both get frustrated and go grab a beer. Because it's all about friends.1 Example:

Player 1: "Housing prices begin to fall because money supply declines, sapping the buying power of asset purchasers."

Player 2: "Mortgage originators buy appraisal companies whose bonus is tied to the number of properties that close after they appraise them. Since a higher valuation is more likely to close, appraisers keep upping the ante."

Player 1: "The loans which are made on this basis will clearly have a higher default rate..."

Player 2: "Originators create a 'zerocoupon' product: a balloon mortgage that doesn't require intervening payments but rather accrues them. Therefore, no default until the balloon comes due!"

Player 1: "...but the balloon comes due and then the bonds backed by these loans default."

Player 2: "No, the bonds are made so all the loans in them mature at the same time. And any homeowner who can't pay naturally rolls into a new mortgage, with new fees for the mortgage company (they don't care...they don't hold the risk)..."

Player 1: "Let's grab a beer."

This is what makes prognostication in this environment especially difficult. There are rocks, after all, that remain precariously balanced for thousands of years (see below - does anyone know where this rock is located?). So it is impossible to know when the fall will happen. All we can do is monitor the stresses.

At present, the biggest stresses are in the debt world, where the ratio of nonfederal debt outstanding to GDP continues to climb to levels never before seen in recorded history (see Chart below). That we can sustain such levels as these is testimony to the power of American financial hegemony but also a testimony to the determination of the institutional infrastructure. Note the declining section of the chart, in the early '90s and roughly where the second arrow points. That corresponds to the biggest banking crisis of the post-depression era: the S&L bailout of the late-'80s/early '90s. Recall that at the time, the federal government bailed out the sector and the Fed eased aggressively in an attempt to fend off the credit crunch ("forty-mile-per-hour headwinds" as Dr. Greenspan referred to it at the time). This moved debt from private balance sheets to public balance sheets, but also impeded the borrowing binge for a number of years after the crunch officially ended. Indeed, had the Fed not kept rates so low for so long in the early part of the decade, the 1990s might have been a time when a decade's worth of expansion and the accompanying imbalances could have been flushed, creating the conditions necessary for the economy to move forward to broad, sunlit uplands (to borrow a phrase from Winston Churchill).

Essentially, in the early 1990's we eschewed several years of pain and several decades of growth in favor of a few years of growth and many more years of pain as the imbalances unwind.

A word about the construction of the chart: the ratio here plotted is the ratio of the non-federal debt, deflated by the GDP Price Index, to Chain-Weighted GDP - so it is the ratio of real debt to real output. If you simply take the ratio of outstanding debt to GDP, you get a more or less continually-rising line. This happens because inflation is good for debtors: as time passes, the number of dollars a debtor owes remains constant while the value of those dollars declines (in an inflationary period). So, in periods like the early 1980s, debtors naturally improved their situation - except that, in fact, they did not...they ladled on additional debt fast enough that the overall debt burden did not appreciably decline despite the recession. In the 1990s, the credit-crunch reduced the amount of real debt per dollar of GDP (but the total amount of real debt did not decline just stopped growing while the economy expanded slowly).

The overall message of the chart is this: in recessions, Americans tend to maintain their standard of living by assuming debt. While recessions tend to slow this borrowing somewhat, the growth of money has enabled borrowers to extend the game repeatedly.

The really amazing thing about the chart is that there is no sign whatever of the recession of the 'aughts. The Fed's tap was turned on so fast, and the American habit of borrowing to get through recession was so ingrained, that even though real economic growth slowed during the recession real debt growth did not. And therefore, the beneficial purgative effect - in which the market's capacity to lend more money is freed up for new enterprises, which drive the new expansion - never happened.

This is fascinating stuff. Americans had grown so accustomed to having debt inflated away that once inflation had died they got into trouble by sticking to their old habits (a profligate Fed policy didn't help the economy re-set, either). It isn't that they had actually thought, over the years, about their debt going down in real terms; it merely got easier to service as their incomes kept growing in terms of constant dollars. I suspect, incidentally, that if I were to break this chart down further into consumer debt and corporate debt, you'd see little difference: in my personal interactions with corporate CFOs, I did not generally sense that they understood the implications of the observation that in a period of low inflation, the drift of their balance sheets away from an optimal capital structure would be slower (the implication being that corporate treasurers should issue inflation-linked debt partly to reduce rebalancing costs in the capital structure).

We are overdue for another flat-todeclining part of this chart, at least. How might this happen? If the economy is growing at 4%, is there any chance that Americans will proactively restrain their borrowing habits so that their debt will only grow at 2%?

If growth slowed, to 2% or less for example, then I suspect the situation gets worse. Here is where the sense of entitlement emerges as a problem: Americans, believing that their standard of living is a right, would maintain that standard of living by borrowing.

I can see two ways out of this situation: (1) a wave of defaults as companies and individuals simply get overstretched. Note that, if the government bails out companies, this could lead to inflation in the long run since regimes that are indebted tend to inflate their way out of trouble whereas societies that are indebted tend to end up in deflation - so if the debt moves from private to public, you could some day get an inflation surge. But in the short-term, it represents wealth destruction and is deflationary. (2) The Fed restrains money and credit sufficiently so that they actually cause a credit crunch, rather than resisting it. This will not happen under Greenspan, at least intentionally, nor under any of the candidates for Fed Chairman reportedly being considered by the Administration. However, it is not at all clear to me that it is in the Fed's power to actively prevent a credit crunch once one gets started, so this is a dangerous game in any case.

Either way, the denouement is likely to be a painful one...once the rock tips!

And it may already have begun tipping. Money growth is anemic at present; MZM is flat over the last six months and growing at a 1.5% rate over the last year. M2 is growing at 3.3% over the last year. And M3 is in the 5.5% range. This is not an accommodative monetary policy, and it argues for nominal growth around 3.5%, which puts real growth around 2% if inflation is tame. And the real risk, of course, is that a slowing economy could tip the rock right over into a worse outcome as nonlinear effects take over.

Tomorrow's Events:

On Tuesday the pulse of economic data quickens with the release of July Consumer Confidence (Consensus: 106.3 from 105.8). If the tales of a resurgent economy are true, Confidence should be among the first indicators to really blast off. So far, it has not, although the current level represents a three-year high.

Also on Tuesday, the Treasury will auction 20y TIPS bonds in a reopening of the Jan-25 issue. At a closing yield of 2.06% today, this is the cheapest issue on the curve and, in today's environment, 2% is a quite reasonable real yield. I like the issue and I don't think $6bln is a big pill to swallow.

In tomorrow's comment, I will take today's big themes and focus on the market implications of them...and also look past the market implications of those themes to the more-immediate question of how markets are likely to trade nearterm while the big themes are waiting to play out.

Question of the Day: What do the four petals of the clover of the 4-H club's symbol stand for?

Answer to Prior Question: The question was, "What famous text took three years to print?" The 1284-page Gutenberg Bible, printed in 1455, took several years to print using medieval technology.

1 In the gloom-and-doom game, this is known as "comic relief."


Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Disclaimer: The commentary set forth herein is the opinion of Ashton Analytics, LLC and is not a recommendation to purchase or sell any securities. The predictions contained herein are merely the opinion of Ashton Analytics, LLC and are not necessarily an indication of future performance or trends. Market indexes are included in this commentary only as context reflecting general market results during the period. The charts, graphs and descriptions of market history and performance contained herein are not representations that such history or performance will continue in the future or that any investment scenario or performance discussed herein will even be similar to such chart, graph or description. All information and opinions contained herein is subject to revisions and completion.

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