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Five Things: Do We Need Debt to Recover?
By
Kevin Depew
Aug 14, 2009 2:45 pm
Why attempting to solve the crisis with the very same policies that caused the crisis is doomed to failure.
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1) Do We Need Debt to Recover?
This is a good question. Do we? According to the Wall Street Journal, citing a recent study of all nine post-World War II U.S. recessions by Barclays Capital, the answer may be, not really.
According to the study, in the first year of recovery net new borrowing almost always lags behind the increase in nominal gross domestic product, incomes and profits so that debt as a proportion of GDP falls. The article also points out that "stripping out residential mortgages, private-sector borrowing -- both by households and the corporate sector -- actually fell in the first year of recovery in each of the nine recessions." (More on that in today's Number Three Item.) And so the conclusion reached in the article is that, "the lack of availability of bank credit is clearly a problem -- but not necessarily the disaster some people think."
I disagree, and the chart below, from the same article, is the reason why.
The premise of this chart is "Back From the Brink." After disastrous GDP prints in the U.S. and Euro zone during Q1, the fact that Q2 showed marked improvement, even while still negative, is chief among the reasons for this newly found optimism about the economic recovery. The third and fourth quarters will also likely add significant fuel to the optimist's fire.
The reality, however, is more grim because this glimmer of optimism is grounded in a false premise; namely, that foreclosures, defaults and delinquencies (debt destruction) are accurately stated.
Because the government and the Federal Reserve are either directly or indirectly supporting so much debt, the destruction of it is being under-reported. And so a false picture of economic health and recovery has emerged. Let's see what this entails by looking a bit closer at the disease this debt destruction is trying to cure.
2) By Definition, the Disease Cannot Also Be the Cure
Yesterday Austrian economist Patrick Barron wrote a terrific essay, "The Real Cause of the Current Economic Crisis and Its Cure," clearly describing what is taking place in simple terms.
"The government's attempt to solve and/or ameliorate the current crisis will only make matters worse, because it is attempting to solve the crisis with the very same policies that caused the crisis--namely, excess fiat money credit expansion," Barron writes.
And I agree. The critical thing to understand about bailouts and the government-led rescue of industries ranging from finance to autos to housing is this:
"Since the government can spend only what it takes from the people, its increased spending will drive the people to poverty even if the spending is on what many might consider worthy infrastructure projects."
By definition, the government can only spend what it gets, or takes, from the people. Think about that. If you understand what that means, then you can understand the long-term consequences of everything that is happening today, which leads us to today's Number Three item... because no discussion of government intervention can be complete without a run-down of the ongoing Deflation vs. Inflation debate.
3) Inflation vs. Deflation... Again
This morning I caught two competing headlines that, at first glance, seem puzzling.
Safeway Lowers Prices
Grocery chain Safeway (SFWY) follows competitors as consumers look to cut expenses in recession
- Baltimore Sun
Monsanto to Charge as Much as 42% More for New Seeds
Monsanto (MON) plans to charge as much as 42 percent more for new genetically modified seeds next year than older offerings because they increase farmers' output.
- Bloomberg
Ok, so what can this possibly mean? Inflation and deflation at the same time? Stagflation? Let's take a look.
Inflation is an increase in the money supply. When the effects of that increase are rising nominal prices then the real value of money is eroded. We have had inflation for decades now, which necessarily sows the seeds for deflation, and which can only occur after a prior inflation. Stagflation is a stopping point in that transition.
Deflation, however, occurs when the money supply EVEN IF INCREASED fails to exceed the demand to hold dollars at the prevailing price level. This is important to understand. Following nominal price levels alone will never yield an accurate view of whether we are experiencing deflation. Over the past two years, the money supply has increased dramatically, but the velocity of transactions has continued to decline because people are using those increased dollars to destroy debt, or simply saving them.
This can clearly be seen in the monetary aggregate charts. (See the charts here via St. Louis Federal Reserve). Pay particular attention to the chart of M2, because that is the area where Fed expansion policies have the least impact. If you want to understand what keeps Federal Reserve Chairman Ben Bernanke up at night, then all you need to do is consider how much Fed activity it has taken to simply prevent M2 from totally collapsing.
But back to our two stories, Safeway and Monsanto. Again, following nominal prices alone is at best misleading, and at worst irrelevant to understanding REAL deflationary effects. Prices are merely one symptom of inflation and deflation, not in and of themselves predictors or indicators.
In order to understand deflation it is necessary to tear yourself away from price levels and focus on 1) declining asset values, 2) availability of AND DEMAND FOR credit, 3) real liquidity and 4) debt destruction and balance sheet repair.
But it is even much simpler still. Why does nominal price not matter? Think about it this way: does any producer anywhere really want the price of what they make to remain the same forever? Perhaps, if living in a vacuum. But in the real world, it is hoped that the real value of the goods they produce will increase. But this can happen regardless of nominal price levels. It can happen through productivity increases or even through changes in the psychology of consumers. It can happen as well via changes in real interest rates and the value of the currency that is being used as a medium of exchange.
Because we live in a world where the central bank has been constantly (over many decades now) increasing the supply of money in the economy, we have been conditioned to view nominal price changes (which have been mostly up for many things) as real indicators of profitability and value. The reality is that nominal prices are nothing of the sort.
The key to understanding this is to recognize that deflation is a psychological shift among consumers and businesses in time preferences and risk appetites. The Fed can make credit available, but they cannot make lenders lend, or potential borrowers take on more debt even when borrowing costs truly are inexpensive and it makes economic sense to take on more debt.
Real lending and economic activity will only begin when real savers see real value at the right risk. That will only occur in the short-run with vastly lower prices, or in the long-run with stagnant prices and the benefit of time.
4) But Don't Just Take My Word for It...
Because DeMark indicators provide the technical foundation for how I look at markets, I work backward from what they are suggesting to consider what possible macro pieces need to be at work for the indicators and exhaustion points to be fulfilled. So, let's back up for a moment and try to fit together what the larger puzzle pieces are saying.
The U.S. stock market is showing signs of long-term exhaustion as the S&P 500 needs to decline below 783.32 just to complete a TD Buy Setup...
S&P 500, Quarterly
CLICK TO ENLARGE
... while the U.S. Dollar Index Spot is currently on bar 11 of a potential 13 TD Sequential Buy Signal...
USD Index Spot, Quarterly
CLICK TO ENLARGE
... and DeMark readings on the Consumer Price Index not yet showing signs of long-term exhaustion.
CPI Year-Over-Year, Monthly
CLICK TO ENLARGE
5) Bottled Water Revisited
The Washington Post earlier this week observed that sales of bottled water have fallen for the first time in at least five years. And on Wednesday Nestle (NSRGY), the largest seller of bottled water, reported that profits fell 2.7% for the first six months of the year.
According to the Post, Americans drank 8.7 billion gallons of bottled water last year, compared with 8.8 billion in 2007 -- the first decline this decade - while per capita consumption dropped from 29 gallons to 28.5. "Jeff Cioletti, editor in chief of trade publication Beverage World, said he doesn't believe bottled water will return to galloping growth for a long while."
And I agree. But it's not for the reasons most people think. I first looked at bottled water for Five Things in 2008, and based on social mood it was relatively easy to predict the perfect storm gathering on the horizon for one of America's biggest luxury items, bottled water.
"Forbes called it "Bottlemania." BusinessWeek recently thrust the issue into it's so-called "Debate Room,": "Bottled Water IS a Big Drain, Pro or Con?" New York City Mayor Michael Bloomberg intends to co-sponsor a resolution to prohibit city spending on bottled water. Meanwhile, Americans drank more than 30,000,000,000 bottles of single-serve water
last year. What's going on here? After all, the bottled water industry is, technically, 30 years old. Suddenly, bottled water is a ripoff? A waste? Or worse, dangerous? What changed?
One thing. Social mood.
Make no mistake, there is nothing wrong with tap water, and there never has been. As the BusinessWeek article points out, we pay up to 4,000 times more for bottled water than tap water, and more than three times what we pay for gasoline; all this for water that is far less regulated and which frequently tests worse than tap water in both taste and purity. Pepsi's (PEP) Aquafina label bottled water is actually tap water. So is Coca-Cola's (KO) Dasani bottled water.
So why do we suddenly care now? Simple, as social mood continues to darken and turn against symbols of excessive wealth and consumption, the former icons of bull market glee and prosperity begin to tarnish in the public eye.
There is absolutely nothing wrong with bottled water other than its cost over tap water. For 30 years it's been fine to pay for the convenience and fashionable appearance of water in a bottle. Now, however, it's something to rail against as mood shifts. Social mood will seek to portray this as a war against waste and excessive cost, but it's actually grounded in the psychological need to vilify the old signs of overconsumption in order to accept the reality of cutting back. The acceptance of that reality is easier if we are able to manufacture something "wrong" with that which is just beyond our economic reach.
So sit back with a tall glass of refreshing tap water and enjoy the rush to disassociate from yet another fading idol of the bull market.
This is a good question. Do we? According to the Wall Street Journal, citing a recent study of all nine post-World War II U.S. recessions by Barclays Capital, the answer may be, not really.
According to the study, in the first year of recovery net new borrowing almost always lags behind the increase in nominal gross domestic product, incomes and profits so that debt as a proportion of GDP falls. The article also points out that "stripping out residential mortgages, private-sector borrowing -- both by households and the corporate sector -- actually fell in the first year of recovery in each of the nine recessions." (More on that in today's Number Three Item.) And so the conclusion reached in the article is that, "the lack of availability of bank credit is clearly a problem -- but not necessarily the disaster some people think."
I disagree, and the chart below, from the same article, is the reason why.
The premise of this chart is "Back From the Brink." After disastrous GDP prints in the U.S. and Euro zone during Q1, the fact that Q2 showed marked improvement, even while still negative, is chief among the reasons for this newly found optimism about the economic recovery. The third and fourth quarters will also likely add significant fuel to the optimist's fire.
The reality, however, is more grim because this glimmer of optimism is grounded in a false premise; namely, that foreclosures, defaults and delinquencies (debt destruction) are accurately stated.
Because the government and the Federal Reserve are either directly or indirectly supporting so much debt, the destruction of it is being under-reported. And so a false picture of economic health and recovery has emerged. Let's see what this entails by looking a bit closer at the disease this debt destruction is trying to cure.
2) By Definition, the Disease Cannot Also Be the Cure
Yesterday Austrian economist Patrick Barron wrote a terrific essay, "The Real Cause of the Current Economic Crisis and Its Cure," clearly describing what is taking place in simple terms.
"The government's attempt to solve and/or ameliorate the current crisis will only make matters worse, because it is attempting to solve the crisis with the very same policies that caused the crisis--namely, excess fiat money credit expansion," Barron writes.
And I agree. The critical thing to understand about bailouts and the government-led rescue of industries ranging from finance to autos to housing is this:
"Since the government can spend only what it takes from the people, its increased spending will drive the people to poverty even if the spending is on what many might consider worthy infrastructure projects."
By definition, the government can only spend what it gets, or takes, from the people. Think about that. If you understand what that means, then you can understand the long-term consequences of everything that is happening today, which leads us to today's Number Three item... because no discussion of government intervention can be complete without a run-down of the ongoing Deflation vs. Inflation debate.
3) Inflation vs. Deflation... Again
This morning I caught two competing headlines that, at first glance, seem puzzling.
Safeway Lowers Prices
Grocery chain Safeway (SFWY) follows competitors as consumers look to cut expenses in recession
- Baltimore Sun
Monsanto to Charge as Much as 42% More for New Seeds
Monsanto (MON) plans to charge as much as 42 percent more for new genetically modified seeds next year than older offerings because they increase farmers' output.
- Bloomberg
Ok, so what can this possibly mean? Inflation and deflation at the same time? Stagflation? Let's take a look.
Inflation is an increase in the money supply. When the effects of that increase are rising nominal prices then the real value of money is eroded. We have had inflation for decades now, which necessarily sows the seeds for deflation, and which can only occur after a prior inflation. Stagflation is a stopping point in that transition.
Deflation, however, occurs when the money supply EVEN IF INCREASED fails to exceed the demand to hold dollars at the prevailing price level. This is important to understand. Following nominal price levels alone will never yield an accurate view of whether we are experiencing deflation. Over the past two years, the money supply has increased dramatically, but the velocity of transactions has continued to decline because people are using those increased dollars to destroy debt, or simply saving them.
This can clearly be seen in the monetary aggregate charts. (See the charts here via St. Louis Federal Reserve). Pay particular attention to the chart of M2, because that is the area where Fed expansion policies have the least impact. If you want to understand what keeps Federal Reserve Chairman Ben Bernanke up at night, then all you need to do is consider how much Fed activity it has taken to simply prevent M2 from totally collapsing.
But back to our two stories, Safeway and Monsanto. Again, following nominal prices alone is at best misleading, and at worst irrelevant to understanding REAL deflationary effects. Prices are merely one symptom of inflation and deflation, not in and of themselves predictors or indicators.
In order to understand deflation it is necessary to tear yourself away from price levels and focus on 1) declining asset values, 2) availability of AND DEMAND FOR credit, 3) real liquidity and 4) debt destruction and balance sheet repair.
But it is even much simpler still. Why does nominal price not matter? Think about it this way: does any producer anywhere really want the price of what they make to remain the same forever? Perhaps, if living in a vacuum. But in the real world, it is hoped that the real value of the goods they produce will increase. But this can happen regardless of nominal price levels. It can happen through productivity increases or even through changes in the psychology of consumers. It can happen as well via changes in real interest rates and the value of the currency that is being used as a medium of exchange.
Because we live in a world where the central bank has been constantly (over many decades now) increasing the supply of money in the economy, we have been conditioned to view nominal price changes (which have been mostly up for many things) as real indicators of profitability and value. The reality is that nominal prices are nothing of the sort.
The key to understanding this is to recognize that deflation is a psychological shift among consumers and businesses in time preferences and risk appetites. The Fed can make credit available, but they cannot make lenders lend, or potential borrowers take on more debt even when borrowing costs truly are inexpensive and it makes economic sense to take on more debt.
Real lending and economic activity will only begin when real savers see real value at the right risk. That will only occur in the short-run with vastly lower prices, or in the long-run with stagnant prices and the benefit of time.
4) But Don't Just Take My Word for It...
Because DeMark indicators provide the technical foundation for how I look at markets, I work backward from what they are suggesting to consider what possible macro pieces need to be at work for the indicators and exhaustion points to be fulfilled. So, let's back up for a moment and try to fit together what the larger puzzle pieces are saying.
The U.S. stock market is showing signs of long-term exhaustion as the S&P 500 needs to decline below 783.32 just to complete a TD Buy Setup...
S&P 500, Quarterly
CLICK TO ENLARGE
... while the U.S. Dollar Index Spot is currently on bar 11 of a potential 13 TD Sequential Buy Signal...
USD Index Spot, Quarterly
CLICK TO ENLARGE
... and DeMark readings on the Consumer Price Index not yet showing signs of long-term exhaustion.
CPI Year-Over-Year, Monthly
CLICK TO ENLARGE
5) Bottled Water Revisited
The Washington Post earlier this week observed that sales of bottled water have fallen for the first time in at least five years. And on Wednesday Nestle (NSRGY), the largest seller of bottled water, reported that profits fell 2.7% for the first six months of the year.
According to the Post, Americans drank 8.7 billion gallons of bottled water last year, compared with 8.8 billion in 2007 -- the first decline this decade - while per capita consumption dropped from 29 gallons to 28.5. "Jeff Cioletti, editor in chief of trade publication Beverage World, said he doesn't believe bottled water will return to galloping growth for a long while."
And I agree. But it's not for the reasons most people think. I first looked at bottled water for Five Things in 2008, and based on social mood it was relatively easy to predict the perfect storm gathering on the horizon for one of America's biggest luxury items, bottled water.
"Forbes called it "Bottlemania." BusinessWeek recently thrust the issue into it's so-called "Debate Room,": "Bottled Water IS a Big Drain, Pro or Con?" New York City Mayor Michael Bloomberg intends to co-sponsor a resolution to prohibit city spending on bottled water. Meanwhile, Americans drank more than 30,000,000,000 bottles of single-serve water
last year. What's going on here? After all, the bottled water industry is, technically, 30 years old. Suddenly, bottled water is a ripoff? A waste? Or worse, dangerous? What changed?
One thing. Social mood.
Make no mistake, there is nothing wrong with tap water, and there never has been. As the BusinessWeek article points out, we pay up to 4,000 times more for bottled water than tap water, and more than three times what we pay for gasoline; all this for water that is far less regulated and which frequently tests worse than tap water in both taste and purity. Pepsi's (PEP) Aquafina label bottled water is actually tap water. So is Coca-Cola's (KO) Dasani bottled water.
So why do we suddenly care now? Simple, as social mood continues to darken and turn against symbols of excessive wealth and consumption, the former icons of bull market glee and prosperity begin to tarnish in the public eye.
There is absolutely nothing wrong with bottled water other than its cost over tap water. For 30 years it's been fine to pay for the convenience and fashionable appearance of water in a bottle. Now, however, it's something to rail against as mood shifts. Social mood will seek to portray this as a war against waste and excessive cost, but it's actually grounded in the psychological need to vilify the old signs of overconsumption in order to accept the reality of cutting back. The acceptance of that reality is easier if we are able to manufacture something "wrong" with that which is just beyond our economic reach.
So sit back with a tall glass of refreshing tap water and enjoy the rush to disassociate from yet another fading idol of the bull market.
No positions in stocks mentioned.
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