One kind of debt replaces another

The following is a sobering article, particularly in light of the extraordinary upswing the Dow Jones Industrial Index has experienced over the last couple of days. Bold sections represent my emphasis. There is a perception that we have turned the corner. But do not be deceived, the fundamental problems emanating from leverage have not dissipated. I wish the economy would be in fact be demonstrating the "green shoots" many pundits talk about. The reality is the opposite, however. There is no greenery to be seen. The stage is merely being set for a dramatic fall in the market later this year.

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One kind of debt replaces another
By Edward Chancellor
Published: May 31 2009 16:18

As the stock market revival survives its third month, talk is turning from “green shoots” to a “sustainable recovery”. Yet this economic pick-up, like the one which followed the technology bust, has a potentially fatal weakness – it is fuelled by the rapid expansion of non- productive credit. America has not yet been cured of its addiction to debt. All that has happened is that excessive growth of household credit has been replaced by an even more extravagant expansion of government borrowing.

Leading economic indicators around the world have picked up in recent months. This is evidence of a synchronised global economic recovery, itself the product of massive co-ordinated fiscal and monetary stimulus. Furthermore, US house prices are no longer in bubble territory. The stabilisation of the housing market should stem the growth of non-performing loans in the banking system. The pronounced decline in Libor – the rate at which banks lend to each other – over recent months suggests the credit crunch may be behind us.

A recent note from Independent Strategy, a research company, questions this upbeat picture. Excess household leverage lies at the core of the credit crisis, it says, but little has been done to remove this problem. De-leveraging in Japan, which followed the banking crisis of 1997 and started from similar lofty levels of private sector debt to GDP, lasted for more than a decade. The era of Japanese debt reduction was accompanied by prolonged economic fragility. The path to rectifying US household balance sheets is likely to be long and arduous. Only a few tentative steps have been taken so far.

Incomes are being maintained by debt- financed handouts from Washington. This creates another problem. The increase in government debt is preventing a necessary rise in the US savings rate after years of profligacy. “If excess consumption lies at the core of the credit crisis,” says Independent Strategy, “the problem has been worsened by government adding leverage to help households sustain their own unsustainable debt.”

Public policy today serves to delay the day of reckoning rather than promote a return to economic equilibrium. We have been through this process before. During the technology boom of the late 1990s, US corporations were expanding net debt at an annual rate equivalent to 6 per cent of GDP.

This was a classic case of Hyman Minsky’s “Ponzi finance”. Corporate profits and asset prices became dependent on access to fresh borrowing. After the stock market turned down in spring 2000, credit dried up and the economy started to contract.

The Greenspan Fed administered the cure: interest rates were slashed and consumers were told to borrow and spend. By 2006, household credit was increasing at a rate equivalent to 9 per cent of GDP. At the time, Ben Bernanke and Timothy Geithner, then head of the New York Fed, hailed the “Great Moderation”. Yet after house prices turned down, consumers found they could no longer use their homes as ATMs. The contraction of mortgage loan growth removed a vital economic prop.

With the consumer out, it is the government’s turn to rescue the economy. Last year, net borrowing by Washington soared to 9 per cent of GDP, according to the Fed’s Flow of Funds data. This increase was equivalent to additional household borrowing at the peak of the mortgage credit bubble.

Bianco Research keeps a tally of the ever-increasing bail-out costs. These currently stand at $4,200bn (£2,600, €2,975), larger than the inflation-adjusted costs of the second world war, according to Bianco.

Another way of quantifying the bailout is provided by Grant’s Interest-Rate Observer, which adds together the fiscal and monetary response (as measured by the increase in the Fed’s balance sheet), expressed as a percentage of GDP. According to Grant’s, the current stimulus totals some 30 per cent of GDP. By contrast, the sum of all the fiscal and monetary measures during the 12 previous US economic downturns since 1929 comes to a mere 39 per cent. Over the years, the US economy has become addicted to massive credit growth in excess of incomes, argues Doug Noland in his web-based Credit Bubble Bulletin. The economy and the financial system, claims Mr Noland, start to buckle when non-financial credit increases by anything less than $2,000bn. For the moment, Washington is providing the source of this credit growth, either directly or through the giant mortgage agencies. A “government finance bubble”, in Mr Noland’s phrase, has replaced the mortgage credit bubble.

Yet the US government cannot support both the economy and the financial system indefinitely without ruining its own balance sheet. The alternative is for Washington to retrench. Only when that happens will we discover whether the current recovery is any more soundly based than the one which preceded it.