Exactly one year ago, my pal James Altucher penned a Real Money article, The Underlevered American Household. I found it perplexing — I didn’t see why anyone would want to lever up more in the fiscal environment we were looking into.
My response was a Real Money (sub only) column titled Ignore Statistical Oddities at Your Peril.
But I also found his column instructive in that it forced me to more carefully articulate some ideas I had been kicking around for a while.
One year later, that process still resonates with me. Here’s my takeaway from our debate last year:
1) Always pay attention to statistical anomalies: They are invariably informative. If for no other reason, they make you think about how we gather and use data. In the "under-levered case," I had to consider different time frames, chew over context.
I thought it was important that the savings rate went negative for the first time in three quarters of a century. That oddity got my attention — and for good reason. Since then, the economy has likely slipped into a recession, and the Dow has fallen 12%.
2) All book keeping is double entry: James reminded me that for every purchase, there is an opposite asset acquired. Its easy to occasionally forget that.
However, just because each side of a ledger entry is quantitatively "balanced" does not mean they are qualitatively "equal."
That’s important to remember, because . . .
3) Assets fluctuate in value, but debt is persistent: We heard similar debt-to-asset ratio arguments in 1999, as proof that
things weren’t at all dangerous. However, even after stocks then — or at present, houses — dropped in price, the underlying debt used to purchase them
persisted. So much for the vaunted asset-to-debt ratio
Its another lesson too quickly forgotten from the 2000 crash: Always distinguish how debt and assets behave in differing economic conditions.
4) Spending habits change as the economy cycles: The savings rate reflected that. People continued to spend not their wages & income, but their assets, in order to maintain a lifestyle and/or a standard of living.
Note that this is more than just miles driven or which cars get purchased due to high oil. Our entire mind set shifts as the cycle turns from expansion to plateau to contraction to bottom. People cut back, spend less, hunker down. While that eventually leads to pent up demand, lifting the expansion when it rolls around next, its a process that takes a few years to play out.
Which leads to . . .
5) Real, inflation-adjusted income matters: Despite real
income being negative, as a nation, we took a long time to adjust our
consumption habits. Consuming
more than earnings has significant repercussions.
Instead of seeing wage gains being used to raise living standards, we consumed Household equity as if it were actual income. There is an enormous difference between borrow and spend, versus earn and spend.
Which is precisely what the negative savings rate was warning those how were paying closer attention . . .
>
Sources:
The Underlevered American Household
James Altucher
TheStreet.com, 6/21/2006
http://www.thestreet.com/p/_rms/rmoney/marketanalysis/10292988.html
Ignore Statistical Oddities at Your Peril
Barry Ritholtz
TheStreet.com, 6/26/2006
http://www.thestreet.com/p/_rms/rmoney/marketanalysis/10293756.html
~~~
quote from above “People continued to spend not their wages & income, but their assets, in order to maintain a lifestyle and/or a standard of living”
I’ll be blunt and point out what you all know
People continued to spend OTHER PEOPLES MONEY
thats what has kept us going, what a system of unbalance, and reward for the masters of that trade
I don’t think there’s anything wrong with debt going up as long as income goes up faster than the debt.
This is just as true for nations as it is for families.
If a nation’s debt increases by 6% per year and its GNP increases by 9% per year there’s no problem. But if the debt is increasing by 6% per year and the GNP is increasing by only 3% per year, which is and has been the situation for the United States for many years, then the situation is not sustainable.
Likewise if household debt doubles, which it has in the U.S. over the past 7+ years, and household income doubles as well, there is no problem. But in the United States incomes have been stagnant.
I suppose all this huge run up in debt has been facilitated by low interest rates. What happens when interest rates return to their historic norms?
Technically, that would be exactly two years ago, but who’s counting.
SAVE US EXXON…DRILL/DRILL/DRILL
SAVE US OPEC…OPEN THE TAP!
SAVE US OIL…WITH MORE WILDFIRES/FLOODS/TORNADO’S?
SAVE US COAL…MELT GREENLAND & ANTARCTICA FASTER!
SAVE US USA…WE NEED INFLATION & WARS
[Even if oil prices fall, the cost of ‘energy’ will keep on rising?]
WE MAY BE IN SERIOUS TROUBLE: Most of my ideas come from simple-minded pattern recognition. And what I now see at work are counter~forces to the hyper-patriotic political correctness of recent decades. And if these became established as a trend then our society may become somewaht less stable. Powerful ‘cheat-to-win’ anti-democatic players, motivated by greed, have helped to hold things together. For example despite generating massive private wealth, there have been no high-profile abductions for ransom money. But if/when taxes & regulations become too onerous, or the super-rich become satiated, or thier heirs takeover and are less motivated/disciplined, things could really become unhinged. I don’t forsee a sharp break with violent, unchecked revolution. But there’s a potential here for a counter~trend that reverses past decades of relative calm.
In general the Universe also seems to cycle from chaos to a stable state and then back again to chaos, driven by various atomic forces and of coarse gravity. From collapse to detonation & chaos. Then atomic forces fuel a new expansion until gravity once again prevails – eventually bringing yet another collapse…Major parts of our consumtion based economy are currently also in a time of collapse. And again if past trends repeat themselves, I’d anticipate things trending lower for decades, until powerful new sources of relatively cheap, renewable energy come~on~line to fuel a sustainable expansion.
DownSouth,
You may be, too quickly, overlooking BR’s point of: “debt is persistent”.
Income Growth, like Asset Valuations, only seem like certainties within the frame of Polaroid. Rolling tape, into the Future, the only known Quantity is the amount of Debt you’ve contracted.
“What happens when interest rates return to their historic norms?”
Just like what we’re seeing with Oil @ U$D ~130, more parts of the Economy begin to shatter..
DownSouth asks:
“What happens when interest rates return to their historic norms?”
Once the US Treasury is no longer able to acquire enough working capital for running the US Government and servicing our National debt, it will be forced to improve the rates offered on US Treasury Bonds. This will push up rates across the board for private, municipal and government borrowing costs.
None of these (3) groups are in any position to take on additional borrowing costs at the present time. In short, if a foreign investor from say China buys our 30-year bond at 4.73% and then subsequently loses on average 5.00% due to a depreciating US Dollar; the investor didn’t make anything at all on his investment and in fact lost money. Foreign investors will accept a few years of losses; but, will also be evaluating better investment opportunities in the meantime and will subsequently reduce purchases in US Treasuries until the risk/return ratio becomes more favorable; which implies higher interest rates and (at a minimum) a stable US Dollar.
I think it is probably smart to view available capital (at least from our perspective) from the US and Abroad as a scarce resource. Our addiction to oil and the ramification of that are really no different than our addiction to credit. The reaction to the latter could potentially react in a similar way as unforeseen interest rate spikes.
Lastly, the US must understand that the rest of the world is NOT going to do us any favors when we get in a pinch financially (or otherwise for that matter). As always in the past, we will have to do the heavy lifting ourselves. Our financial situation and pull-back to more rational levels will be no different.
Debt is persistent and known only in nominal terms. While real income growth is negative or minimal, the flip side is that the real carrying cost of your debt is near zero or can even be negative. On the U.S. treasury’s borrowing from China, for instance, the Chinese are being paid back less real value than was borrowed from them.
Doug:
That is exactly my point!
How long do you think the Chinese are going to put up with an arrangement like that? They are not stupid. They invest here to get a (real) competitive rate of return on their investment relative to what they could have gotten else where in the world.
We had better start anticipating how foreign investors are going to react in the future to (potentially) low or actual negative returns while holding US debt. We are no longer in the cat-bird seat, THEY ARE.
I don’t think America will change their habit without a lot of pain and a new generation of Americans who learned from the borrow and spend way. Have you ever talked to anyone who went through the Great Depression? They have a habit of thriftiness. Americans now think they are entitled to everything.
☺☺”Income Growth, like Asset Valuations, only seem like certainties within the frame of Polaroid.”–Posted by: Mark E Hoffer | Jun 22, 2008 10:22:58 AM
I agree.
But what do you call it when one goes out and gorges himself on debt when there is no recent track record, or even any realistic hope, of increasing income?
We shouldn’t be too quick to make assumptions about generational spending patterns.
My parents lived through the Great Depression and I had to teach them how to manage money and avoid debt. Our seven grandchildren are in their early 20s and most of them are very frugal.
DownSouth,
to your Q: Criminally Negligent, or, possibly, part of a Conspiracy to Defraud.
Assuming Debt Service then outstrips ability to repay.
Otherwise, it may be construed as a version of Selling/Shorting..
also, to edit my post: the Polaroid.
Further, I think the premise that the PROC is looking for ‘competitive (real) rates of return’, on their purchases of U.S. Treasury obligations, should be examined.
‘Free Trials’ exist in many Marketplaces for a reason.
James reminded me that for every purchase, there is an opposite asset acquired. Its easy to occasionally forget that.
Asset acquired, indeed. Like a house? Like an SUV? Like a plasma TV? Like a gallon of gas? Like a sweet New England Patriots grill cover? Awesome.
The scariest part is… the people who spent all their phantom equity now want to spend the equity of the people who did not borrow and consume.
And yes, Altucher fails to distinquish between capital assets and consumables. Some times smart people fail to see the most obvious things.
“Asset acquired, indeed. Like a house? Like an SUV? Like a plasma TV? Like a gallon of gas? Like a sweet New England Patriots grill cover? Awesome.”
What about those steaks and chinese restaurant meals? What about groceries? How about those vacations? Are those long lived assets? In fact when credit card companies start their massive charge-offs, very little will be left for them to take possession of.
I don’t think the economic problems of the U.S. right now are based on people spending what they didn’t earn. The real problems are based on those people who invested the money that other people didn’t earn. There was a huge pool of investment money that in reality, simply didn’t exist at all.
One of the reasons I keep coming back. The discussion informs.
For example, it’s interesting to observe how the iterative nature of the discussion transforms seemingly arcane ideas to a manageable and understandable size.
At a micro level, however, it’s a little harder to translate easily the principles into action, viz. Super Cuts vs. a hair salon on Rodeo Drive?
Frugal isn’t hard if you’ve never had it. Becoming frugal is hard if you’ve never known the difference.
Many of us have overcome our inbred frugality and learned to love our up-grades. And now we have to become frugal again? One can scarcely imagine the social and political costs associated with reestablishing that kind of thinking as a cultural norm.
Just another part of our double-entry bookkeeping?
the other point about ever increasing debt loads is that at some point servicing the debt requires *more* debt. i believe minsky called it “ponzi finance.”
once you reach that event horizon, it’s pretty much game over. hence the credit crisis.
Bob A & Steve B hit the nail on the head: debt on capital with a real return should be encouraged, because the return on capital automatically services the debt.
but houses, SUVs, tvs, etc., don’t automatically pay off the loan. you’d think this should be common knowledge….
BG – “the Chinese are going to put up with an arrangement like that? They are not stupid”
and further down – Bob A I hear ya – play the game like the flock or else .. sometimes it sucks to be good
I think they (Chinese) realized what Bob A points out – the fireworks era has expired and been replaced with super high tech
learn to play with the big dogs or stay on the porch
(which when were talking about Earth – it leaves slavery or death and thoughts of space float)
Jihad
Doug – “…the Chinese are being paid back less real value than was borrowed from them.”
BG – “How long do you think the Chinese are going to put up with an arrangement like that? They are not stupid.”
While I agree the buildup of Chinese claims on US assets (which is another way of saying a claim on future US earnings) is an underappreciated issue, it’s important to understand the whole picture from the Chinese point of view.
The accumulation of US debt isn’t a standalone investment. It’s a natural and necessary part of their ongoing industrialization strategy, a primary component of which is the crawling peg to the US$. The ROI to the Chinese includes not just the cashflow from treasuries, but also the gains from industrialization and what they perceive as a diminished risk of a nasty Asian flu recurrence and the social tensions brought about through poverty and some scary demographics.
In that light, it’s not hard to make the case that the Chinese have received a pretty good return on investment so far. All things considered, it’s harder to make the case that they’ll change their development strategy much in the near term, and since the accumulation of US debt is a necessary part of that strategy, it’s hard to make a case for a significant reduction (or outright net sale) of US debt.
Importantly, the developmental gains forming part of the Chinese ROI aren’t necessarily available to others (such as US or European investors), so it’s non-Chinese investors who are more likely to abandon US debt.
The risk then might be rather than China et al not buying US debt, it’s that they simply don’t buy it fast enough to offset capital flight by others.
Hmm fascinating didnt know:
http://online.barrons.com/article/SB121400286913193263.html?mod=9_0002_b_this_weeks_magazine_home_top
Estragon,
Good points. Plus we don’t know that the Chinese may just view low/no/negative real returns in US Treasuries as merely a cost of doing business and in so doing, gaining access to US consumers.
However, a noose around your neck never hurts until it is drawn tight. The US needs to get its financial house in order before that window of opportunity closes completely and permanently.
Estragon-
Can you explain this further?
specifically, how do treasury purchases support industrialization?
m3,
to your Q: think ‘vendor financing’..
mark-
i meant how do treasury purchases support *chinese* industrialization. i can see how treasury purchases can finance the war, but i don’t see the connection between sovereign debt & the increased export of consumer goods or the required industrialization to produce those goods.
also, the EU does more trade with China than the US (without vendor financing), and for a long time the EU had a trade surplus with China.
that means EU-China trade has been booming without massive purchases of euro-denominated paper.
so i’m curious as to why it works for the US but not the EU; and if it does, why does loaning uncle sam money increase industry in china? i can see the argument for agencies, but i’m confused about treasuries….
The problem has been evident for anyone who has paid attention to the US fiscal condition for the past several decades, even to authors like this one, whose “solution” is an aggravated version of the problem. At least he is aware of the problem:
The Return Of Thrift: How the Collapse of the Middle Class Welfare State Will Reawaken Values in America
http://www.amazon.com/RETURN-THRIFT-Collapse-Welfare-Reawaken/dp/0684823004
m3,
I think that their inflow into the Treasury complex helps the FedRes keep i-rates low throughout the curve. That yield curve, still, seems to be the basis for the great many i-rates found throughout our Economy…The subsidy effect of their actions, both to our Treasury and their ‘domestic’ suppliers, increases our net aggregate demand (of their products).
That’s the, short-hand, way I’d begin to describe the phenomenom.
As to the EU’s situation v. PROC, I’m, simply, not as familiar, and would leave it to others to endeavor toward an answer to that part of your query..
mark-
Thanks for the reply. i figured that’s where you were going, that’s why i brought up the EU, where the argument falls apart. but i think what you are saying *does* make sense vis-a-vis agency debt, because that is a direct subsidy of US home owners, who buy consumer goods. but the us gov’t doesn’t really buy consumer items from china en masse, does it?
also remember that the US consumer has been dragged out and shot (look at retail stocks & consumer sentiment #’s. and that’s *with* a low 2% FFR), however the chinese economy is still doing ok…
it seems rather silly for the chinese to lend money to the US gov’t, so that americans can buy more goods, so the chinese can build factories. i think it’s far more logical for the chinese to lend money to *themselves* to buy goods & build factories.
i’ve never heard a good explanation why they vendor finance the US consumer, and not the chinese or european consumer. there are more chinese people in the world, after all…
i dunno. i’m just trying to figure out these contradictions…
m3,
you have to look back to this chap: Deng Xiaoping, and the state of the PROC’s Economy when he kicked off his quasi-Capitalist Revolution in the ‘Special Economic Zones’. Then, add the U.S.’s granting of MFN to the PROC. (see: By Ann Devroy
The Washington Post
WASHINGTON
President Clinton Thursday reversed course on China and renewed its trade privileges despite what he said was Beijing’s lack of significant progress on human rights.
Echoing the case made by George Bush when he was president, Clinton said he was convinced the Chinese would take more steps to improve human rights if the issue were separated from the threat of trade sanctions… http://www-tech.mit.edu/V114/N27/china.27w.html )
As you said, the EU, for the longest time, had a trade Surplus–Import restrictions, really–with the PROC…
Further background to your queries..
Mark / m3,
The reason China has to buy US debt is the crawling peg to the US$ and the pattern of bilateral trade. Somewhat oversimplified, the Chinese central bank has to buy USD from exporters and invest in US debt to maintain the exchange rate. If it didn’t, the value of the USD vs RMB would fall.
Since there is no peg to the Euro, there’s no need to buy Euro debt. The pattern of Euro/Chinese trade is also more balanced than US/Chinese trade (though this is changing as the RMB falls against the Euro), so even if there was a Euro peg, there would be less need to buy Euro debt.
US debt (total governmental, personal and corporate) is growing exponentially and as a percent of GDP it is now well over 300%. The previous high was about 190% (you guessed it) in 1932.
http://www.bullandbearwise.com/DebtOverGDPChart.asp
Although this graph doesn’t go back that far, it surprised me that the total debt during WWII didn’t grow that fast. The Federal Government ran up big debts during WWII, but people and corporations had trouble borrowing money, so total debt didn’t grow that fast during WWII.
So this graph shows how far we’re in debt, and it doesn’t include the unfunded liabilities to Medicare the prescription drug program(and much less importantly SS).
Me thinks this won’t end nicely.
Somewhat oversimplified, the Chinese central bank has to buy USD from exporters and invest in US debt to maintain the exchange rate. If it didn’t, the value of the USD vs RMB would fall.
ok, that makes more sense to me. i always thought the PBOC purchases of dollars were directly from treasury auctions. but you’re saying they are buying them from exporters, then dumping the excess in treasury securities.
it’s not vendor financing, per se, but it’s their way of dealing with the account deficit. (?)
m3,
the PBOC is buying USTreasuries [(mostly) b/c this ‘asset’ ruffles the fewest feathers] to manage their Exchange Rate v. the U$D. This, extension of credit/purchase of Debt, creates additional U$D ‘buying power’. It is why I was alluding to ‘vendor financing’..
Estragon adds a few key points: it’s about the Exchange Rate (and management thereof), and the PBOC/PROC is the actor, as opposed to individual, Exporting, firms loaded with U$D..
mark-
i am aware that the PBOC manipulates the exchange rate with treasury purchases, but i think you misinterpreted him. the $ inflows to exporters are also a problem. the PBOC is trying to sterilize the USD inflow.
read this article:
http://tinyurl.com/6b7w4x
“To cap the gusher of cash from abroad and ease the burden on banks, analysts say China needs to let the yuan rise much faster…The central bank buys nearly all the foreign exchange entering the country with yuan to keep the exchange rate stable… The biggest contributor, albeit on limited evidence, has been hot money…
This points to one solution to the problem: curb speculative inflows. Given China’s role as a major trading nation, though, capital controls are very hard to implement effectively….”
we agree that they are buying treasuries to maintain the exchange rate, but it’s the *inflow* of capital due to trade (i.e. exports) that’s partly to blame. they’re buying dollars that are entering the country through trade & investment, as well as at treasury auctions.