[p2p-research] DEBT IS STILL THE PROBLEM AND DEFLATION IS THE PAINFUL SOLUTION

[Ryan]

This is...exactly...right.

Sent to you by Ryan via Google Reader: DEBT IS STILL THE PROBLEM AND
DEFLATION IS THE PAINFUL SOLUTION via PRAGMATIC CAPITALISM by Comstock
on 7/8/10

By Comstock Partners:

We understand that we have discussed the debt problem in this country
for what seems to be forever, but we can’t stop talking about it now
that the debt is clearly the catalyst for the latest stock market
downturn. Debt is discussed by the pundits on financial TV also, but in
almost every case the discussion revolves around government deficits
relative to GDP or government debt relative to GDP. They are constantly
comparing the U.S. government debt to every other country in the world
(especially Portugal, Italy, Ireland, Greece, and Spain-PIIGS). We
believe that the government debt should be taking a back seat to the
private debt which is much larger and must eventually be deleveraged.



(Exhibit 1)

The private debt is about 6 times larger than our government’s public
debt; about 4 times larger than our government’s gross debt (including
the government debt used to fund our Social Security shortfall); and
about 2.5 times the gross government debt plus the total state and
local debt. Household debt alone is equal to 96% of GDP; private
domestic nonfinancial debt is 183% of GDP; total credit market debt is
357% of GDP (see first chart Selected Debt Measures as a % of GDP).
Please note that the only form of debt that isn’t rolling over is the
government debt.



(Exhibit 2)

We have been predicting for over 3 years that the government debt
(including public, gross, and state and local governments) will
increase substantially, while the private debt (all forms) will roll
over and decline substantially. In round numbers total credit market
debt is $55 trillion and government debt is $15 trillion, leaving
private debt at approximately $40 trillion. We have drawn debt cones
(see 2nd chart-debt cones) to illustrate the concept. We believe the
government debt will rise towards the $30 trillion level while the
private debt will drop towards the $20 trillion level. This coincides
with the Cycle of Deflation (next chart) which we authored years ago.



(Exhibit 3)



(Exhibit 4)

Most bears on the stock market are fearful that the Administration and
Fed are printing far too much money that this will result in potential
runaway inflation. We, on the other hand, do not think the results of
the Fed’s balance sheet increasing through quantitative easing (QE)
will result in inflation in the next few years, although it could very
well be a serious problem further down the road. We believe the private
sector debt will continue to decline (deleverage) regardless of what
the Fed and Administration do to attempt to jolt the economy.

The reason that the attempt at money printing to juice the economy will
not work, in our opinion, is that the whole private sector is frozen
due to the fear of losing more money. Corporations are continuing to
build up cash positions and individuals are afraid of taking risk in
this environment. The latest economic releases verify our opinion that
the private sector is losing confidence. Corporations are afraid to
take on more employees—we gained only 33,000 jobs in the private sector
in May and just last week reported a disappointing gain of 83,000 jobs
in the private sector. It would take average monthly increases of over
130,000 jobs just to keep up with the average gain in the labor force.
Last week the Conference Board reported that the Consumer Confidence
index for June declined to 52.9 from 62.7 in May.



(Exhibit 5)

New single family home sales collapsed 32.7% from April to a record low
rate of 300,000 (see the next two attached charts). There are estimates
of about 10 months of shadow inventory of foreclosed homes currently
off the market and not included in the national inventory. The national
inventory of homes available rose to 8.5 months supply in May. Today it
was announced that demand for mortgages to buy homes dropped 2%. It was
the 8th weekly drop in the 9 weeks since the credit for home buyers
expired on April 30th. We just recently wrote a comment dealing with
the potential for a second dip in housing prices on June 10th titled
“The Dire Outlook for Housing”.



(Exhibit 6)

The Fed believed that Quantitative Easing (QE) would stimulate the
economy much more than it did. QE includes all of the measures the
central bank takes to increase the monetary base, hoping that this
translates into increased money supply. However, in the current credit
crisis QE is not working as well as the Fed and Administration
expected. While it has succeeded in jump-starting the monetary base it
has failed to increase the money supply or velocity (the ratio of
economic transactions to the money supply). Thus, while the banks now
have the ability to make new loans, not enough qualified borrowers are
interested in borrowing money, and banks are not willing to loan money
to anyone that is not a prime borrower. What we need to stimulate the
economy is “velocity” which measures the rate at which money in
circulation is used for purchasing goods and services. The velocity of
money is computed by dividing the nation’s output of goods and services
by the total money supply (circulating currency plus checking account
deposits). Velocity of money is also influenced by interest rates. When
rates are low, people hold more money in cash, when rates are rising,
they put more money in interest paying investments.



(Exhibit 7)

When velocity is low the nation essentially winds up in a “liquidity
trap” which is a situation where monetary policy is unable to stimulate
the economy either through lowering interest rates or increasing the
money supply. This was the condition that Japan found itself enveloped
in from 1989 to present. We expect the same problem in this country and
hope (really hope) to be wrong. If we are lucky we will be able to go
through the slowdown we expect (or double dip) and repair the household
balance sheets enough to grow out of this mess in less time than it is
taking Japan.
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