A sophisticated presentation from the New York Times, The Debt Trap. Especially the interactive chart of a century of debt and savings (under “lifetime”), that puts today’s staggering household debt burden into perspective.

One looks at that chart and says, wow, what a bull market in credit. Consumer credit in various forms has been around for millennia, but it seems like it really exploded after World War II. The effect of rising consumer credit and falling savings rates is to accelerate consumption.

Going back in time, people saved to buy a house. Then, as we move along the timeline, they just saved for a down payment, but expected to save the rest later as a function of their mortgage payment. Then they didn’t need to wait to save a down payment. Then they didn’t need to save the balance - to amortize the mortgage balance. Over time, they expected the appreciation of the house to not only cover the interest, but to supplement their incomes. At each step, people expected to be able to buy a house earlier and earlier in the life cycle of their household. Price also became less of an issue at each step, and so houses became bigger and more costly. Most recently, price sensitivity even became inverted, as a more expensive house was seen to generate more dollars of appreciation and bigger tax savings.

We see the same phenomenon in other lifetime purchases, such as a college education, which have clearly gone through similar structural shifts. Particularly the price-raising part, in the case of colleges. So we had more and more debt, moving earlier and earlier in the household life cycle over a long period of time.

If you drew a household life cycle as a timeline, you could divide it into three segments, a savings segment, a debt servicing segment and a retirement segment. As debt has increased, the debt servicing segment has spread out to take over the other two segments. When we reached the point where a newly formed household expected to buy a house immediately, in addition to servicing their student loans, and would likely end up at retirement with outstanding debt still to service, we reached some kind of a limit. “You can’t get blood out of a turnip”.

I was watching the Suze Orman show last night. The show has this “can I afford it?” segment. I was particularly struck by the guy who was making $7,000 a month who wanted to buy a new Bentley convertible for $212,000. He was, admittedly, debt free except for an existing car lease of, I think it was, $695. He claimed to be able to finance the Bentley at 6.5%. I fired up my trusty HP-12C which shows that the monthly payment on a 48-month loan would be $5027.57. So his total car payments would be $5,700 or so. And then, of course, there are operating costs. How was he going to eat? People just do not understand the implications of buying on credit.

Consumption has to balance with income over the household life cycle. That is, if I buy a Bentley Continental, I have to cover the depreciation on that puppy from my income or my savings. So that may mean less money to spend on other things now, or I may choose to burn my savings and have less to spend in retirement. People have chosen to burn their savings on consumption, in general. That lack of savings for retirement is the demographic part of the debt trap that many analysts have observed.

The other part of the debt trap is that, so long as the debt servicing part of the lifecycle continues to expand, consumption is being pulled forward. But it eventually reaches a limit, when consumption is pulled so far leftward that it cannot move any further. I would argue that we have reached that point. Then aggregate debt cannot expand further than the present value of aggregate income for all households. In effect, real consumption cannot expand faster than real income. In fact, it has to shrink because retirement savings are clearly insufficient. As the baby boomers move through, the average household in the mix becomes older - further along the timeline - and transfer payments from younger households are going to have to be made in order to feed and house the elderly who have over-consumed and lack savings to sustain them.

The debt-servicing segment of the household life cycle will have to be shrunk to some equilibrium value, on average deferring consumption. As this equilibrium point is found, aggregate consumption will fall drastically. The tailwind that increasing debt has given to economic growth will reverse to a howling headwind. Other developed countries will suffer similar circumstances. Countries, such as China, which are in a different phase of economic development, still emphasising savings over debt, will be moving to equilibrium from the other side, giving them much stronger internal growth.

But, you retort, all this debt is just paper accounting, isn’t it? It is just money that we owe to ourselves, after all. The economy has been pumping out all the goods and services that we need, why won’t it continue to do so, indefinitely? Sure, savers aren’t going to get rewarded in goods and services as they expected, because the borrowers won’t be repaying. But, over all, why should consumption fade when the capacity to produce all the SUVs and cellphones and bottled water that people want is obviously there? Manufacturing productivity keeps rising, doesn’t it?

Ah, I respond, then let me count some of the ways that productive capacity will decline.

• Malinvestment. Over this long secular trend, massive investment has been made in things like housebuilding and the associated financial services that will not be needed in the future. Shifting the economy to produce other things will subtract productive capacity from the economy while the shift is being made. We have enough SUVs. And probably enough cellphones and bottled water, too.
• Underinvestment. Bridges are falling down and highways are cracking. Why is the price of oil so high? Because of insufficient investment in energy production. Energy production capacity is declining, which is affecting the supply of goods and services in that they become scarcer and hence more costly. Inadequate maintenance of infrastructure saps productive capacity. Everything is wearing out and not being replaced. Another shift in the economy to produce different goods and services.
• Overconsumption (or underproduction). The US is no longer self-sufficient in anything. We consume more than we can make. It is simply untrue to say that this debt is money we owe to ourselves, much of it is owed to foreigners who have delivered goods and services to the US. All you need to see is the impact of defaults on foreign banks and investors reported in the press almost daily. That debt needs to be serviced, and it is serviced by goods and services that we send overseas in return for those that we have received in the past. Production will shift to increase emphasis on goods and services our foreign creditors will want.

In summary, the economy will change, and will lose productive capacity while changing. The change will be massive, as it will represent a reversal in a hundred-year-old trend. It is the end of an empire built on credit.

Indymac Bank, a top 10 S&L and one of the more aggressive California mortgage lenders, announced today that it would shut down most new lending and lay off more than half its staff of 7,200. Indymac has been unable to raise new capital to replace its losses.

I expect that there will be a dismal litany of such announcements. At some point in time, the bulls will realise that even the tech companies can’t make money without credit for consumers. But not today.

A couple of notes following up on previous posts.

I spent some bits criticizing Paul Krugman of the New York Times for his assertion that the futures market doesn’t influence the price of crude oil. In addition to the arguments that I set out, what I didn’t know was that many OPEC countries actually use the futures market prices as a benchmark to set the contract prices at which most oil is actually sold. Apparently this is done because the spot market is too thin, and therefore too easily manipulated. This excellent post, with supporting references, sets it out. The same kind of speculative money also appears to be driving up grain prices (Edit: although one imagines that burning food isn’t helping). I think that we can safely discount any notion that the futures market does not affect actual selling prices.

Edit: This is probably all Jim Rogers’ fault, by the way. While there have been commodity funds and commodity pools for a long time, I think Jim was the first to start a mutual fund whose asset value per unit tracked a commodity index. Jim developed his own index, more broadly based than others such as the GSCI, and then (circa 1998) started a fund, the Rogers Raw Materials Fund, whose return was based on the change in the index. There has since been an avalanche of new money chasing this idea. I’m not sure what the state of the fund is currently, I think it got caught up in the Refco bankruptcy for which the CEO just got sent to jail. If you want to see the effect of these index tracking funds, check out what happened when Goldman Sachs unexpectedly reduced the weighting of gasoline in the GSCI in August 2006, from 8.75 percent  to just 2.3 percent. This change caused indexers to unload gasoline futures in a hurry; wholesale gasoline fell 82 cents over four weeks, an unprecedented drop; and crude oil, which in July 2006 had traded over $79 -  a record -  fell to around $56 by January 2007.

The government action eliminating the tax on forgiven or cancelled debt resulting from a short sale or foreclosure seems to be accelerating the “walk-aways,” where borrowers simply decide that their house was a bad trade and cut their losses. Jim the Realtor posts a comment made on his blog which typifies the “just a business decision” attitude. Edit: In the Sac Bee,

Walking away is embarrassing, Fatius, a pipefitter and welder, admits. But staying is “stupid,” he says.

The lenders and the housing market are in deep, deep trouble.

The program pumpers are able to move the market, as always, but as soon as they stop it sags. The problem is the banks. The banking index ($BKX) and the regional bank HOLDRs (RKH) are well below their March lows. People are starting to realize how widespread the problems are. The problem assets of the big money center banks like Citi are well known, as are the mortgage problems of the S&Ls like WaMu. But also coming to light are the developer and builder loans. These are especially poisonous because, like neg-am mortgages, the banks often add the interest to the loan (called an interest reserve) during its life. This means everything looks good until the project is finished, but unsold. All of a sudden the developer needs to start paying down the loan, but he can’t. Something like 60-70% of the assets of the smaller banks are real estate related.

Even without actual defaults, these banks are going to have their balance sheets loaded with loans just sitting there waiting for something good to happen. And that means their capacity to make new loans will be impaired. Given that this economy depends on perpetually increasing debt, this is a huge problem and the semi-smart money is starting to figure this out. (The smart money is long gone, or short; the dumb money is buying “beaten-down values” from the semi-smart money).

And the TICK skyrockets as yet another jam job program runs. In the meantime, members of Congress are leaning on the CFTC to find evidence of “speculation” in the oil market. Morons. What do they expect? They let the Fed run the dollar into the ground, and then get all surprised when people put money into something they think will keep its value

The WSJ has a piece this morning on “buy and bail,” where a borrower, underwater on his or her house, buys a new house, moves, and then allows the original house to fall into foreclosure. The borrowers can get away with this in the non-recourse states, notably California, where the original lender cannot pursue them for a deficiency judgement. As I’ve mentioned before, the delicious irony is that those non-recourse laws were generally enacted during or following the Great Depression, in order to restrain the behavior of the lenders by making them share the pain of foreclosures.

Next month, Michelle Augustine plans to walk away from her four-bedroom house in a Sacramento, Calif., subdivision and let the property fall into foreclosure. But before doing so, she hopes to lock in the purchase of another home nearby.

“I can find the same exact house as what I live in right now for half the price,” says Ms. Augustine, 44 years old, who runs a child-care service out of her home. She says she soon will be unable to afford her monthly payments, which will jump to $4,000 from $3,300 in August, and she doesn’t want to continue to own a home that is now worth $200,000 less than what she paid for it two years ago.

On top of that, I’m hearing about the enhanced variation - the double play, if you will. In which, as soon as the borrower moves, he actually rents out the old house. But he stops making the mortgage payments anyway, as soon as the tenant moves in. Then, given the delays inherent in the foreclosure process, he pockets 8-9 months rent at least, and probably much more. No mortgage payments, no tax payments, no insurance, no nothing. Ta-da!

As a libertarian, I just have to shake my head at the way nearly every government action, well-meaning or not, has the opposite effect to that intended. The religious faith in government as a panacea for social ills is ludicrous. Morality and civility come from within, from culture, education and social homogeneity, not because of threats of violence from “legislators” or “diversity.”