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.

I certainly spend a fair quantity of bits criticizing conventional economics and economists. However, there are always exceptions who question authority and see what is really going on. Paul Kasriel of Northern Trust is notable, but here’s another, Richard Alford. He is interviewed by Institutional Risk Analytics.

If the US consumer were to go back to savings rates of the 1996 period, then you are talking about savings going from essentially zero today to approximately 8% of disposable income. Since US GDP is about 70% consumption, that implies a decline in demand of about 5 to 5.5%. That would be a very dramatic effect.

No kidding. Because of course the decline in demand would reduce employment, which would further reduce income in a vicious circle. That is why Ben is moving heaven and earth to avoid an increase in savings.

Politically and economically, there is no painless solution to the imbalances in the US. For US policymakers, it seems that even short-term pain is intolerable. Nobody in Washington wants to bite the bullet and explain the full dimension of the required change to the US electorate, so we muddle. Going back to the early 1990s, US politicians have bought support from the voters by keeping consumption on an ever rising trajectory. For at least 12 years, we’ve had debt induced increases in consumption and the political class optimized their behavior to maintaining that illusion of rising consumption even as the economic fundamentals worsened.
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The US population is not ready to hear that their real levels of income, assets prices and other indicia of national well being may be falling or relatively stagnant for the foreseeable future. This is just politically not acceptable. So our politicians will attempt to maintain the appearance of growth, but not address the underlying causes.

This is the lending clampdown in progress. This is the reason that there is a long way to go to equilibrium.

NEW YORK (MarketWatch) - Bank of America said Tuesday that it will institute strict new lending guidelines when it completes it acquisition of troubled lender Countrywide Financial Corporation later this year. The new changes instituted will include ending the origination of subprime mortgages, greatly reducing the number of no- or low-documentation loans and issuing adjustable rate mortgages that have a much longer interest-only payment period in order to reduce huge resetting payments. Bank of America agreed to purchase the nation’s largest lender, Countrywide, in a white knight, $4 billion all-stock deal scheduled to close in the third quarter. When the merger is completed, Bank of America will originate or service at least one out of every four of the country’s mortgages. “We recognize this tightening, by definition, restricts the availability of credit to some borrowers. However, this will help ensure that those who get loans can afford to repay them,” said Bank of America Global Consumer Credit Executive Bruce Hammonds in a statement.

Italics mine.

The weekend pump rumor is that central banks are going to take up the mass of mortgage-backed securities that are essentially either illiquid or worthless. From the Financial Times:

Central banks on both sides of the Atlantic are actively engaged in discussions about the feasibility of mass purchases of mortgage-backed securities as a possible solution to the credit crisis.

Now this rumor has been denied by the Fed, which makes it even more likely that it is true. So let’s say the Fed and/or other central banks start buying MBS on a grand scale. Either they simply print the money, in which case the Fed balance sheet skyrockets. Currently, the monetary base is about $860 billion. Direct purchase of any size by the Fed would be enormously inflationary, remember there’s some $11 trillion of mortgage debt out there. I doubt that they would do that.

So the alternative is to issue government debt, i.e. treasuries, to pay for the MBS. The current swap facilities are essentially doing this anyway, the only difference is that some third party would have to buy the Treasury for cash - and the taxpayer would take the credit risk. Basically you’re looking at a massive expansion of the Fannie/Freddie/Ginnie system, now formally guaranteed and the inevitable losses funded by the taxpayer. Basically the end of private finance of mortgages, they’d be originated by banks and brokers for a fee, presumably, and then bought by the taxpayer.

Would this make mortgages easier to get? Probably, depending on the terms offered by the taxpayer. Could it reflate the housing bubble? Possibly, if mortgages become easy to get again we’ll go right back into the bubble mode. Speculation will be rampant. I myself will be stepping up to be subsidised by the taxpayer if it is attractive to do so, because you’d be an idiot not to. Savings will be even less attractive, as there won’t be mortgage debt to invest in, only Treasury debt. If you wanted to ensure that the US economy will ultimately crater from underinvestment and malinvestment, this would be the thing to do. It sounds like just the kind of thing that Helicopter Ben would like.

The real issue here is government direction of the economy. The Soviets tried this with Gosplan, and ended up with no toilet paper. Or much of anything else, either. Mr Bernanke, and his predecessor Mr Greenspan, have been trying to do the same, in a broad sense, by manipulating monetary policy. As this fails, their response has been “do more”, more facilities, more manipulation, more Fed-speak and so forth. This will ultimately fail, because it is the paradigm that is broken. One more time, we need to establish an economic environment based on savings and investment for the future, rather than continuing to encourage short-term consumption of scarce resources without future benefit.

All of the bailout and liquidity enhancement proposals share a common flaw; they can’t possibly work. “Work” being defined as putting things back more or less the way they were - rapid price appreciation in housing juicing consumption so that economic growth appears to continue and defaults stop. There is just too much supply of housing.

The nasty fact is that the housing bust hasn’t really begun. It is well established that most of the defaults that we’ve seen to date are the result of fraud of one kind or another in the origination of the paper, not rate adjustment or economic stress (unemployment). The published inventories of new housing are way understated, because they don’t include cancellations or most condo developments, especially the high-rises. The inventories of resale houses are similarly misleading, even though they are already approaching last year’s fall highs in the bubble areas, because they don’t include large numbers of houses that are in the foreclosure process, stalled by processing backlogs at the lenders. Or the owners who have given up and are just waiting for the hammer to fall, or who will put their house on the market at the first sign of any hope of sale.

Even ECRI has finally acknowledged that the economy is in recession. Now we start to see the real bust, as layoffs start to bite at incomes and people who thought they were fine can no longer pay. Private mortgages are going up in price, not down - according to bankrate.com, the 30year jumbo fixed is at 7.17%. This has a the effect of driving the purchase price down to maintain a certain payment level, further eroding the collateral value for existing financing. And then commercial real estate starts to get hit.

Now we introduce the notion of further government subsidies to housing - not only the existing tax relief, but straightforward underwriting of loan losses by the taxpayer. The loan losses immediately convert to new federal debt, compounded by the interest paid on the debt as well as the subsidy. What it boils down to is allowing further borrowing by giving the lender the backing of taxation to guarantee repayment - ultimately that the lender can, in effect, collect at the point of a gun from the remaining people with income and/or assets. Needless to say, this is a sign of deep disease, attempting to defer the end by aggravating the problem. The end probably is the Zimbabwe routine if Ben goes down that path. A wrecked economy and a wrecked currency.

It is absolutely necessary to reduce consumption. It will happen, one way or another. A country cannot consume its way to wealth. But it will be painful, and politicians hate pain. So if it cannot be prevented, everything will be done to defer the pain, just so long as it happens to someone else.

Sitting on a mooring at Foxy’s Taboo, his daughter’s place on the east end of Jost van Dyke (should probably be Dijk, really, but that’s how it is spelled). I’m thinking about the complete disconnect between the equity and the credit markets. I’ve been whining about the daily jam jobs and stick saves in equities, while every day the credit markets deteriorate further. To the point that a major Wall Street broker/dealer, Bear Stearns, has failed, while other majors like Citibank have had to turn to the coffers of the Arabs for (temporary) bailouts.

Mr Bernanke’s attempts to reflate the US debt bubble by lowering interest rates and swapping Treasuries for junk bonds drive the US dollar lower every day. This means higher prices, not only for imports, but for anything with a world price, making it less and less likely that real consumption can be sustained. Credit is increasingly hard to obtain as lenders find there is no room on their balance sheets for more assets because their capital is impaired by loan losses and valuation write-downs.

Mortgage rates continue to increase as risk is priced in, defying he Fed’s desire for lower rates. Not only mortgages, but swap spreads and junk spreads continue to blow out. Corporate junk bonds are yielding over 10% now. This is serious stuff, yet equity bulls claim “it’s just a flesh wound”, incessantly call bottoms and keep on partying in tech stocks. But the real effect of the credit market distress is going to be to hit consumption hard, and corporate earnings likewise. I don’t see any reason to believe that other countries are going to be unaffected by falling demand in the US, given the years of outsourcing and disinvestment. It is clear to me and, I think, most serious analysts, that a major down cycle is here. We can argue about how bad it is going to be, but there is no way to know for sure. My opinion is that it will be extremely severe (meaning a 20-25% drop in real GDP). We’ll see. But one thing is for sure, that all the folks who didn’t see this coming have no credibility in calling its duration or severity. None.

I’ll take the position that I did see this coming, this blog is my credential to talk about it even if it did take longer to come than I thought (but that is the story of my life). I’ll probably be early on the upturn also. But that’s a long way in the future. Probably five to ten years – but just guessing, I don’t see any straws in the wind that even hint at recovery, just spreading panic and a Fed trying to achieve the impossible by simultaneously satisfying inherently conflicting goals.

In the short term, the equity markets will take this seriously one of these days. It may take a major panic to overcome the iron grip that the quant funds and the big brokerage houses have on the markets. Perhaps a run on mutual funds by individual investors? It looks like the Bear Stearns fiasco was triggered by a lack of liquidity to meet investor withdrawals. If people see this and more failures, and realise that they are exposed to huge risk for the sake of little possible upside, they may decide to take the money and run while they still can. If so, that’ll cause a flush that will put a real intermediate-term bottom in place. Not for the economy, but for the markets. Otherwise we’ll probably just continue to grind lower while the boyz are dragged out of their holes one at a time, kicking and screaming, to be put in the stocks in the town square for all to mock and throw rotten tomatoes. Could go on for months, I suppose, there are a lot of holes with a lot of nasty little animals in them.

I cannot over-emphasize the danger of being over-exposed to risk in this market. We aren’t dealing with a normal business cycle here, but rather the accumulation of multiple business cycles that have been somewhat suppressed by the actions of the Fed, combined with extreme levels of leverage, taken on with the expectation of continued low volatility of asset prices. Analysts are looking at inventories and the other normal characteristics of the business cycle to declare that the problems are not too serious. They are looking in the wrong place. The fundamental problem remains leverage, the accumulated business cycle pressures are merely the trigger. Too many promises to pay supported by too little capital or real money. Credit availability will likely over-run on the downside as defaults lead to more defaults, and it will infect more than financial institutions. The spreading of risk celebrated by Mr Greenspan will prove to be a really, really bad idea (like most all of his ideas) as the credit derivatives mountain implodes, when counterparties cannot meet their obligations.

Every day brings a new proposal to save the housing market. The latest gem is a $15,000 bonus from the taxpayer for buying a house. Talk about a reality distortion field enveloping Washington. Either the $15,000 is fresh printing, in which case it hurts the dollar and people pay at the pump, or it takes away from other Federal spending and the pain is felt by the ex-recipients of that spending. What nonsense.

The only recovery possible is to return to sound fundamentals of savings and investment, complemented by a highly educated and productive workforce. Other countries, notably China, understand this. But the US feels entitled to a free lunch, to be produced by the wizards of the Fed who will somehow produce Camelot by manipulating interest rates and money supply. It is no coincidence that all of the members of the Chinese governing council have degrees in science and engineering, while the US is run by lawyers who are used to free lunches.