Will “stimulus” restore the economy to perfect health? Not unless you think government stimulus will sustain the massive private debt mountain we built up over the past 25 years.
In his latest quarterly letter, the great Jeremy Grantham of GMO explains the problem and offers several possible ways out. None are happy endings (with the possible exception of finding another bubble to push asset values back to the stratosphere).
And, before you start reading, here’s the picture that’s worth a thousand words, courtesy of Yves Smith at Naked Capitalism:
But let us look for a minute at the extent of the loss in
perceived wealth that is the main shock to our economic
If in real terms we assume write-downs of 50%
in U.S. equities, 35% in U.S. housing, and 35% to 40%
in commercial real estate, we will have had a total loss
of about $20 trillion of perceived wealth from a peak
total of about $50 trillion.
This relates to a GDP of about $13 trillion, the annual value of all U.S. produced goods
and services. These write-downs not only mean that
we perceive ourselves as shockingly poorer, they also
dramatically increase our real debt ratios.
Prudent debt issuance is based on two factors: income and collateral. Like a good old-fashioned mortgage issuer, we want the debt we issue to be no more than 80% of the conservative asset value, and lower would be better. We also want the income of the borrower to be sufﬁ cient to pay the interest with a safety margin and, ideally, to be enough to
amortize the principal slowly.
On this basis, the National Private Asset Base (to coin a phrase) of $50 trillion supported about $25 trillion of private debt, corporate and individual [Note: The chart above includes government debt]. Given that almost half of us have small or no mortgages, this 50% ratio seems dangerously high.
But now the asset values have fallen back to $30 trillion,
whereas the debt remains at $25 trillion, give or take the
miserly $1 trillion we have written down so far. If we
would like the same asset coverage of 50% that we had a
year ago, we could support only $15 trillion or so of total
debt. The remaining $10 trillion of debt would have been
stranded as the tide went out!
What is worse is that credit standards have of course tightened, so newly conservative lenders now assume the obvious: that 50% was too high, and that 40% loan to collateral value or even less would be more appropriate. As always, now that it’s raining, bankers want back the umbrellas they lent us.
At 40% of $30 trillion, ideal debt levels would be $12 trillion or so,
almost exactly half of where they actually are today! It is
obvious that the scale of write-downs that we have been
reading about in recent months of $1 trillion to $2 trillion
will not move our system anywhere near back to a healthy
balance. To be successful, we really need to halve the
level of private debt as a fraction of the underlying asset
values. This implies that by hook or by crook, somewhere
between $10 trillion and $15 trillion of debt will have to
Given where we are today, there are only three ways to restore a balance between current private debt levels and our reduced, but much more realistic, asset
- we can bite the bullet and drastically write down debt (which, so far, seems unappealing to the authorities);
- we can, like Japan did, let the very long passage of time wear down debt levels as we save more and restore our consumer balance sheets; or
- we can inﬂate the heck out of our debt and reduce its real value.
(In the interest of completeness I should mention that there can sometimes be a fourth possible way: to somehow re-inﬂate aggregate asset prices way above fair value again. After the tech
bubble of 2000 Greenspan found a second major asset
class ready and waiting – real estate – on which to work
his wicked ways. This time there is no new major asset
class available and, although Homo sapiens may not be
very quick learners, we do not appear eager to burn our
ﬁngers twice on the very same stove. As a society, we
apparently need 15 to 20 years to forget our last burn. With
so many ﬁnancial and economic problems reverberating
around the world and with animal spirits so crushed, re-
inﬂ ating equity or real estate prices way above fair value
again in the next few years seems a forlorn hope if indeed
it is possible at all.)
Each of the three realistic possibilities listed above would
be extremely painful, each is loaded with uncertainties,
and even the quickest of them would take several years.
Our path this time is likely to involve a hybrid approach:
we will certainly take some painful debt liquidations; this
crisis will almost certainly take far longer than normal
to play out; and probably, before a new equilibrium is
reached, we will see inﬂation rates that are well above
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