Karl Denninger, "2009 Labor Day Ponderings..."

A Comment: To quote Morpheus again, "I didn't say it would be easy. I said it would be the truth." Some have questioned why articles posted here are sometimes very lengthy. It's because the world's a pretty complex place, and many situations and circumstances simply can't be described sufficiently in a brief manner. My assumption, if you're reading this, is that you're not a stupid sheeple content with 144 letter "Tweets", and that you have a serious intent of understanding for yourself why things are the way they are. This article will make you work a little- it's good for you, you can handle it...

"2009 Labor Day Ponderings..."

by Karl Denninger

"After a bit of prodding I decided to go back and expand a bit on the "Weekend Chart To Ponder" posting. Be warned: this is a far more esoteric undertaking than the previous, and may make your eyes glaze over. Nonetheless I believe it is important, as it sets forth some "boundary conditions" that, when analyzed against current economic trends and behavior, are likely to lead you to inescapable (and perhaps ugly) conclusions.

Expanding this chart was particularly difficult to do because The Fed doesn't make it easy to find the data I was looking for - specifically, total outstanding borrowings on mortgages. Their "Flow of Funds" report shows changes, but that's not sufficient - I need total numbers outstanding. Fortunately The Census Bureau keeps track of that data - albeit with a bit of a lag (they don't have 2008 yet.)

Just to reiterate for those who didn't catch this up front - these numbers are expressed as percentage changes and are all per-capita. The latter is important and often ignored - a rising population of course can support a larger (total) amount of credit outstanding, but at the same time it mutes GDP growth. That is, if you have 100 million people in the nation and double it (to 200 million) GDP doubling doesn't actually improve anyone's lot in life - the per-capita GDP is the same. Ditto for total incomes, and total debt - rising debt is bad, but only if it is rising per-capita.

Many people have asked why I didn't include inflation in these numbers. There are a number of reasons, the most-important of which is that it doesn't matter when one is comparing against incomes. There is also the problem of defining inflation - exactly what do you include and what do you not? Government statistics are notoriously inaccurate - for instance, they did not define the rise in house prices from 2003-2007 as "inflation", since they use a thing called "owner's equivalent rent" in the computations - a farcical measure for the majority of Americans, since the majority own their homes. Then there are what are called "hedonic" adjustments; the simplest explanation of "hedonics" is that when steak becomes too expensive the government substitutes hamburger, since both are meat and contain protein (yeah, really.)

We can fight over "inflation" numbers all day and all we'll generate is heat, not enlightenment. The easiest way to avoid doing that is to compare against what matters when it comes to debt - that is, income. Why? Because the servicing of debt requires income. The greater the outstanding debt (per-capita) in regards to income, the closer "the wall" gets to the consumer.

So with that, here's the chart (click on it for a bigger copy):
Now let's agree on a few things, shall we?

First, there is a "critical level" beyond which all debts will default - without exception. That point is where the carrying cost exceeds income. For example, if you have a $100,000 mortgage and $9,999 (or less) in income, if the interest rate is 10% every such mortgage will default since you can't pay $10,000 with $9,999.

A direct comparison of this sort is, however, a ridiculously optimistic scenario. "Money income", as defined by the Census Bureau, includes all money earnings before taxes (Census definition) and excludes non-cash benefits (that couldn't be used to pay debts) such as food stamps and housing subsidies. It also excludes capital gains and losses (we can argue over whether it should, but it does.) Note, however, that taxes are not included, and for essentially all employed persons there is an explicit tax hit (even if you have zero federal income tax) for Social Security and Medicare, never mind state taxes, property taxes and other forms of tax, all of which reduce income available to service debt.

Second, before you can service debt you must have the basic necessities of life. Chief among these are of course food and shelter, the latter often being a big source of that debt too (mortgage debt in particular.) Therefore, we must subtract out of your income the cost (per-capita) of the basic necessities of life. We'll define this as the Federal Poverty Threshold; since the average household is 2.59 people (per the US Census again) this places the per-capita requirement for basic necessities of life at ($14,540 / 2.59) (arithmetic average of the 2 and 3 person poverty level divided by actual average household size) or $5,614 as of 2007. This must be subtracted from the per-capita income of $26,804 (for 2007) knocking the actual income available to service debt (in the best case) back to 1998 levels, when it first crested $20,000, or 500% of baseline.

Third, all forms of debt are additive. That is, you can't compute the percent interest necessary to force 100% default rates just for mortgages unless mortgages are the only form of debt out there, and clearly they're not. When you try to "blend" the numbers you again run into the need to make assumptions that make it impossible to set an accurate "must default" level.

Finally, we must add in the costs associated with the income and debt you are trying to service. This is often ignored and yet it can't be - the cost, for example, of a vehicle (including insurance, gasoline, repairs, etc) to get to work, if you live where mass transit is unavailable between your home and office, is an unavoidable expense that must come out of income before anything is available for debt service. The impact that this has on an individual varies greatly.

Does this particularly enlighten us on the promise (or peril) going forward for America? Not really, but it does give us a framework to start thinking about whether what we've been doing to "address" the recession since 2007 can possibly work.

Now let's think for a moment about the actual "default function"; that is, how outstanding debt compared to income actually results in defaults (or not) in a real system. I would argue that it is most like the rational function f(x) = 1/x where x is a positive number representing the "displacement" from "zero hour", or the maximum debt possible to be sustained, and y is the default percentage with infinity representing 100%. The "zero point" is where debt service (if all debt) is impossible with current income (that is, interest due exceeds current after-tax and after-necessity income.) That is, once we get a reasonable distance away from that "zero point" the change in default rate for a given displacement is rather small. This behavior is what leads to booms during loose lending periods - reasonably large changes in income and debt levels do not immediately lead to large changes in default rates - so long as we're a "safe" distance away from the "zero point."

But this behavior is deceiving, because the change in default behavior is in fact parabolic, not linear, as one approaches the "zero point." As debt continues to build in the system the ratio gets closer to the zero point for (x), and as that occurs the default rate starts to rise - first slowly, then much more rapidly for a given excursion toward zero. What's worse is that the act of default forces the equation the wrong way, since defaults tend to cause bankruptcies of both borrowers and lenders, and thus business failures - and the latter results in unemployment (thus driving per-capita income down.)

So, you say, this is all a nice bunch of arm-waving, but what does it mean? (Are your eyes glazing over yet?)

On that point we can reach some conclusions. We know, for instance, that unlike all previous recessions since the 1930s this one began with consumer defaults on subprime loans. That is, we began to approach the zero point through the dramatic increase in debt outstanding and the most-marginal borrowers were unable to make their payments. This in turn caused the cessation of origination of these loans and the construction of homes that were enabled by them, which forced people out of work both in those lending and building enterprises (thus forcing per-capita income downward.) That in turn drove us even closer to the zero point, and the damage began to move up the scale. Higher-quality borrowers began to default - first on ALT-A loans and then prime loans, and the defaults spread into other areas of finance including credit cards and commercial real estate.

The Fed and Government, in response to this trend, flooded the system with liquidity in an attempt to drive down borrowing costs (that is, to get the interest component down so "the wall" was further away.)

Did it work? No - because the banks, rather than being forced to admit their losses and come clean, were instead permitted to hide them. They took this "cheap money" for themselves and instead of lowering interest costs for consumers, moving the default function in the desired direction, raised them on consumer debt, forcing the default function the wrong way! The government in turn stepped up its borrowing and replacement of actual income with subsidy, since the interest rate for government borrowing did indeed go down. This prevented an all-on implosion at that instant in time. But did it fix the problem?

NO! Why not? Because the debt is still out there and the ability of the government to continually borrow more money forever to use in these subsidies for the purpose of halting the shift to the left in the debt/income default function does not exist. Oh sure, government can do this for a while - and it has. But not forever, and yet "forever" is what is required, until and unless those debt levels go down or income levels go up to get us back into the "safe" zone of the default function.

Yet the government's actions in fact move the curve the wrong way over time! That is because government borrowing is in fact debt that ultimately must be paid for out of individual income. While it is "cheap" borrowing it has not (and doesn't) replace the high-cost debt that is causing the problem - it is simply a means of attempting to subsidize the current payment required to keep the default from happening "right now" (as in this month.) We are doing the wrong thing because government and The Fed have misdiagnosed (either intentionally or not) the cause of the recession and thus whether their tonic can be effective.

During an ordinary inventory-led recession where excessive credit is not the triggering cause (rather, it is over-capacity in the economy) the tonic applied is useful, because stimulating demand causes the slack to come out. It also causes debt:income ratios to expand, but remember the default function - so long as you are a good distance away from the "zero point" this has little cost in terms of increasing the actual number of defaults. It does, in each and every case, shave the safety margin. We've gone through multiple recessions (all the way back to the 1970s) where we had lots of safety margin, and as a consequence this "tonic" seemed the right medicine for the job.

The problem is that we never forced the contraction of borrowing and thus never, over more than 30 years time, caused the safety margin to be rebuilt!

When you are in a recession that is occasioned by getting "too close to the sun" - that is, too close to the zero point - such policies are a disaster, because there is no safety margin left - you have in fact entered the parabolic zone of defaults, where anything that ramps the debt/income ratio at best masks the problem for a period of time and at worst can drive you into the maw of what amounts to a singularity - the implosion of your economic and monetary system.

I believe the evidence is clear and in fact irrefutable - we are in this mess because we reached the parabolic portion of the default function - in fact, we just touched the edge of it. As such what the government and The Fed have done is exactly backwards and is only going to make the inevitable pain that must be taken worse.

In 1933 Roosevelt devalued the dollar to get out of this death spiral. He was able to do so because the dollar was linked to gold, and thus he could simply sign a document and change the exchange rate, at the same time banning private ownership of the metal (and thus preventing the market from immediately counteracting his devaluation and rending it meaningless.) Today all currencies are fiat and this option is not available - should it be attempted via massive money printing (doing so would require The Fed to literally print the entire asset base underlying the credit system in the US - somewhere on the order of $20+ trillion dollars!) the outcome would be an instantaneous ramp in energy costs (and all other imports) by more than 1,000% and the immediate collapse of both our economy and all banks, including The Fed itself, since wages would not and cannot increase by that same 1,000% in a global economy.

We must force the outstanding credit levels down to sustainable levels. This will cause a huge number of bankruptcies, especially among the financial "heavy hitting firms" on Wall Street and the pension and insurance funds of Americans as the true "value" of their so-called assets are exposed. The problem is that there is no alternative - we squandered the ability to rebuild our safety margins over the previous 30 years, and now we're into the maw of the parabola with no remaining margin available to exploit. The longer we wait to do the right thing the worse the outcome will be, and if we wait too long we will lose our nation - literally.

History has shown that the 2000-01 recession "avoidance tactic" of more than doubling outstanding consumer credit in mortgages and increasing it by 60% in other debt while income only rose 23% during the same period bought us seven years of delay and a collapse far worse when we hit the wall - unemployment only reached 6.3% during the 00-01 recession (in 2003) while we are now at 9.7% (officially) and climbing. Consumer spending and defaults were a non-factor in 00-01 - today they are the feature of our recession.

Today we simply have no more "forward debt capacity" in our economy. This is not conjecture or belief - it is hard fact and has been proved by the structure of the current recession. Attempting to use even more lending - that is, credit - to "pull us out" of this recession is not only doomed to fail it will drive the default equation closer to zero. We must stop this madness and the accumulation of damage that must be taken in our economy before we find ourselves in a monetary and fiscal gravity well from which we are unable to escape."

- Karl Denninger, http://market-ticker.denninger.net/

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