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Debt Saturation

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March 22, 2010 – Comments (15)

I and many others have been discussing this very topic for awhile. My contention has been that while the first round of Quantiative Easing was engineered to prop up all kinds of asset classes, most notably the housing market (in that case to slow the free fall) and the stock market. QE-I is about to run out (the Fed MBS purchase program ends this month). And I have stated before that there will be a Quanitative Easing Two / QE-II [a.k.a. big bertha], only this time instead of propping up failing assets, the aim of QE-II will be soley to keep the governement running.

Why? Because of debt saturation.

I talked about this very issue in my December post: The Long View - Q&A:

this Dollar bounce was not unexpected either. Many of us have been watching and calling for it. The question is now, what does it signify? Is it the start of a major multi-year dollar rally (some think so), or is it a bounce that lasts a few months (I am in this camp).

I think the Dollar Carry trade is about to unwind a bit. And I think this bounce was more or less engineered. The QE fund pool is almost dried up, and the demand from foreign governements during the last bond auctions was severely anemic. So the Fed needs a good "deflation scare" to get a second round of Quantitative Easing authorized.

And the purpose of this next round of QE will be to keep the government running, not to prop up the stock market. Like you observe above, tax revenues are down, yet the national debt ceiling is being *raised*. Government is *growing* in the face of shrinking revenues. And the only way to accomplish this is through defecit spending. And if foreign governments won't buy our debt to allow our government to run, then we have to buy our own debt (via debt monetization courtesy of the Fed, of course). It is the only way to keep the government running, other than slashing services. And the chance of that happening in an election year? Approximately 0.0%.

This is why the outcome was never going to be deflationary. As long as there is Fed, debt monentization will always be the preferred expedient action.

But just because the outcome is inflationary, it does not mean that assets will rise. I hemorrhage a lot when I read economic commentary because nobody tries to understand the complexity of the macroeconomic situation. And since 2000, we have seen first hand how little the ramifcations of monetary policy decisions are made not only by the public, but even by those who are making them. I still hear a lot of "dollar down = stocks up" or "inflation means stocks will rise".

Inflation "helps" (used *very* loosely) stocks rise ... until it doesn't. Stocks can fall in an inflationary environment, because the economic fundamentals are weak, and the inflation starts to exascerbate the weakness, not hide it. This happened in the 1970s. And it is called stagflation.

When stocks fall again due to poor fundamentals, people will say this is proof of deflation. I mean after all, if assets fall, it's deflationary right? Not if you want to understand cause and effect and not if you want to understand what the macroeconomic ramfications are. Mislabelling the next downturn as deflationary is exactly the misperception that the Fed wants so that it can be more aggressive with QE and similar policies (ramp up inflation while everybody is focused on "deflation" -- which is actually a deflation scare). Hell, they even said they were buying more mortage back securities today! (monetizing debt is directly inflationary). It believes that it is helping to solve the problem, but in actuality it is reinforcing it.

Peter Schiff had a great bit on his video blog (which kdakota always does a great job of reposting) regarding the PPI interpretation and extrapolation. Check out this post: http://caps.fool.com/Blogs/ViewPost.aspx?bpid=312473 and watch from 3:05 to 5:15. It is easy to see how this argument has ramifications for lower stock prices within an inflationary environmentThe comparison between now and the 1970s has a lot of compelling aspects: high inflationary environment, poor fundamentals, and falling asset prices. The only difference now is that the structural imbalances are a lot worse. Which means that the monetary inflation is going to reinforce the problems much more than they did in the 1970s.

A valid question would be "well once the Fed realizes (supposing they do) that it is a positive term in the feedback loop, not a negative one, won't they just stop inflating?".

The first answer is: no. And the first clue is the yield curve. Nobody but the Fed is buying our long term debt. The only reason why the government is running at the moment is because the Fed is funding the Treasury, it isn't getting money from foreign governments (well it is, but in much smaller proportion). And the National Debt ceiling is being *raised*. The Fed needs to inflate to get the government running.

The second answer is: it doesn't matter. Because once the inflation is detectable in general prices, the massive monetary inflation will have already done vast amounts of damage. And because of the inertia in the economy, we will be feeling the aftermath of that inflation for a very long time.

Things you own go down in value, the things you need to consume cost more. Sounds like stagflation to me.

And there is evidence that Debt Saturation is taking place right now.

See Nathan Martin's newest post THE Most Important Chart of the CENTURY

The latest U.S. Treasury Z1 Flow of Funds report was released on March 11, 2010, bringing the data current through the end of 2009. What follows is the most important chart of your lifetime. It relegates almost all modern economists and economic theory to the dustbin of history. Any economic theory, formula, or relationship that does not consider this non-linear relationship of DEBT and phase transition is destined to fail. It explains the "jobless" recoveries of the past and how each recent economic cycle produces higher money figures, yet lower employment. It explains why we are seeing debt driven events that circle the globe. It explains the psychological uneasiness that underpins this point in history, the elephant in the room that nobody sees or can describe. This is a very simple chart. It takes the change in GDP and divides it by the change in Debt. What it shows is how much productivity is gained by infusing $1 of debt into our debt backed money system. Back in the early 1960s a dollar of new debt added almost a dollar to the nation’s output of goods and services. As more debt enters the system the productivity gained by new debt diminishes. This produced a path that was following a diminishing line targeting ZERO in the year 2015. This meant that we could expect that each new dollar of debt added in the year 2015 would add NOTHING to our productivity. Then a funny thing happened along the way. Macroeconomic DEBT SATURATION occurred causing a phase transition with our debt relationship. This is because total income can no longer support total debt. In the third quarter of 2009 each dollar of debt added produced NEGATIVE 15 cents of productivity, and at the end of 2009, each dollar of new debt now SUBTRACTS 45 cents from GDP! This is mathematical PROOF that debt saturation has occurred. Continuing to add debt into a saturated system, where all money is debt, leads only to future defaults and to higher unemployment.

ENLARGE

15 Comments – Post Your Own

#1) On March 22, 2010 at 3:23 PM, lemoneater (79.38) wrote:

Who squeezes the sponge out when it gets too soggy? Or do we just keep adding more sponge?

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#2) On March 22, 2010 at 3:26 PM, binve (< 20) wrote:

Hey lemoneater! The problem is, as the chart above shows, in the 1960s we were adding dry sponges. Today, all the sponges are soaked. Which means the sponges are already soggy when adding then to the soggy sponges. It doesn't work and actually componds the problem now (or it reinforces the structural imbalances in the economy as I point out above).

Thanks!

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#3) On March 22, 2010 at 3:47 PM, lemoneater (79.38) wrote:

I like easily understood metaphors, binve. Thanks for the clarification:)

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#4) On March 22, 2010 at 3:49 PM, binve (< 20) wrote:

LOL! me too :) no problem :)

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#5) On March 22, 2010 at 4:02 PM, Tastylunch (29.54) wrote:

yup that's what's happened alright

that's all I got.

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#6) On March 22, 2010 at 4:09 PM, brickcityman (< 20) wrote:

So I guess the next questions is... what to do?

 

How does one protect one's self from this phenomon should it play out the way you expect?

 

Are there particular asset classes that become highly attractive (metals, raw goods producers, etc)?  Do you seek to diversify your currency holdings?  Stock up on soup and bullets?  

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#7) On March 22, 2010 at 4:12 PM, russiangambit (29.49) wrote:

The whole idea that keeping money cheap, i.e. having low interest rates might work if there are enough saving and demand to back up increases in productivity in production. The problem that in case of the US there is little demand for additional productivity so the money goes elsewhere since there is the law of sdiminishing return at work within the US market. What is in the FED's charter -  maintain stable unemployement in the US or in the rest of the world? Because the best thing they can do for the unemployement in the US is stop tinkering with the interest rates and let then return to their natural state so that some savings can occur and demand can build up.Now  if they were trying to maintain labor market in China and India and Brazil then they certainly succeeded beyond their wildest dreams.

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#8) On March 22, 2010 at 4:17 PM, Griffin416 (99.98) wrote:

Binve,

 I enjoy reading your posts as you seem to be both a technician and a fundamentalist. While I agree with your Peter Schiff attitude, there are a couple of things I would like to point out/argue.

1) One of the reasons the market is going up is liquid cash...money goes to where it is loved the most. The 30-year T-bills is about 4.6% now, right? Are you telling me that the stock PM which has 4.6% yield (as of this writing) will not go up in 30 years...especially given its 100% revenue in foreign currency?  

2) Big inflation is BAD (nothing but gold is safe), I agree, but there is a sweet spot your writings do not seem to take into account for. Forgetting about the silly gov't made numbers, I figure they will always lie the same amount. When inflation is between 2%-5% the market and the economy take off like a rocket. This is almost where we are now. When you go above 5% is where your scenario plays out. We are not quite there yet. 

3) I severely disgree with the recent political action, but, the election cycle - (not my idea) I read somewhere that throughout history, the best year to own stocks in the 3rd year of the first term presidency (2011). Secondly, the best time to own stocks is when we have a democratic prez with a repub congress...again, possibly, 2011. This year, I predict will be flat-ish. 2011 could be good given points 1-3 ;o)

4) One other thing I would simply like to point out, gold is not done going up. Chart wise, the exact opposite of stocks, gold peaks on spikes and bottoms in rounding patterns. Given the bullish 6-years and no big spike to end it, I'm a gold bull.

Separately, One of the first things I learned about looking at both charts n fundies is how would you feel if the chart was upside down? A question to ponder...what would your technical analysis of the S&P look like if you were bullish.

Griffin

 

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#9) On March 22, 2010 at 4:23 PM, binve (< 20) wrote:

Tastylunch,

Yep. It really put the idiotic economic theories from these blowhard economists into perspective, and dispels the biggest fallacy of a "jobless recovery"

brickcityman,

>>How does one protect one's self from this phenomon should it play out the way you expect?

Here is a good summary of how I see the macro picture: http://caps.fool.com/Blogs/ViewPost.aspx?bpid=330962#comment331037.

Because I am optimistic about the long term prospects of the US and the economy (after we go through some needed purging the next several years) I invest in gold and real assets.

If one is more pessimsistic about civiliation and how it will handle this crisis, then soup and bullets are a good call :)..

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#10) On March 22, 2010 at 4:46 PM, binve (< 20) wrote:

russiangambit ,

>>The whole idea that keeping money cheap, i.e. having low interest rates might work if there are enough saving and demand to back up increases in productivity in production. The problem that in case of the US there is little demand for additional productivity so the money goes elsewhere since there is the law of sdiminishing return at work within the US market.

Exactly.

This is Japan as a case in point. Japan is a saving country so its citizens were able to soak up a lot of the financials shennanigans and massive goverment debt. So instead of a Great Depression-type crash, there was a 20 year grinding bear market.

If the Japanese government has bit the bullet and decided to stop tinkering with monetary policy Japanese private savings could have fueled a new bull market.

But now the Japanese problem is becoming more like a US problem. The majority a Japanese savers are entering retirmenent age (similar to the baby boomer problem we will be experiencing) and it needs to sell assets (the NIKKEI but more importantly, government debt) in order to retrire.

The demographics are clear, a widespread problem is coming to a head that cannot be solved with debt.

Griffin416 ,

Thanks! Yes, I think both are necessary and no mutually exclusive.

>>While I agree with your Peter Schiff attitude

I don't mind that comparision at all, becuase I agree with a great deal of what Peter Schiff says. But if there is one analysts who I most agree with and who I think has by far the best grasp on the macroeconomic situation, it is definitely Steve Saville.

1) One of the reasons the market is going up is liquid cash...money goes to where it is loved the most. The 30-year T-bills is about 4.6% now, right? Are you telling me that the stock PM which has 4.6% yield (as of this writing) will not go up in 30 years...especially given its 100% revenue in foreign currency? 

You have to look at yield in the proper context. And I think chasing yield on long term government debt is a dangerous game to play right now. See this conversation (http://marketthoughtsandanalysis.blogspot.com/2010/03/what-bond-market-is-trying-to-tell.html#comment-40549033) from this post http://marketthoughtsandanalysis.blogspot.com/2010/03/what-bond-market-is-trying-to-tell.html .

2) Big inflation is BAD (nothing but gold is safe), I agree, but there is a sweet spot your writings do not seem to take into account for. Forgetting about the silly gov't made numbers, I figure they will always lie the same amount. When inflation is between 2%-5% the market and the economy take off like a rocket. This is almost where we are now. When you go above 5% is where your scenario plays out. We are not quite there yet.

Fair enough. I agree that things at the macroeconomic level to not move quickly. And while the conditions are ripe for the current round of monetary inflation to go into real good, things like the Dollar carry trade have further to unwind. So in this case, ripe might not necessarily mean imminent. It could, but it doesn't have to.

3) I severely disgree with the recent political action, but, the election cycle - (not my idea) I read somewhere that throughout history, the best year to own stocks in the 3rd year of the first term presidency (2011). Secondly, the best time to own stocks is when we have a democratic prez with a repub congress...again, possibly, 2011. This year, I predict will be flat-ish. 2011 could be good given points 1-3 ;o)

LOL! I hear you. And in fact I acknowledge that previously here: http://caps.fool.com/Blogs/ViewPost.aspx?bpid=350605. We might not be at the top of P2. We might in fact be in the middle of a Cycle Degree X wave. Which means we could spend the second half of 2010 is a sideways B of X and then move higher in 2011 in a C of X. But an X wave is ulimately just a correction. Cycle Y will make lower lows. I have yet to find a compelling technical or fundamental argument that we are in a new secular bull market.

So we either make lower lows this year / early next year (P3 of Cycle C) or new highs 2011 and then new lows 2012 (Cycle X and Cycle Y). It is impossible to know where we are in the wave structure right now. I have a gues, but that is all I or anybody else has.

4) One other thing I would simply like to point out, gold is not done going up. Chart wise, the exact opposite of stocks, gold peaks on spikes and bottoms in rounding patterns. Given the bullish 6-years and no big spike to end it, I'm a gold bull.

Exactly. Same here man. Especially if you look at the monthly chart and tune out the noise of the daily chart. The bull market picture is very much intact.

Thanks for the comment! Great thoughts!!..

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#11) On March 22, 2010 at 10:28 PM, mrindependent (96.18) wrote:

This post is absolutely awesome and Russiangambit's comments could not be more spot on.

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#12) On March 22, 2010 at 10:38 PM, binve (< 20) wrote:

mrindependent , Thanks!! That is much appreciated!!..

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#13) On March 28, 2010 at 10:47 AM, carfun (< 20) wrote:

Is the chart explained by the fact that more and more of the debt is government owned which is inherently non-productive?

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#14) On March 29, 2010 at 12:06 PM, jdlech (< 20) wrote:

When the carry trade unwinds, all markets turn upside down.  That which QA indicates should go down will go up and vice versa.  This is because those involved in carry trades also leverage and use QA to determine their posittions.  Unwinding makes everything go backwards.  It also happened at the beginning of sub prime mortgage securies meltdown.  This time should be a lot better controlled, though.

If I'm right, what's been going up will go down and vice versa.  That should give you some idea of what to expect for the next few months.

 Of course, stocks in international companies should get hammered as the dollar surges.   So I'd look for international companies that have been rising these past few months for a possible short position.

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#15) On March 29, 2010 at 12:09 PM, jdlech (< 20) wrote:

Should have mentioned this the first time.  I don't expect the carry trade to unwind until the FED raises the Federal Funds rate.

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