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May 20, 2010 – Comments (5) | RELATED TICKERS: DE , B , T

I have been hammering on the topic because it is the critical issue to understand how all of the advanced economies government's action will not only fail to produce the desired effects, but will more importantly make matters worse. The main issue is  Debt Saturation - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=357428. It is critical to understand that an increasing debt load has decreasing marginal utility and there comes a point due to servicing requirements that all new debt has a negative economic impact. This is why we were NEVER going to be able to borrow and spend our way out of a crisis that was caused by too much debt to begin with.

This sets up an extreme deflationary environment (this debt load is unsustainable) within which the Federal Resevere will monetized uprecendented amounts of debt at uncprecedented rates. Which will result in a simultaneous deflationary and inflationary outcome: stagflation. There is NEVER anything in economics and especially macroeconomics that has only one cause and one effect. There are always multiple effects with varying degrees of influence (both in absolute value and transience). There will be deflationary impulses and there will be extreme monetary inflation, the Fed will see to that. Which means that I think the most likely outcome will be a combination of the two: stagflation. Economically correlated assets go down in value (like your home and equities as a general asset class) and things you need to buy/consume (such as real assets / commodities) cost more. Really the worst of all possible outcomes.

I do think that most inflationists discount the amount of debt that is collapsing (even though most deflationists use measures like M2 and M3, which have a lot of non-monetary components to prove their point) while at the same time most deflationists discount the amount of monetary inflation the Fed can generate (they argue that the Fed creating base money is like pushing on a string because the banks don't have to lend, even though I am many others have pointed out that the Fed has gone around the banking system and has started monetizing private sector debt directly, which is a trend that is likely to increase not decrease). Most people on either side of the debate is not considering strong evidence that both forces are significant.

Nathan Martin has another excellent post regarding debt saturation. Read it. This is the most important macro issue on the horizon. This is not isolated to the US, but to all major advanced economies.

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Debt Saturation Equals Diminishing Growth, Employment, and Capacity Utilization…
by Nathan Martin Monday, May 17, 2010

http://economicedge.blogspot.com/2010/05/debt-saturation-equals-diminishing.html

[excerpt]

When a debt based money system is born, the system is not yet saturated and adding debt (leverage) to the system works to increase growth of the economy.  

The economy cycles, and if one adds debt time and again to stimulate down cycles yet fails to remove that stimulus on the up cycles then DEBT accumulates over time.  This accumulation starts out slow, but with each cycle builds upon itself creating exponential growth.  Witness the charts of public and private sector debts below:

Federal Government Debt:



Household Sector Debt:



As debt begins to permeate the economy, the stimulation effect diminishes as was thoroughly demonstrated in the last article on THE Most Important Chart of the Century:



I have been pointing out the continuous series of lower highs on that chart that gave way to a phase transition into negative territory at the debt saturation point. I’ve presented descriptions of a debt saturated environment and noted that employment and production should fall once saturation is reached and still more debt is added.  This is due to the fact that new income must be used to service existing principal and interest payments.  I even theorized that the recent “jobless” recoveries are part and parcel of debt saturation.


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5 Comments – Post Your Own

#1) On May 20, 2010 at 9:14 PM, d1david (29.35) wrote:

Good blog entry.  America is like the person that makes 50k annually, but has 3000 monthly mortgage and $30,000 amassed in consumer credit cards.   He refinanced 3 times in the past 5 years to "debt consolidate", pay off about $30k in consumer debt and get $40k additional cash out each time.   Living large with all that spending and cash.  But he now finds himself underwater 20% on his house.  He can't refinance now and its just a matter of time before the bankruptcy hammer comes crashing down on him.  

America can only "refinance" so many times before there is no more equity.  Right now we are at 97% ltv.... not much room left before the house of cards falls. 

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#2) On May 20, 2010 at 10:03 PM, binve (< 20) wrote:

d1david ,

Thanks! I really like your analogy. It is very appropriate.

On top of that the average maturity of our national debt is *very* short (on the order of 4-5 years). This means that if we somehow avoid a crisis now (which is highly unlikely) then we are only living on "borrowed" time (pun intended).

Thanks!..

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#3) On May 22, 2010 at 6:18 AM, mhy729 (34.68) wrote:

binve

Excellent post!  That last chart is indeed very frightening.  It makes some of the predictions by gloom and doomers like Marc Faber speaking of hyperinflation and wars breaking out not so outlandish.  Hopefully we can find a way out of the mess we have put ourselves in before such scenarios come to pass, but I am not sure what can be done at this point.

I'm a US citizen of Korean descent, and have never really put much thought into it back when it happened, but recently with all that's been happening across the globe and my reading of relevant material as has been made available at this site and others, I've started to look into the financial crisis that erupted in Asia back in 1997.  Here's something interesting I came across in the Wikipedia entry:

Since the countries melting down were among not only the richest in their region, but in the world, and since hundreds of billions of dollars were at stake, any response to the crisis had to be cooperative and international, in this case through the International Monetary Fund (IMF). The IMF created a series of bailouts ("rescue packages") for the most affected economies to enable affected nations to avoid default, tying the packages to reforms that were intended to make the restored Asian currency, banking, and financial systems as much like those of the United States and Europe as possible. In other words, the IMF's support was conditional on a series of drastic economic reforms influenced by neoliberal economic principles called a "structural adjustment package" (SAP). The SAPs called on crisis-struck nations to cut back on government spending to reduce deficits, allow insolvent banks and financial institutions to fail, and aggressively raise interest rates. The reasoning was that these steps would restore confidence in the nations' fiscal solvency, penalize insolvent companies, and protect currency values.

The effects of the SAPs were mixed and their impact controversial. Critics, however, noted the contractionary nature of these policies, arguing that in a recession, the traditional Keynesian response was to increase government spending, prop up major companies, and lower interest rates. The reasoning was that by stimulating the economy and staving off recession, governments could restore confidence while preventing economic loss. They pointed out that the U.S. government had pursued expansionary policies, such as lowering interest rates, increasing government spending, and cutting taxes, when the United States itself entered a recession in 2001, and arguably the same in the fiscal and monetary policies during the 2008–2009 Global Financial Crisis.

(italics mine)

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It is curious to see that the medicine the US prescribed to debt-ridden Asia is not the same medicine it administers to itself.  Maybe I am missing an important point, but why would this be?

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#4) On May 22, 2010 at 1:08 PM, binve (< 20) wrote:

mhy729 ,

Thanks!

>>It makes some of the predictions by gloom and doomers like Marc Faber speaking of hyperinflation and wars breaking out not so outlandish.

For the record, like I outline above, I don't think the outcome will be hyperinflation. There is too much debt collapsing. I think both effects will be severe => stagflation (IMO).

>>but recently with all that's been happening across the globe and my reading of relevant material as has been made available at this site and others, I've started to look into the financial crisis that erupted in Asia back in 1997.

I think that is a very relevant thought process. And if you look at the long term chart of the NIKKEI, it tells that story pretty clearly: http://caps.fool.com/Blogs/ViewPost.aspx?bpid=350605. A 20 year long grinding bear market. That is why I think those expecting the US bear market (which is much worse in both size and scope than what Japan is going through) to be over in 9 years is bordering on delusional.

>>It is curious to see that the medicine the US prescribed to debt-ridden Asia is not the same medicine it administers to itself.  Maybe I am missing an important point, but why would this be?

The fact that it is not is what will make our crisis that much worse. IMO. Thanks for the comment!..

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#5) On August 10, 2010 at 6:47 PM, checklist34 (99.72) wrote:

But a bout of significant inflation, by whatever means, can effectively mitigate debt saturation... 

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