Comstock Partners, Inc.November 12, 2009
Debt Dynamics Will Hold Back Economy
Government Debt could Double While Private Debt could be Cut in Half
We believe that U.S. government and private debt levels will diverge over the next four or five years as the authorities attempt to use government debt to replace the private debt that is almost certain to decline substantially. U.S. total debt is presently just under $55 trillion, comprised of public (government) debt of about $15 trillion and private debt (U.S. corporations and individuals) of about $40 trillion. The similarities to Japan at its 1989 economic and market peak leads us to believe that we are close to the same road map that Japan was on starting at that time and continuing until today. With that said, we expect current U.S. government debt of $15 trillion to double to about $30 trillion and private debt to drop in half to about $20 trillion over the next 4-5 years.
We wrote about this in the "special report" titled "Deleveraging of the U.S. Economy" in August of this year when we made what some would call outrageous predictions. In fact, the report received much attention in the press (including Abelson's Up & Down Wall Street article in Barron's) as well as the internet and internet blogs. What probably surprised us most was that there wasn't much attention given to the outrageous predictions mentioned above that we still live by today. In the report we stated, "We expect the private debt to continue declining in the future as the deleveraging of America unfolds, while the government debt will very likely explode to the upside as the government tries to keep the economy afloat while the private deleveraging weighs it down."
We went on in the August report to show the similarities and differences between the U.S. now, the Great Depression following 1929 and Japan in 1989, when their bubble burst, leading to two lost decades. Later we quantified the explosion of government debt and the decline of private debt. We essentially predicted the true government debt of $7 trillion (government debt ex the debt to fund the short-fall of Social Security and State and Local Debt) to triple to $21 trillion and private debt to decline from $39 trillion to about $20 trillion.
In this report we will attempt to make it easier to follow the prediction by rounding the numbers and explaining the different numbers used when discussing government debt. Let's just round the total U.S. debt number to $55 trillion since it is close enough. Keep in mind that if we include the shortfall of Medicare, Medicaid, Social Security, the costs of two major wars, and obligations of the latest bailouts, the $55 trillion level would more than double.
Using the $55 trillion as an approximate total debt figure, let's now subtract the government debt. As stated in the August report the true government debt is about $7 trillion (or 50% of GDP - the same % of GDP as Japan in 1989). But that $7 trillion figure does not include $4 trillion of U.S. government bonds used to fund the Social Security shortfall and $4 trillion of state and local debt. If you add that $8 trillion to the $7 trillion of official government debt you come to the $15 trillion of total government debt.
Subtracting the $15 trillion of government debt from the $55 trillion total debt gives us $40 trillion of private debt. Now we will make a similar prediction as to where these debt levels will eventually reach before we can say the private sector balance sheet is finally repaired. And as we stated in the August report we are using the Japanese road map to make these predictions. We expect the government debt of $15 trillion to double to about $30 trillion. Remember, we stated previously the $7 trillion of actual U.S. government debt will rise to $21 trillion. Since state and local debt will also rise, $30 trillion seems like a reasonable estimate. On the other hand, we expect total private debt to be cut in half to about $20 trillion in order to return to reasonably healthy private sector balance sheets. (This includes major debt declines for credit cards, mortgages, auto loans, commercial real estate and corporate debt).
We expect private debt, particularly that of households, to decline sharply, correlating to patterns following the Great Depression and Japan in 1989. The consumer won't soon go back to the old ways of borrowing and spending that led to the internet bubble and the housing and stock market bubble of a few years ago.
Only after the private sector rebuilds its balance sheet can we expect them to resume normal levels of spending and saving. However, we still will not be out of the woods since the government's balance sheet will be the next dilemma for the country. The government will have to rebuild its balance sheet just as the private sector is doing now. The government expansion of debt will more than likely drive their debt to over 200% of GDP. This is where Japan's debt is now, and just this week Fitch warned that they may have to lower the ratings on Japanese sovereign debt. Hopefully, after the government debt build-up, Japan and the U.S. will both be able to unwind the debt without inflation becoming a major problem (Granted, that is a big assumption). As you can see this is a very precarious situation that every country will experience after going on a speculative binge where they wind up borrowing more than $5 of debt to generate $1 of GDP.
The bottom line of all this is that we expect the government debt to explode to $30 trillion from $15 trillion presently and the private debt to contract to about $20 trillion from the present $40 trillion. This process we expect will be associated with a weak economy and the continuance of the secular bear market in stocks which started in 2000.