Comstock Partners, Inc.January 25, 2010
The Total Debt Relative to GDP Trumps Everything Else
The Deleveraging has Begun
Barron's magazine printed the first part of its annual Roundtable discussion of 2010 this past week. We noticed that many of the participants were very concerned about the debt (mostly government debt while we think total debt is a much more useful metric). Marc Faber, in fact, talked about a 7,000 word New York Times article by Professor Paul Krugman. He stated that the article "How Did Economists Get It So Wrong?" never mentioned that excessive credit growth or leverage was the cause of monetary instability and brought about the financial crisis. Bill Gross stated that by lowering interest rates we promote consumption instead of manufacturing. Central bankers were forced to respond with liquidity to a problem that developed over the past 25 years. There was more discussion of credit growth (another way to say debt growth) in the macro analysis that is always presented in the first part of the three Barron's articles of the Roundtable. The amazing thing to us is that most of the roundtable participants understand the same problems we talk about almost every single week, yet are mostly very positive on the market for 2010.
It seems that most of the roundtable participants understand the debt problem we have been talking about for the past 14 years. The worst period of the debt explosion started with the outrageous internet bubble in the late 1990s, continuing through the correction in the internet bubble, then the housing bubble which should have been obvious to everyone (even the Fed) and then the financial crisis of 2008. We are astounded that we have the potential for another bubble in the stock market now. We expected the rebound from a much oversold market in March of 2009, but not a 70% rebound from the lows. We don't believe it is possible to fool the investors in the U.S. stock market one more time. Especially this close to the 2003-2007 and 1996-2000 bubbles.
Hopefully, all of our regular viewers know that we have been, and still are, very concerned about the debt situation in this country-- and many others. Until balance sheets are repaired we don't think the stock market will do well and expect the secular bear market to continue. We really don't know why the roundtable participants, or virtually anyone else for that matter, do not bring up the fact that the total debt in this country doubled from 2000 to present (from $26 trillion to $53 trillion). This drove the debt (both public and private) to 375% of GDP in this country before recently declining to 370%. This 370-375% number is the highest since the Great Depression when it reached 260% at the peak, even with a collapsing GDP. Even more incredible is that the present debt level does not include the entitlement and pension obligations that would just about double the total debt from where it is now.
This U.S. debt to GDP started accelerating in the 1960s (with the Vietnam War, Space Race and continuation of the Cold War) when it took $1.53 to generate an additional $1 of GDP. Then during the 1970s, with the continuation of the Vietnam War, it took $1.68 to generate $1 of GDP. In the 1980s (including Leveraged Buyouts and Star Wars) it took $2.93. In the 1990s (with the internet bubble) the debt it took to generate $1 of GDP climbed to $3.12. However, the most incredible of all was the first decade of this century when it took over $6 to generate an additional $1 of GDP. That decade included the war on terror, two wars, private equity firms (new name for leveraged buyouts) and housing and another stock market bubble, as well as promises of entitlements that we have no possibility of being able to keep. Clearly, needing over $6 to generate $1 of GDP is unsustainable.
We have been trying to compare the U.S. total debt to GDP to other countries for some time and have some figures that were just corroborated with a recent McKinsey report. As high as our U.S. debt to GDP number is, believe it or not, it is not as bad as many other countries according to a recent report by McKinsey Global Institute (the research arm of McKinsey & Co.). The UK debt to GDP is about 470%, Japan 460%, Spain 340%, South Korea 340%, Switzerland 315%, France and Italy about 300%, Germany 275%, and Canada 245% (all are records of debt to GDP). The BRIC countries (Brazil, Russia, India, and China) all have debt to GDP under 160%. We have been warning our viewers about the pain of deleveraging for some time (Special Reports-'Deleveraging the U.S. Economy" 8/09-comparing our deleveraging to Japan, and "Debt Dynamics Will Hold Back Economy" 11/09). The McKinsey report agrees that the deleveraging will be painful and take years to resolve.
You may think that since China and the other BRIC countries are not as leveraged as the more developed countries that they could grow enough to pull up the global economy. But you have to remember the McKinsey report was as of 2008. China had a stimulus package that was three times the size of the U.S. stimulus package relative to GDP. This means the U.S. stimulus package of $787 billion would have been over $2 trillion if we had a package as large as China. Also, the Chinese government encouraged bank lending, and banks loaned out $1.3 trillion during 2009. They could now be more leveraged than the United States. China also could be the next bubble as they are building up their economy to sell products to a world that is deleveraging.
As we stated in many commentaries and "special reports" in the past we expect the deleveraging of America, as well as many other countries, to be the primary focus of central banks worldwide-not the escape from the financial crisis, not the earnings that are supported by cost cutting, and not the economic rebound supported by the stimulus and inventory rebuild. The deleveraging of America and much of the global economy will trump everything else.
In the past when a nation's total debt rose to unsustainable levels it would just debase its currency enough to try to export its way to prosperity, and even this didn't always work. However, when all its major trading partners also need to debase their currencies, it becomes an impossible task. This takes us to the "Cycle of Deflation" chart (attached) which we authored and point to in almost every discussion of our debt problem. We are still in the competitive devaluation part of the cycle; however, you can only devalue or debase your currency relative to other countries in order to gain a competitive advantage. And when all of your trading partners are in the same boat as you, then you are forced to take more drastic measures, and that brings you down the "Cycle of Deflation" to "Beggar-thy-Neighbor policies. This essentially means that the country in trouble will do whatever it takes to sell its products abroad. When a country needs to keep its plants open it might have to sell its products at less than cost, or put restrictive tariffs on imports and/or subsidize exports.
Essentially, we believe we are still in a continuation of the financial crisis we entered in 2008. We have been headed for this crisis for a few decades but are just now realizing the consequences of the debt build up over the years. Before this is over we expect the private debt in the U.S. to drop substantially (from $40 trillion now towards $30 trillion or even as low as $20 trillion) while the government debt explodes to at least double the $15 trillion presently. And since most of our trading partners are in the same boat as we are, they will also be forced to become more protectionists. This does not bode well for the global economy.
In conclusion, we cannot emphasize enough that the total debt to GDP is so onerous for the economies of most mature countries as well as China, that the global economy will suffer tremendously over the next few years. We have discussed this over and over again and, in fact, with a little "tongue in cheek" stated in many comments and "special reports" that when Obama realizes what he inherited he will "demand a recount" of the 2008 election. The masses don't trust the liberals and they don't trust the conservatives -they don't like Democrats and they don't like Republicans-they don't like any institution be it government, journalism, or anything else-they just want things to CHANGE. The regulation of the banking industry, the tea parties, the populist demands, the election in Massachusetts, the healthcare reform, even the employment situation all take a back seat to the enormous amount of debt relative to GDP. The masses want a change because of the pain they are going through presently and just don't understand the invisible hand of the interest on the debt absorbing so many dollars that could have been used to support the economy.
This invisible hand is causing the masses to want change even though they don't understand why they feel so uncomfortable and don't know who is to blame. They are just "mad as hell and can't take it anymore" (from the movie, "Network"). All of this causes the deleveraging as shown in our Cycle of Deflation as the private sector pays down debt or defaults. This process is very painful while taking many years to resolve. The process has already started as business loans and consumer credit are shrinking at record rates while the government debt is expanding at record rates. This deleveraging we expect will take place on a global scale and will take many years to resolve. Japan has already suffered two "lost decades" and has still not solved its problem. We expect this to take place globally and will continue to be painful. We honestly don't want to be correct in this assessment for the global economy, but we can't see how this deleveraging process and the consequences of the process be avoided.