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Debtwatch No. 25: How much worse can “It” get?

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  • Debtwatch No. 25: How much worse can “It” get?

    Debtwatch No. 25: How much worse can “It” get?

    by Steve Keen

    Editor's Note: Since our last interview with Dr. Steve Keen, he has made a number of Debtwatch updates to his excellent Debt Deflation blog where he chronicles the over-expansion and collapse of the Australian debt bubble. Read his update below and listen to his interview on ABC here and you'll swear he's talking about the US, except for the part about the resources export boom – and the Australian accents, of course. Steve's economic philosophies can be distinguished from the mainstream in two vital ways. First, they account for the critical role that private sector debt plays in creating demand, a factor of demand that most economists prefer to regard as ancillary and insignificant. Second, events tend to unfold the way his theories predict, which puts him completely at odds with most economists.

    We are believers in Steve's debt deflation theory, and in fact named our 2008 bear market call after it. I'm interviewing Steve today to get back to the crux of the issue: how does debt deflate in the US, via monetary inflation or deflation? Now that the debt deflation is here, is the demand loss caused by debt deflation responsible for recent declines in commodity prices? Will they continue or will the US government monetize debt and send the dollar reeling again, deflating dollars against hard assets? Stay tuned. We'll make the interview available later this week. - Eric Janszen


    Last month closed with some far from comforting news about the state of the US housing market (sales and prices still falling), US financial institutions (Fannie Mae and Freddie Mac in need of rescue), Australian banks (NAB’s 90% write-down of its US CDO portfolio). Then ABS figures showed that retail sales had fallen “unexpectedly” by one percent in June. The recent rally in stock markets came to a sudden end, and after a brief period of renewed confidence, the question “how much worse can “It” get?” is once again doing the rounds.

    My answer is: a lot worse. The empirical grounds for this assessment are:
    • The ratio of asset prices to consumer prices–or the inflation-adjusted asset price index;
    • The ratio of private debt to GDP; and
    • Japan

    In short, global asset markets have a lot further to fall, and a serious recession–the worst we have experienced since the Great Depression–is inevitable. Let’s first look at what the recent drop in retail sales implies for the economy.

    [media="400, 224, 0, 0"]http://www.itulip.com/movies/20080804-latebiz-keen.wmv[/media]Interview with Dr. Steve Keen on ABC July 4, 2008
    (You must be a Registered User to see the video)


    The USA: Double Bubble

    While the Dow has fallen substantially in the last year, its inflation-adjusted value is still three times its long-term average, and more than 4 times its average prior to the start of this bubble. Even if the index falls merely to its long term average, it still has another 62% to go (in real terms) from its current level. If it reverts to its pre-bubble average, it has another 73% to go.


    Figure 1

    If those figures seem ludicrously pessimistic and unrealistic to you, take a look below at the CPI-adjusted Nikkei–which fell 82% from its peak at the end of 1989 to its low in 2003. At the time, most commentators blamed Japan’s Bubble Economy and subsequent financial crisis on the opaque and anti-competitive nature of its financial system. We were assured that nothing so ridiculous could happen in the transparent, competitive and well-regulated US financial system.

    Yeah, right.


    Figure 2

    The story for the US housing market is little better. The index has already fallen 23% from its peak in 2006. A reversion to the long term mean implies a further 38% fall in the average house price in America; while reversion to the pre-Bubble mean implies a further 41% fall.

    Write-downs by US financial institutions certainly haven’t yet factored in that degree of possible fall in housing values, and as Wilson Sy, the cheif economist at APRA, pointed out recently in two brilliant research papers (1 2), the banks’ “stress test” modeling greatly under-emphasizes the impact of such asset price falls on their financial viability. House price falls in the USA are far from over, and likewise “unexpected” write-downs by US financial institutions.


    Figure 3

    Overall, if US markets fall back to their pre-Bubble levels, the stock market will plunge about 80% from its peak (much the same degree of fall as applied in Japan) and the housing market will fall 55% (rather more than happened in Japan, where average house prices fell 44%–but less than Tokyo, where they fell over 70%).

    The unique feature of this US asset bubble is that it affects both stocks and houses. There have been three Stock Market Bubbles in the USA in the last century: the “usual suspects” of the 1920s and 1980’s, but also one that doesn’t normally rate a mention: a ’60s Bubble that peaked in 1966, and was followed by a slump that only ended in mid-1982 (see Figure 6).

    As Figure 6 indicates, this dual bubble has no precedent. Not only is it a bubble in both asset markets, both bubbles dwarf anything previously experienced. Even the great Roaring Twenties stock market bubble barely pokes its head above the long term average, compared to the 2000s Stock Market bubble–and in the 1920s, as Figure 4 shows, the housing market was relatively undervalued. The over-valuation of today’s housing market far exceeds the now comparatively minor bubble when Keating (Charles, not Paul) was on the loose in the USA.


    Figure 4

    While the Australian Stock Market is not as severely overvalued as the American, it is still substantially over its long term trend. Even after the recent falls, the inflation-adjusted All Ordinaries Index exceeds its level before Black Tuesday in 1987. It has another 30% to go before it will have reverted to the mean of the last 25 years (see Figure 5).


    Figure 5

    The prognosis for the Australian housing market is substantially worse. Even on short term data–covering only the last 22 years–the market could fall 40% if it reverted to the mean, and 50% if it reverted to the pre-bubble mean. Nigel Stapledon’s research into long term house prices in Australia–which is not shown here–implies an even greater potential for a fall in house prices.


    Figure 6

    Of course, such talk can seem nonsensical and alarmist. Especially if you ignore what happened in Japan.

    Japan: the world’s most recent debt-deflation

    Japan clearly underwent a debt-deflation after its “Bubble Economy” spectacularly burst in 1990. In its aftermath, house prices across Japan fell on average by 42%, and by over 70% in Tokyo (though they have since recovered slightly).


    Figure 7


    Figure 8

    What has happened there can happen in Australia, the USA, and the rest of the OECD–especially since our Bubbles, while smaller than the Tokyo bubble, are larger than that for Japan as a whole (see Figure 9).


    Figure 9

    The killer behind the Bubble: Debt

    The level of over-valuation of asset markets reflects the unprecedented scale of private debt, both here and in America–since the vast bulk of that debt was undertaken to finance “Ponzi” speculation on shares and housing. This is the reason that this recession will be so severe–as will the asset market bust.

    Every “recovery” from a debt-induced recession since 1970 has involved resumption in the tendency for debt to grow faster than GDP (see Figure 12, where the once seemingly major debt crisis of the late 80s is now just a pimple on the upward trend of the debt ratio to its current unprecedented level).

    Yet today the debt to GDP ratio is more than twice that of the Great Depression. It is simply cannot go any higher. Who else, after all, can banks lend to, now that they have exhausted the “subprime” market?
    The only way for the debt to GDP ratio now is down (unless we’re unlucky enough to experience deflation, in which case the ratio will rise further, as in the Great Depression), and as it heads down, so will output and employment. A serious recession is inevitable.

    Welcome to “the recession we can’t avoid”.


    Figure 10

    An “unexpected” fall in retail sales

    Retail sales fell sharply in June, taking most economic commentators by surprise. Even perennial optimists, such as Shane Oliver, were forced to consider that the odds of a recession were “at least 40 percent”.

    In reality, the fall in retail sales was inevitable. Spending in Australia has been driven by the biggest debt bubble in our history, and when that bubble peaked, spending had to fall. Since households had taken on a far larger share of debt than business during this bubble, the impact was bound to be seen first in retail sales, rather than investment spending, as I pointed out in November 2006:
    “If households reduce their debt levels smoothly, they will have less disposable income to spend and retail sales will slump. If bankruptcies become widespread, the sales downturn will be overlaid with a financial crisis.” (Debtwatch, November 2006, p. 18;
    See http://www.debtdeflation.com/blogs/p...twatch-reports

    The suddenness of the turnaround is also no surprise, when you look at the data from a financial point of view. Just as your personal spending each year is the sum of your net income plus the change in your debt, aggregate spending for the economy is the sum of GDP plus the change in debt. As debt rises, the contribution made to spending by any change in debt also rises. Private debt–and household debt in particular–has risen so much in Australia that, at its peak, the change in debt was responsible for almost 20 percent of aggregate demand.


    Figure 11

    As is obvious in Figure 1, debt’s contribution peaked at the end of 2007, and it has been falling ever since. The monthly figures make this even more obvious (Figure 1 records change in debt over a whole year). The monthly increase in total private debt peaked at $30 billion in mid-2007, and trended up to $27 billion by the end of 2007. It has since fallen to a mere $5 billion in the month of June (see Table 1 and Figure 12).


    Table 1


    Figure 12

    At some point, it will turn negative, and change in debt will therefore substract from aggregate demand rather than adding to it. Given that at its peak, debt financed almost 20 percent of demand, even stabilising debt at its current level–$1.85 trillion, compared to a GDP of $1.1 trillion–would result in a 20 percent fall in aggregate demand.

    This hit will be felt by both asset and commodity markets: asset prices will fall, as will output and employment. The government’s attempts to counter this–by running a deficit rather than a surplus–will initially be swamped by the sheer scale of the turnaround in debt-financed spending. Even if the government runs a deficit of A$20 billion–the same scale as this year’s intended surplus–it will make up for less than a tenth of the fall in debt-financed spending.

    The current “credit crunch” is, therefore, only the first act in a long-drawn out process of reducing debt levels. The second act will be “the recession we can’t avoid”. That recession–which will affect most of the OECD, since all major OECD nations bar France have suffered a similar blowout in private debt levels–will only add to the current decline in asset prices.

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    Last edited by FRED; 08-20-08, 02:19 PM.
    Ed.

  • #2
    Re: Debtwatch No. 25: How much worse can “It” get?

    Fred and/or Eric, how is iTulip distiguishing

    disappearing fictitious value

    from

    debt deflation

    and do you have a guesstimated relationship?

    I'm assuming the relationship is much tighter with real estate than it was with the Internet collapse, where several trillion in fictitious value was written off, but there was little debt deflation because

    1. it was not the banks doing the writing off
    2. FED rate reductions / new bubble blowing


    Originally posted by FRED View Post

    Comment


    • #3
      Re: Debtwatch No. 25: How much worse can “It” get?

      So how does this relate to potential commodity price deflation, i.e. oil, metals (especially gold), foodstuffs, etc?

      Comment


      • #4
        Re: Debtwatch No. 25: How much worse can “It” get?

        Oh my. I had a sudden insight into how bad it had gotten when I was skimming the filled-in graphs in Fig 3, and realized I had to squint to see if the data stopped or went vertical to zero on the right edge. My brain never used to consider "suddenly plunging vertically to zero at the right edge" as a plausible reading of a graph.

        Comment


        • #5
          Re: Debtwatch No. 25: How much worse can “It” get?

          Originally posted by whitetower67 View Post
          So how does this relate to potential commodity price deflation, i.e. oil, metals (especially gold), foodstuffs, etc?
          We explain that in the interview done yesterday and published later this week.
          Ed.

          Comment


          • #6
            Re: Debtwatch No. 25: How much worse can “It” get?

            There's one problem that I see with one of the charts - the Nikkei chart only goes back to 1980 - the start of the boom. Since the Nikkei goes back to 1950, the chart is meaningless.

            Not saying that the premise isn't valid, its just that that chart does nothing to support your thesis, and the mistake makes me question the rest of the article.

            Easily fixed - just get a Nikkei chart that goes back to 1950, and draw a new line - I'd be interested in seeing that.
            -----
            Getting the direction right and the timing wrong since 2001.

            Comment


            • #7
              Re: Debtwatch No. 25: How much worse can “It” get?

              Originally posted by netdance View Post
              There's one problem that I see with one of the charts - the Nikkei chart only goes back to 1980 - the start of the boom. Since the Nikkei goes back to 1950, the chart is meaningless.

              Not saying that the premise isn't valid, its just that that chart does nothing to support your thesis, and the mistake makes me question the rest of the article.

              Easily fixed - just get a Nikkei chart that goes back to 1950, and draw a new line - I'd be interested in seeing that.
              They're referencing a specific asset hyperinflation which occured within that period of time shown in the chart. Why do we need a longer time frame?

              Comment


              • #8
                Re: Debtwatch No. 25: How much worse can “It” get?

                Originally posted by FRED View Post



                Figure 3

                Overall, if US markets fall back to their pre-Bubble levels, the stock market will plunge about 80% from its peak (much the same degree of fall as applied in Japan) and the housing market will fall 55% (rather more than happened in Japan, where average house prices fell 44%–but less than Tokyo, where they fell over 70%).

                The unique feature of this US asset bubble is that it affects both stocks and houses. There have been three Stock Market Bubbles in the USA in the last century: the “usual suspects” of the 1920s and 1980’s, but also one that doesn’t normally rate a mention: a ’60s Bubble that peaked in 1966, and was followed by a slump that only ended in mid-1982 (see Figure 6).
                Has Steve Keen heard about how manipulated the US CPI is? Note how both charts shoot up after the 1982 changes were made. And then they really take off after the mid-'90s changes. Why do we use government CPI on iTulip? It's apples and oranges and we all know it.

                By my calculations, pre-1982 methodology (thanks to bart and shadowstats) puts the real CPI at about 2.7x the official CPI. The Dow level of 888 in the top chart would really be 329, 36% above the pre-bubble (and pre-CPI-rigging) average. The current housing index level would adjust down to just 65, 37% below the average of 103.

                The housing bubble is over as far as fictitious value and speculative pricing. However, tight credit markets, recession and unemployment will continue to pull housing prices down, but it's not because they're higher than historical norms. As the real CPI indicates, and as I will show you in the example below, they are lower.

                I picked 1955 randomly, as it was about 50 years ago, but just about any year would tell a similar story. In 1955, you could get a median, 1200sf home for $10,950. That's about 313 oz. gold, 3,950 barrels of oil, or 2.65 years' salary. 50 odd years later, you can get a median, 2352sf home for $213,000. That's 240 oz. gold, 1775 barrels of oil, or 4.6 years' salary. Much better value in gold or oil terms, but you have a higher percentage of income going to housing than in 1955. No worries, you can always opt for that cute '50s ranch for $108,675- only 123 oz. gold, 905 barrels of oil, or 2.35 years' salary! Cheaper than it was 50 years ago by any standard (except the ridiculous government CPI).

                Jimmy

                Comment


                • #9
                  Re: Debtwatch No. 25: How much worse can “It” get?

                  how does debt deflate in the US, via monetary inflation or deflation?


                  Interesting mind twist which I never considered before. Inflation/deflation of debt are two sides of the same coin. Both accomplish the same thing, elimination of bad debt. Deflation simply marks the true value of bad to market, while monitary inflation maintains the nominal value of the debt, but the real value is slowly eliminated.

                  Comment


                  • #10
                    Re: Debtwatch No. 25: How much worse can “It” get?

                    Jimmy, That is a great issue about whether true CPI vs government numbers are used in the graphs. When you say that the housing bubble is over though I question that as other historical trends (like Case-Shiller) and analyst like Ms. Meredith Whitney call for further falls like 10 to 50%. This also makes me wonder if CPI (using true value) evaluations square with other metrics such as P/E (for stocks), X times salary = house price, etc.
                    "The issue ... which will have to be fought sooner or later is the People versus the Banks." Acton

                    Comment


                    • #11
                      Re: Debtwatch No. 25: How much worse can “It” get?

                      Why do we need a longer timeframe on the Nikkei chart? Well, that depends on what period was used to compute the average level - if it was computed starting at a "normal" level, like the other charts, then fine.

                      If, on the other hand, it was computed using just the bubble prices and the resultant crash, then it doesn't actually say anything - of course it's currently trading at below the average, it's not using any non-bubble distorted data. You could draw a line in housing starting at, say, 1995, and see much the same thing.

                      If you want to prove the point that prices revert to a mean, you need to pick a mean that actually makes your point. Starting the Nikkei price at the beginning of the bubble doesn't do that. Starting it at 1950 would - which is why the other charts start so far back in history.

                      Oh, and in case it's not obvious which chart I mean, I'm referring to chart 2.
                      Last edited by netdance; 08-05-08, 05:14 PM. Reason: Add comment on which chart.
                      -----
                      Getting the direction right and the timing wrong since 2001.

                      Comment


                      • #12
                        Re: Debtwatch No. 25: How much worse can “It” get?

                        Jimmy -

                        First, we agree completely regarding the point of CPI - though keep in mind that the way the CPI used to be figured included housing costs, and now they don't - so all you're really doing by reimposing the old standard is deflating housing costs by the difference in housing costs, which is kinda circular, and may not lead to the results that you were looking for.

                        And while it's true that the housing bubble may be over for some portions of the country (much of Florida, Sacramento, etc), don't forget that in many parts of the country (Silicon Valley, LA, NYC) housing is still way, way off from historical norms. For instance, that 1200sf 1950 bungalow you mentioned is still selling for $500k 'round my parts - after being only $300k 8 years ago. Not exactly the $100k that you're proposing.

                        The point being that there's a lot further down to go nationally than you think.
                        -----
                        Getting the direction right and the timing wrong since 2001.

                        Comment


                        • #13
                          Re: Debtwatch No. 25: How much worse can “It” get?

                          Originally posted by orion View Post
                          Jimmy, That is a great issue about whether true CPI vs government numbers are used in the graphs. When you say that the housing bubble is over though I question that as other historical trends (like Case-Shiller) and analyst like Ms. Meredith Whitney call for further falls like 10 to 50%. This also makes me wonder if CPI (using true value) evaluations square with other metrics such as P/E (for stocks), X times salary = house price, etc.
                          The currency in the ratios you referenced cancels out, so CPI has no effect. A stock's P/E is the same in 1955 dollars, 2008 dollars or Zimbabwe dollars. The ratio of your income to your home price is also a ratio that is independent of the currency used, as long as the same is used in the numerator and the denominator.

                          When I said "housing bubble is over as far as fictitious value and speculative pricing", I in no way meant that prices will not fall further. That's why I immediately followed up with "tight credit markets, recession and unemployment will continue to pull housing prices down". My point was that we are now in the overshoot phase of the process, having passed the historical mean. My data shows that the current price of 2.9 gold grams per sq ft is lower than any point in the last century, other than the top of the 1980 gold bubble. Anyone who expects gold to rise and housing to fall should realize that pushes the ratio further into uncharted territory. It will eventually correct toward the historical average of 5.7 gg/sf.

                          Doesn't mean it won't get a lot uglier, just means the deals will be even better at the bottom. When production picks back up, I expect it to be geared toward smaller, energy-efficient homes.

                          Jimmy

                          Comment


                          • #14
                            Re: Debtwatch No. 25: How much worse can “It” get?

                            Originally posted by netdance View Post
                            Jimmy -

                            First, we agree completely regarding the point of CPI - though keep in mind that the way the CPI used to be figured included housing costs, and now they don't - so all you're really doing by reimposing the old standard is deflating housing costs by the difference in housing costs, which is kinda circular, and may not lead to the results that you were looking for.

                            And while it's true that the housing bubble may be over for some portions of the country (much of Florida, Sacramento, etc), don't forget that in many parts of the country (Silicon Valley, LA, NYC) housing is still way, way off from historical norms. For instance, that 1200sf 1950 bungalow you mentioned is still selling for $500k 'round my parts - after being only $300k 8 years ago. Not exactly the $100k that you're proposing.

                            The point being that there's a lot further down to go nationally than you think.
                            Good points, netdance. I was referring to national averages, and each market is unique. Of course, the people living in $500k bungalows generally make a lot more than $46k, too.

                            Housing in most markets tracked by Case-Shiller is back to 2004 levels. Some have further to go to fully let the air out of the balloon. Then it's all overshoot.

                            Comment


                            • #15
                              Re: Debtwatch No. 25: How much worse can “It” get?

                              JG,

                              The analysis you are doing with respect to g-AU/sq. foot is interesting, but you have to keep in mind that gold was basically a fixed price commodity up until 1973.

                              This skews the value of longer term historical precedents.

                              Furthermore having gold as a fixed reference reduces the value in your assumptions because there is no longer a fixed reference point.

                              We could have a commodity bust where gold drops to $500 of inflated US$, but housing stays the same. We could have a 'peak oil/peak food' scenario where housing stays the same due to government efforts, but gold prices shoot up.

                              In an era where the convertability of fiat currency to gold is a variable, I caution you to rely on historical precedent.

                              After all, even the values post 1973 for gold could be said to be a wild oscillation as gold attempted to find an equilibrium value, and it is equally safe to say that such a level - if it exists - has not yet been found.

                              Comment

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