Economics Is Hard?

Market Ticker – Karl Denninger
View original article
June 28, 2010 07:09 AM

An amusing piece of mental masturbation from Richmond Fed Economist Kartik Athreya has been making the rounds….
In this essay, I argue that neither non-economist bloggers, nor economists who portray economics — especially macroeconomic policy — as a simple enterprise with clear conclusions, are likely to contibute(sic) any insight to discussion of economics and, as a result, should be ignored by an open-minded lay public.

Yes, he really got the spelling error past whatever review this paper received.  That would be none, right?

One wonders if the “or”, however, is what he intended.  After all, if you can’t spell, can you properly construct grammar to make your point clear?
In the wake of the recent financial crisis, bloggers seem unable to resist commentating routinely about economic events. It may always have been thus, but in recent times, the manifold dimensions of the financial crisis and associated recession have given fillip to something bigger than a cottage industry.

Really?  You mean as opposed to pieces like Bernanke’s “Making sure ‘it’ doesn’t happen here”?

Well, dear Mr. Athreya, it has happened here:

That’s credit contraction.  That’s the “it” Bernanke was talking about.

In terms of houses, we’ve suffered a fairly-severe deflation.  Of course there’s another way to look at it too, which is that under Greenspan and Bernanke we have spent more than 20 year in what amounts to a credit-led hyperinflation, fostered and intentionally caused by these two gentlemen, and thus we are “merely” deflating that which they inflated.

Nonetheless, Bernanke’s “Magnum Opus” argues that this outcome can be prevented, and many have rested comfortably believing him, in no small part, I’m sure due to the little three letters “PiledHigher and Deeper”, after his name.

It concerns me greatly that the author spends this digital ink blasting away yet didn’t read his own paper before he published it, for if he had, the light would have gone on.

The main problem is that economics, and certainly macroeconomics is not, by any reasonable measure, simple. Macroeconomics is most narrowly concerned with the tracing of individual actions into aggregate outcomes, and most fatally attractive to bloggers: vice versa. What makes macroeconomics very complicated is that economic actors… act. Firms think about how to make profits, households think about how to budget their resources. And both sets of actors forecast. They must. One has to take a view on one’s future income, health, and familial obligations to think about what to set aside for retirement, how much life insurance to buy, and so on. Of course, all parties may be terrible at forecasting, that’s certainly a possibility, but that’s not the issue. Even if one wanted to think of all economic actors as foolish and purposeless organisms making utterly random choices, one must accept that their decisions will still affect, and be affected by what others do. The finitude of resources ensures this “accounting” reality.

Well, well, well.

Read that last sentence again.  And again.  And again.

Bang yourself over the head with it until you “get it”, because that is the very point I’ve been trying to drill into your f$#king head for the last three years you jackasses at The Federal Reserve – and Congress!

It is indeed that fact that leads to my simple-sounding reply to such arguments about this or that in the context of economics: The math is never wrong.

Indeed, you can try to cheat, you can try to scam, you can try all sorts of games.  But in the end there is a totality of resource available – a totality of wealth production, or actual output, that can be distributed around the economy.

You would think that a degreed “economist” would look at the following graph and instantly “get it”:

There’s nothing complicated in that graph.  It points out in clear pictorial form that until the late 1970s as a nation we primarily used credit for purposes that ultimately boosted output – that is, GDP. 

We bought factories, milling machines, lathes, forges and similar instruments on credit.  We used it a means to finance things that provided more output over their useful life than their amortized cost.  That is, of the three types of credit use, the primary driving use was productive investment.

In the late 1970s this changed.  Credit became a means to consume a hamburger today and pay for it tomorrow – not buy a grill and charcoal with which to cook hamburgers for sale.  Worse, it turned into an instrument to leverage speculation, with no productive impact whatsoever in the economy, other than the ability to spend the winning bets.

But for each winning bet in such an endeavor there was a losing bet, and as such consumption of these “winnings” was not an actual addition to the economy at all.  That is, said consumption came at the expense of the loser.
Examples of this approach done right in the context of some of the topics mentioned above are recent papers by Robert Lucas of the University of Chicago, Jonathan Heathcote of the Minneapolis Fed, or Dirk Kreuger and his co-authors. Comparing, even momentarily, such careful work with its explicit, careful reasoning, its ever-mindful approach to the accounting for feedback effects, and its transparent reproducibility, with the sophomoric musings of auto-didact or non-didact bloggers or writers is instructive. For those who want to really know what the best that economics has to offer is, you must look here. And this will be hard.


How many of those papers (and yes, I’ve read a good number of them) account for the outrageously insane activity of The Fed and other actors in the regulatory and government sector in fostering and promulgating the current credit environment?

How many account for The finitude of resources ensures this “accounting” reality?

Zero, in my experience.

I have yet to see any of the “research papers” deal with the role of credit expansion for the purpose of consumption of speculation, and the corrosive effect that such an environment has on the macroeconomic welfare of a nation – or the world.  I have yet to see any of these authors opine that the monetary resources are in fact finite, and that playing Wimpy has a natural conclusion: bankruptcy.

It cannot be otherwise, incidentally, so long as credit is used for those purposes.  Credit used for consumption does nothing more than shift the time of said consumption (that is, it pulls forward demand) while credit used for speculation provides no economic benefit at all and is in fact corrosive to the economy because the “wealth” the winner accumulates comes at the direct expense of the loser. 

It cannot be otherwise as the actual resource is, as noted, finite.
Naifs write books, and sell many of them too.


It seems to me that the “naive and inexperienced” would be those who believe that the laws of thermodynamics and mathematics do not apply to macro economics, and refuse to validate their claimed works against those principles.

Indeed, the entire premise of much modern economic theory is nothing other than a claim of perpetual motion – an outright fraud that is well-recognized in the world of physical science.
So far, I’ve claimed something a bit obnoxious-sounding: that writers who have not taken a year of PhD coursework in a decent economics department (and passed their PhD qualifying exams), cannot meaningfully advance the discussion on economic policy.

Ah, now we get down to it.  Those who do not agree with the orthodoxy of so-called “economists” are unqualified because, well, they just are.

Yet as I’ve noted the primary problem with most “mainstream” economic thought these days, including at the doctorate level, is that they put forward very complicated nonsense that fails to honor the basic mathematical fact that both sides of an equation must balance and that all dynamic systems in the real world suffer loss – that is, whatever you put in you will receive less, in total, back out.

This is the premise of thermodynamics – that there is no such thing as a free lunch.  You cannot in fact break even, say much less win.  Yet mainstream economics continues to espouse that one can look at macro economics through a lens where credit expansion can continue forever at rates that exceed that of productive output, that mean reversion need never occur and that through manipulation of various aspects of the economy one can prevent or mitigate recession.

This is a mathematical impossibility.

As soon as you allow lending of capital at interest you have produced a dynamically unstable system.  This is trivially easy to prove, as nobody will intentionally lend at a loss.  That is, on balance all persons who lend capital will only do so at a rate of interest that exceeds the growth rate in the economy.

The fact that both growth and interest are compound functions means that it is inevitable that the service of that debt will outstrip the ability to pay for it via production. 

This is a fundamental mathematical fact that cannot be avoided.

Recessions serve an essential purpose in all such economies in that they bankrupt both lenders and borrowers.  In doing so they extinguish the excessive debt at the margins – that is, the weakest actors in the economy (both as creditors and debtors) go bankrupt.

That the macro economic environment is operating properly is evidenced by a reasonably-stable debt-to-gdp ratio.  We had that during the 1950s to late 1970s.  Recessions were frequent but allowed to occur.

It was the very idiocy of the so-called “economic elite” that led us down the path we now walk.  The belief that recessions could be “managed.”  The belief that credit expansion could continue indefinitely in violation of the laws of mathematics.  The belief that macro economic “policy” could be willfully shaped to violate what amounts to laws of physics.

This willful and intentional blindness has come from so-called “elite” economists with plenty of letters after their names.  I find it outrageous and indeed insulting that any so-called “professor” or “professional economist” can present an economic theory to the public, or any paper bearing thereupon, that fails to conform to the fundamental laws of mathematics – that is, the fact that two exponential functions, where one exponent is larger than the other, will always run away from each other.

Any such “theorem” is inherently a Ponzi Scheme.  It relies on geometrically increasing numbers of participants to continue, which is, in a finite world with finite land mass and resources, mathematically impossible.

It is true that there are “bloggers” and even “economists” (Krugman anyone?) who post bombastic piles of dog squeeze.  But then again, so do most so-called “articles” in the so-called “academic press”, when it comes to matters economic.

I propose a seminal test for all such papers: Those that fail to account for the fundamental principles of mathematics, including the law of exponents and the fundamental principles of thermodynamics as applied to the economic field – that is, that all process involves loss and there is no such thing as a free lunch or even managing to break even, must be discarded.

Under this standard Bernanke’s famous “printing press” speech, not to mention virtually all “modern” economic work I have seen, must be judged infirm and discarded.

Where We Are, Where We’re Heading (2010)

Market Ticker – Karl Denninger
View original article
December 31, 2009 05:35 AM

Let’s score the 2009 edition first:
The economy will NOT recover in 2009:  I’ll take this one, although some would argue I only deserve half (I said 8% unemployment U3, we actually got 10%.) 
Deflation, not inflation, will become evident well beyond housing.  Miss.  Valid if you look at energy, but the “well beyond” includes a meaningful subset of the various things people buy.  Nope.
Housing prices will continue to decline: Direct hit.
The Fed’s attempt to “pump liquidity” will be shown to be an abject failure: 1/2 a point.  Certainly if you look at stock prices, it’s a miss.  If you look at whether credit creation was stabilized and increased, its a horrifying score.  We did get the instability in the dollar, but no bond market crash.  I didn’t specify how, so I can’t take credit for that which I didn’t predict.
GDP will post a 12-month negative number, Depression print. Clean miss.
The stock market has not bottomed.  1/2 credit.  It had not bottomed but my SPX 500 @ 500 call was not achieved.  The 50% swing, however, got damn close.  Lots of money to be made if you’re quick and good, but an absolute minefield if you’re a long-term investor – spot on.
Precious metals will not be a safe haven: Clean miss.  Gold and silver have both performed well.
The Dollar will not collapse.  Correct.  It hasn’t.  It ended the year of 2008 at 82, it now trades at 78, down 5% or so. 
The pound or Euro – and perhaps both – will be where the FX dislocation initiates if it occurs.  Early, which means wrong.  Clean miss although the last month sure looks bad for the Euro.
The US Consumer goes from negative savings to positive:  Direct hit.
Commercial Real Estate will effectively collapse: Direct hit although the effect has been well-hidden.  Several Tickers have been written on this, including major banks walking off 50% underwater properties.  I can’t take full credit as the REIT explosion I expected didn’t happen, so I only get half a point.
Along with the above, expect 10% of retail stores to close.  I don’t have accurate numbers on this but it sure looks that way.
Several states will get in serious financial trouble and the default of one or more may occur.  Point.  While the default didn’t happen that wasn’t a condition of the test, and the list of states in trouble is long and getting longer.
Mortgages are not done:  No kidding.  Default/delinquency/foreclosure rates continue to skyrocket.  Point.
If you want to refinance you may get one brief shot with long rates around 4%.  You got two, but I don’t lose for multiple points of impact.  Both of those were good opportunities IF your property isn’t severely underwater (in which case there is no such thing as a good deal.)
Those who have said that the corporate bond market is being “unreasonable” will start to look like the jackasses that they are.  Maybe.  Actual defaults did in fact skyrocket but new issues are coming to market and subscribing – even for crap-grade paper.  I can’t take a point on this one as my expectation when I wrote it was that issue would go in the toilet.  Miss.
The calls for “more lending” will go exactly nowhere.  Bingo.
GM and Chrysler will go bankrupt.  Bingo.
Protectionism and currency manipulation: Miss, at least in the way I described it.
Commodities will appear to be headed for a new bull market (falsely): Hit.  Soy, Wheat, etc – all looked to be going parabolic in June.  Now, not so much.  “Beans in the teens” eh?  NOT!
Sovereign debt defaults will number at least three:  Clean miss.  Greece and a couple of others are on track but didn’t happen this year.  No points for “on track.”
China will have its first large-scale rumbling of civil unrest:  Clean miss.  I have to admire how they prevented it – more capacity building into an overcapacity world.  That won’t end well but for now they’ve stove it off.
Foreign uptake of Treasuries will be choked off – by necessity: Hit.  Almost missed that one, but China has stopped buying as the trade imbalance disappeared.  They have, as expected, turned resources inward.
The City will get it worse than we are:  Since the test was relative I get credit for it; they’re doing things like imposing 90% taxes on banker bonuses.
Things will get “revolting” in nations: Nope.  Riots and such in Greece don’t count – “revolting” meant what it said.
I count 14 “hits” (including half-points) out of 25, for a score of 56%.  That’s not so good, especially compared to last year.

Ok, so where did I go wrong?

That’s pretty simple: I dramatically underestimated the willingness and ability of “the criminal class” (that would be those in DC and on Wall Street) to lie, cheat, steal, paper over insolvency and get away with it – at least for a while.

Will this ultimately lead to an actual recovery?  No.  It mathematically can’t.  A short-term bounce in various metrics, yes, just like an insolvent person can spend on his credit cards until they get cut off and look like they’re improving.

The S&P 500 currently stands at roughly 1120.  Most “market callers” are expecting another 20% increase next year, which would put it at 1350, just 15% off the all-time high of 1576 and fairly close to where it finished 2007 – that is, as if 2008 and 2009 never happened.  Lunacy, says I, unless leverage can return to where it was in 2007.

Can it?


Let’s remember what happened in 2005 and 2006 that made those things possible.  Investment and commercial banks were stuffing various sorts of securitized paper with garbage loans they knew could not be paid, then selling them off to “investors” (who would later be shown to be bagholders.)  This allowed for an unprecedented expansion in consumer and financial system credit – and that, in turn, allowed the buying of “stuff”, whether it was companies playing LBO or you buying a house to flip with an OptionARM.

That was the legacy of the “expansion” in 2005 through 2007, and it is not coming back.

In short this time it really is different, and the proof is right here:

This is the first time since records began at The Fed that credit outstanding has decreased.  I have taken the liberty of breaking down the periods into 10 year chunks, which makes it easier to see:

Pay attention to this last graph, as it is the important one in terms of the 2003-2007 “recovery” – note that we went from ~32 trillion in outstanding debt to $53 trillion at the peak, an expansion of 66%. 

That’s how we “recovered” from the tech bust, and to believe that we will “recover” from this one you must either find a way to expand debt by a similar amount – that is, to nearly $90 trillion all-in – or figure out how you will get $35 trillion in spending in the US economy above and beyond what we’re doing now over the next three to four years.  In short, we cheated, and to believe we can do it again you must explain how we can cheat once more – and to that degree.

And by the way, for those keeping score – since our monetary system is debt-based declining credit outstanding is the definition of deflation in the monetary sense!

This is exactly what Bernanke said he could avoid.  He was wrong and there is no further room for argument on that point.

Further, I do not believe for a second that the Bernanke’s “pulling back” from the monetary playing field has a thing to do with the “stability” of the markets, especially housing.  Specifically, there is no evidence to be found that housing has stabilized or is improving – quite to the contrary.  Treasury’s “modification” programs have been a joke, with banks either not following through with their supposed responsibilities and borrowers unable to provide documentation of income and assets (because they didn’t have the documentation required at the time of the original loan, and still don’t!)  In short all these “programs” are simply an attempt to paper over the Ponzi in residential housing – with little actual success, but lots of smoke, mirrors and lies. 

Madoff got away with the same game for years – produce some false statements and keep soliciting for that new business.  All is well until the cash flow forces disclosure of the fact that you’re broke – then the ugly truth, that there is no money as it’s all gone – comes out.

Such is happening now.  Servicers have been passing through the interest payments on MBS but principal isn’t there to be repaid.  The journal entries are being ignored – for now – because none of this trash is actually trading.  It’s all being held at or near “par” (100 cents on the dollar) when in fact many of these securities will be lucky to recover anything at all.  Even the “credit supported” tranches are in trouble – nobody ever believed, especially in the “prime” space, that defaults could reach beyond 2 or 3% and recoveries be under 80 or so.  But they are.  Worse, the HELOCs and “silent seconds” are in fact worth zero where the house is worth less than the first note due to priority of claims – yet most of those are being carried at or near full value.

A big part of the reason for this deterioration is due to “misclassification” of loans.  That is, loans were claimed to be “prime” when they were not – they were either “ALT-A” or worse, Subprime in fact, but stuffed into MBS as “prime paper” and then resold onward.  Fannie and Freddie have been recently fingered as a major part of this, but unlike the author of the recent WSJ Opinion piece I believe this and scam went much further than the two GSEs – and there has yet to be any honest examination (say much less prosecution) for this conduct.

There’s a rather complex “prisoner’s dilemma” going on at the present time, with none of the banks wanting to liquidate either securities or inventory lest they trigger an avalanche.  Yet each is eying the door, fully-aware that the first one through will be the only one who gets through should anyone bolt.  One of the more-interesting identities for the man yelling “FIRE!” could be a lawsuit – or state prosecution – over the myriad misrepresentation in this space during the bubble years.

Last year (2009) there was almost no net debt issuance between corporates and Treasuries, adjusted for Quantitative Easing.  Indeed, it was only about $200 billion.  That this sort of extreme measure was required to prevent a bond market implosion is rather telling.  But what’s worse is what’s on the calendar for 2010 – nearly $2 trillion of net issue, duration-adjusted.  A huge part of this is Treasury debt, and there the news is even worse, as there’s a serious duration problem in this regard – nearly half (about 40%) has a maturity of one year or less.  This means that Treasury must roll over that debt – about $3 trillion worth – “or else.”

Ask the asset-backed commercial paper market and auction-rate securities folks what happened to them when their short-duration paper couldn’t be rolled on commercially-reasonable terms.  Then extrapolate that to what happens to Treasury if (or possibly when) they’re unable to roll $3 trillion plus issue another $2 trillion on top of it to fund the deficit.  Do you really think that $5 trillion and change of Treasury paper is going to be “all ok” sans “monetization” – or will “they” foment an intentionally-engineered stock market crash to scare people into Treasury debt?  I wish Timmy the best of luck with this – he’s going to need it.

Remember, the belief that foreigners will not be there to rescue us this time around is not speculation – it in fact is born out by the latest TIC data, which showed that China had bought a net zero in Treasury issue in October.  Nor did anyone else step to the plate.  In short foreign nations are chock full of their own issues and are either issuing debt themselves or need their capital internally.

The equity market loves “liquidity” no matter how it comes, whether the truth is embedded in reports or not.  Nasdaq 1999 anyone?  Those firms were not making money and never would but that didn’t stop their stocks from doubling, tripling, and in some cases skyrocketing to 10x their IPO prices. 

The key point is that most of them eventually collapsed and were worth zero, but if you were quick (or lucky) you made a lot of money.  Of course the other side of that ditty is that if you weren’t you lost everything.

There are many who claim that valuations are not “extended” or “bubble-like” and point to the disasters of Q3 and Q4 of 2008 as “drags” on the P/E ratio, claiming that one should ignore negative earnings.  This is kinda of like going to the casino and only counting the winning wagers when determining how well you’ve done.  It may look impressive when you brag to your friends but it won’t change the fact that you go home broke, and ignoring negative earnings is part and parcel of the same sort of disease.

The fact of the matter is that if you look to corporate and personal income taxes they have all but collapsed.  These are of course regressive and governments have been handing out various tax breaks to corporations so this may not be a fair indication of business and consumer activity.

However, sales taxes are, if anything, going up in percentage charged – not down – and yet they are also deep in the red in terms of collections by the states.  Since some “necessities” (specifically food in many states) are not taxed this is particular troublesome since this trend points directly toward a collapse in discretionary spending – exactly what we need to power the economy forward.  Then there’s China, which reported on the 27th that toy shipments to the US were down 15% year/over/year from 2008 – but we’re told that Christmas sales were down “only” 1%.  Riiiiight.

So much for  “economic recovery.”

Productivity has been on a tear – and no wonder.  Watching everyone around you get laid off has a way of providing a hell of an incentive to work harder, lest you follow your friends to the unemployment line.

These trends – letting employees go and demanding that your remaining workers do more for the same pay, does provide a lift to profits.  For a while.  But it also destroys the base of consumers you need to buy those products over time, and thus the lift that you enjoy from such downsizing and squeezes is short-lived.  The hangover from that speedball should be hitting in Q1 or Q2 of the coming year, and I expect it to be quite the doozy.

China, on the other hand, has outdone us.  Burdened with far too much capacity they are, of course, building even more!  That would be great except that there’s no chance they can absorb the output internally.  Not that they care in the short term, as their definition of “GDP” is different than ours – they count a product when it is produced, not sold.  Gee, why are there all these products lined up unused, from cars to washing machines to – gasp – literal empty CITIES of townhouses and apartments?  How far does that bubble inflate before it blows up?  Hell if I know – the Chinese are not exactly models of transparency so the degree of game-playing they can get away with before someone yells “FIRE!” and runs for the door is more difficult to discern than it is over here. 

In the last few days the Chinese Premier has said that he won’t “bow to pressure” to allow the yuan to appreciate.  This of course is code for a weak currency which China desperately wants for its export trade.  Then again, so does Japan, and so does anyone else who exports.  Competitive devaluation sounds quaint, but you’re seeing it, and it is likely to continue as an attempt to play “beggar thy neighbor” in the coming year – and beyond.  Playing with explosives these nations are (including our country!)

In the credit arena few lessons seem to have been learned.  CDOs, CDO^2s and other similar loose-pin grenades aren’t back – yet – but an awful lot of questionable deals are, including, believe it or not, a couple of PIK/Toggle issues.  Those, for the uninformed, are bonds that allow payment not in money but in more debt!  This sort of “debt pyramiding” is the epitome of stupidity when done by a person and a fairly reliable sign of impending default.  In the corporate world we call it “reaching for yield.”  Uh huh.

Many market commentators believe that last year and through March 09 was a “financial panic” similar to 1987, from which the market recovered quickly.  Really?  Go look up the page a bit at the credit chart for the 1980s.  Do you see any contraction in 1987 and 1988 – anywhere?  Nope.  None.  In fact, credit growth continued unabated even though the stock market crashed.  The same occurred in the 2000-2003 time frame (again, look above) during the Tech Implosion.  That’s the differentiating factor: This was not a market panic, it was and is a credit lock-up caused by outstanding debt exceeding servicing capacity for several years, where the premise became not paying debt through current income but rather a Ponzi-style pyramid that permitted refinancing and the appearance of solvency only so long as asset prices rose!

This is an event that last occurred in America in the 1920s and it occurred this time for the same reason it did the last time: lax or utterly absent regulation allowed people to foist off trash on people while claiming that it was “money good”, just as happened with Florida Swampland in the 1920s.  The entire premise of the so-called “financial innovation” then, as now, was fraud.

The simple fact of the matter is that greed often comes with stupidity and nearly always is shortly followed by disaster.  “Rescued” by governments the “princes of finance” learned nothing, were forced to disgorge nothing, and still walk free among us instead of being either jailed or worse, strung up from a lamp post. 

So far.

Whether the people of the various nations will put up with another trip down the bailout, Quantitative Easing or “stimulus” road is another matter entirely.  Tim Geithner and others have gone too far in their grandstanding, cheerleading and claims of “Armageddon Avoided” – or if you prefer, “Mission Accomplished.”  Such claims make for great sound bites but have a habit of slamming the door on future intervention, especially if the need for it appears shortly after the claimed “success.”  Remember well that 2010 contains a midterm election in November, and as things stand our new President has seen his approval rating drop faster than a condemned man does through the floor when the handle is pulled.

Then there’s the “HAMP”, or “mortgage modification” programs generically (there have been several.)  It was claimed that HAMP in particular would prevent 4 million foreclosures by the end of 2009.  It has actually resulted in about a half-million trial modifications, but fewer than 100,000 permanent changes.  This should not surprise – the reason people got in trouble in the first place as that they bought more house than they could reasonably afford on any rational mortgage plan, using schemes such as 1.5 or 2% negative amortization “OptionARMs.”  These were not actual mortgages in intent – they were predicated on ever-rising home “values” so that they could be rolled over in a couple of years and amounted to a perpetual below-market rent payment to a bank, collateralized via the speculative bet that prices would continue to rise.  When home prices stopped going up there was literally no way around the inevitable – foreclosure.

Government refuses to recognize this as all the trash paper is literally everywhere around the globe!  What’s worse is that the very same banks that were making these bets along with homeowners then extended HELOC and other second-priority lines behind the first, extending the trash brigade even further.

Never mind Geithner’s insanity, as displayed here:
GEITHNER: We were very careful from the beginning—but the qualifications get lost—to say that we are going to focus the bulk of the financial force on bringing interest rates and mortgage rates down to cushion the fall in housing prices and help stabilize home values, which will feed into people’s basic sense of financial stability.

The reason we got a bubble in the first place was due to excessively-low rates – that is, a cost of borrowing money that did not reflect the fundamental economic realities of repayment and duration risk.

Insanity defined: Doing the same thing over and over but expecting a different result.

There is much hot air blown about how businesses and consumers have “de-levered.”  Hogwash.  Again, back to the top graph – we’ve taken a whole $21 billion off the net credit exposure.  Oh sure, if you remove FedGov from the picture (and you arguably should) it’s more like $850 billion – but let’s be real here – we’re talking about a fifty-three trillion dollar debt. 

Even a trillion is less than a 2% reduction in net leverage!

That’s “de-leveraging”?  Like hell.

There is much, much more to go.  To get back to the leverage levels seen in 2000 – which themselves were overheated – we’d have to drop back some twenty five percent, or roughly $13 trillion dollars.

We’re less than 10% of the way there, and we were overheated in 2000.

What’s a more reasonable leverage level?  How about the “more reasonable” time period between 1951 and say, 1983?  175% of GDP?  That would require we cut the outstanding debt by close to half!

Will we see policies that accomplish that?  Not voluntarily!

On a more-macro (beyond one year) level, let’s look at this last-decade debt chart again:

In the beginning of 2000 the total systemic debt outstanding was approximately $25 trillion.  It is now about $53 trillion, or more than double where it was in 2000. Let’s look at where we were in various metrics at that time:
GDP was at $9.7 trillion.  It is now 40% higher, roughly.  (Gee, did we really produce all that with our hands, or did we borrow the money, spend it, and then count that as “GDP growth?”)

Aggregate GDP over the 2000-2009 years was about $124 trillion; of that, about 20% (25 trillion) was increase in debt over the same period of time. Our so-called “growth” over these years was in fact a chimera in that more than half of it was not real – and that’s assuming ZERO interest expense now and forevermore.  Of course interest expense isn’t, in fact, zero……

The S&P began the year 2000 at 1469.  It now stands at 1126, and that’s before inflation adjustment.  The DOW was at 11,500, again, before inflation adjustment, and the Nasdaq 100 was at 3708 (it currently trades 1870.)  Again, all before inflation.  Take 30% off all of today’s numbers to adjust for devaluation of the currency’s purchasing power (that is, inflation) over the last decade and you’re roughly in the ballpark.  The bottom line: you have lost big – more than half if you were in the S&P 500, about 40% in the Dow and a crushing 70% if you were in the Nasdaq 100 over the last ten years.

There was no shelter to be found in Real Estate either.  Home prices are back to 2000 levels in many parts of the nation, but a huge number of homes are “underwater” on the profligacy of debt taken on my Americans: about 25% of all loans are underwater nationally and nearly half in Florida.  In 2000 that number was basically zero.

There was no net job creation but we went from 282 million to 307 million people in America.  That means 25 million people are unemployed simply due to population growth.  Ain’t that grand?

Median household (and per-capita) income has actually declined since 2000 adjusted for inflation.  Of course gasoline is more than twice as expensive ($1.26/gal in January of 2000), eggs are more expensive (double, roughly) and such.  Never mind medical insurance and health care – double-digit escalations every year have been the rule rather than the exception with medical insurance costs being up a literal 200% or more over the last ten years.
This little game of Ponzi (faking “GDP” by taking on more and more debt), by the way, is not new.  I present for your edification the following table:

This is the aggregate GDP (that is, all GDP produced) during each decade from 1960 onward, the “DTi” (or debt increment) during that decade – that is, the additional debt outstanding in all sectors during that decade, and the percentage of “GDP” that in fact was NOT from production, but rather was “created” due to raw borrowing.

Yes, before you ask, the 1960s decade is accurate – the entirety of “economic growth” in the 1960s was not production – it was debt.  It should now be clear to you why what happened in the 1970s with interest rates and inflation occurred!  Those events had exactly nothing to do with Nixon closing the Gold Window – rather, it was the expected and perfectly-predictable outcome of the 1960s debt orgy!

What we are facing down today is a fifty year Ponzi scheme.  Drill that into your head folks – for fifty years we have created false output gains, with the last 40 of those years having between 15-20% of each year’s supposed “GDP” not created by the work of people, but by BORROWING MORE MONEY which will have to be repaid with interest.

This is why we hit the wall in 2007.

To run an increase in GDP of about 5%, as so many “pundits” are claiming we will going forward, we would have to increase the total debt in the system to roughly $90 trillion dollars from the present $53 trillion over the next ten years.

That debt would, of course, need to be serviced.  And nobody in their right mind can possibly believe that government could take on another $37 trillion – when the current oustanding public debt is just seven trillion (that is, government would have to increase its debt by 500%!)

If you take nothing else away from this Year in Review Ticker, it should be that singular chart above and a decent understanding of what it means:
To come back into equilibrium, assuming we do not decrease debt in the system at all, we would have to shrink GDP by about 20%.  But shrinking GDP means that money available to pay down debt would also decrease which would generate even more defaults. 

This is how deflationary depressions happen – years, even decades of playing Ponzi by layering debt upon debt.  Bernanke and Geithner, along with President Obama, are well-aware of these facts which is why they are all pounding the table demanding that banks “loan more.” 

The problem with such a prescription is that the wise person won’t borrow, for he knows what’s coming.  The unwise has no collateral to pledge, and thus can’t borrow.

If the government forces (either by persuasion or legislation) lending to those who can’t pay they only extend the Ponzi and in doing so make the inevitable collapse WORSE.

We have made no progress economically in terms of the common weal of the average American but have added debt in dramatic amounts to paper over the deficiency.  That’s the bottom line on the 2000s, and despite all the crooning that “the economy is on the mend” one has to look at the reality of the common man on the street to see what’s coming around the bend for our economy and ask the following question:
How do we get positive economic growth when by every metric available the disposable personal income available to Americans has gone down, personal wealth has in fact decreased when one subtracts out debt (and you must; nobody in their right mind argues that if you go to the bank and take a cash advance for $20,000 on your credit card that you are “more wealthy” as a consequence of having done so!) and while employment at first blush looks “equal” to 2000 in fact there are 25 million more unemployed due to population growth – people who create drag on the economy due to entitlement spending rather than contributing to productive output?

So with all this said, here’s what I believe we’re looking at for 2010… ready or not, here it comes!
No, this is not a new Bull Market; the market will be lower on December 31st than it is on January 4th, quite possibly by a a hell of a lot.  We may not break the March 2009 lows – but I also don’t believe for a second we’re going back to 1576 on the SPX.  Not without the leverage – and we can’t get the leverage.  I believe we will end the year down from where we begin on January 1st.  McHugh calls it “Wave 3 Down”; I call it “aw crap.”  Either way “irrational exuberance” is back for now but cash flow always wins in the end.  I’ll be a “generational buyer” of stocks when dividend yields are over 5% and P/Es are in single digits.  We didn’t get there last year and yet those are the historical metrics that mark true Bear Market bottoms.  With that said, I would not be surprised if we hit 1220 on the SPX some time earlier in the year – but it is by no means a lock, contrary to what virtually everyone in the “pundit community” expects (most of which are looking for 1350 or more!)

The Long end of the Bond Curve is going to move higher on yields.  We have completed a long-term (multi-year) inverted Head and Shoulders pattern.  The probability of the targets set by that pattern being achieved is extremely high.  The target?  6.9% on the 30 year “long bond” – a rate that puts 30 year mortgage money at least to 7%.  This prediction assumes that we do not get a panic-style sell-off in the Stock Market – if we do get one (and I think it’s 50/50 on that) then I withdraw this prediction.

House prices will fall another ~20% – whether as a consequence of the rate back-up or utter destruction in the markets generally.  Sorry folks, the housing mess is not over.  The math on this is simple; a $200,000 principal loan at 4.75% for 30 years produces a P&I of $1039.18.  That same payment with a rate of 7% produces a principal financed of $157,107.95.  If, for whatever reason (engineered or not) the stock market collapses then you get your housing price crash anyway.

Banks will “give up” on holding their real estate as rates start to backup and will dump their foreclosure inventories.  Why?  Because the regulators may let them to play games with alleged “values” when people can get mortgages at 4%, but at 7% there’s just no way the numbers work and the fraud becomes too difficult to countenance.  There are rumors of major banks dumping hundreds of thousands of homes on the market next year – this is likely the backstory on “why.”

Credit will not ease for “ordinary people.”  All the exhortations about “lending more” have been going on now for more than two years yet have gone nowhere.  The jawboning will continue but the results will not come, simply because there is no more good collateral left against which to lend.  This will in turn lead to.

A massive second wave of small business bankruptcies will sweep the nation.  We’ve seen the first part of it.  The second will be worse – far worse.  With long rates backing up and the 30% credit card sweeping the land those who have relied on credit to operate in the small and mid-sized business world will get relentlessly squeezed.  Many will fall.

Unemployment will appear to be stabilizing – for a while – but that will prove illusory.  We finish 2010 over 10% – no material improvement.  If things get real bad we might see 12-14%.  Yes, U-3.  I won’t stick my neck out that far as a prediction but I believe ending the year at or above 10% is a lock.

The “revolting” call for last year was early – but not wrong.  There will be at least one major coup or other violent overthrow of a government in 2010 tied to economic instability – either directly or via a war it spawns.

The states will go to the government well for handouts, they will probably get them, but it won’t matter.  They’ll get some assistance at least, but in the grand scheme of things it doesn’t make any difference in a world where long rates are rising precipitously.  California and Arizona are in the biggest trouble, with Michigan, New Jersey and New York right behind.  The public employee unions will have a kitten but again, it won’t matter – that which isn’t there isn’t there, whether you want it to be or not.

A “double dip” will be recognized by the end of the year.  Between taxes and rising rates – or an intentionally-detonated stock market to stop the long end of the bond curve going bananas – you can bet on it.

China will lose control of their property and plant bubble – with horrible consequences.  They’re good at the game, but that which can’t go on forever won’t.  I bet it blows up before the end of the year.  If so, Australia’s property market better watch out – they’re levitating on the strength of China’s commodity demand and pricing there is California-style. 

The Canadian Real Estate Market will show signs of cracking – especially in places like Vancouver.  They may have another year before it all goes to hell, but the time approaches.  Beware.

The Fed’s games will “leak” and credibility will be shaken severely.  There’s too much pressure.  Something will give, somewhere.  Washington DC is too hostile a place for the “hold hands and head for the cliff together” game to work with an election coming up……

The Democrats lose big in the House.  Time is probably too short for a viable third party to emerge for the midterm elections, and I don’t expect the Democrats to lose House control.  However, I do expect them to lose their filibuster-proof majority in the Senate, and to lose enough seats in The House to trash their “steamroller” approach to legislation.  This might be bullish for the markets late in the year and into 2011 – maybe (divided government is generally good for the markets.)

Congress continues to try to spend its way out of the recession – and runs head on into rising rates.  Watch the TBAC reports.  Those will be your “tell” along with the TIC data.

One or more of the PIIGS (Portugal, Ireland, Italy, Greece, Spain) either defaults technically or is forced into austerity by the ECB.  Further, Eastern Europe becomes dangerous destabilized.  There is a real possibility of outright hostilities in that part of the world next year.  Let’s hope not.  The ECB has a nasty problem on their hands; I have said for quite some time that the Euro is likely to trade at PAR down the road.  This year is probably not the year for it, but the cracks in the dam that ultimately could destroy the European Union should become very apparent in 2010.

Contrary to virtually EVERY “investment pundit” on the street today return OF capital will once again assert itself as the primary consideration.  Sentiment indicators as of 12/31, along with 52-week highs, all are at levels that have been associated with tops on a historical basis.  Treasury has to issue $2.5 trillion this year, while we all cheered when they issued $1.5 trillion last year – and got away with it.  China has housing trading at 80x average incomes, Australia and parts of Canada have housing markets at 10x or more average incomes and the banksters and “investors” alike appear to have learned nothing, with “reaching for yield” coming back in force.  Ponzi ponzi ponzi!  Add to this geopolitical event risk and things get interesting.  That which can’t continue forever won’t – we merely argue over timing, not outcome.  I’ll lay the marker on one or more of these timers reaching zero in 2010.
Note: Subject to minor edits/revisions and perhaps an addition or two until the end of January 1st, as usual.