Wednesday, March 25, 2009

How Much Delevering is Coming?

The below is from an email back and forth that a bunch of my family members were on sent March 2nd, 2009. After having read this article from Thursday March 26th's WSJ, I'm more confident than before that my numbers below are reasonable.

I organized the emails such that the earlier emails are at the top followed by a response and then my response to the response. Don't worry, my conclusion is everything's better. I mean, the stock market's up 25%, doesn't that constitute a new bull market? Happy days are here again - yippee!

I most recently discussed this topic last December here on The Investment Linebacker.

Lightly edited, the emails begin below:

Going back to [my cousin's] first email about thinking about all the system participants in aggregate, I've read slightly different numbers. Jeremy Grantham at GMO basically said that privately held assets in the US (stocks, resi real estate and comm. real estate) totaled to about $50 billion before the "crisis" began. I'll exclude government assets and liabilities for the moment. That Private Asset Base (as he phrased it) was supported by about $25 billion of private borrowings. If you assume the private asset base is now worth about $30 trillion (down 40%, which is probably right, but you can pick a different number if you want), assuming some further deterioration in housing and CRE prices, then the $30 trillion is now supported by $25 trillion of borrowings. This is an incredibly precarious position If we believe that the original 50% debt to equity ratio is the right one, then debt needs to decline by about $10 billion or three fourths of a year of GDP. That's the definition of pain. And that pain is going to be shouldered by the private market, barring further socialization of our private obligations. Even if socialized, it's still born by private individuals, but the burden is shared by people that did not actually borrow the money rather than merely by those that did borrow the money. Adding a new, substantial tax burden will further reduce the value of the assets - since the cash flow off them will be less - merely compounding the problem.

The basic thesis behind taxes is that at virtually every mix of tax rates above a very low level, federal taxes end up fluctuating around 18.5% of GDP. An increase in taxes will cause a quick pop in tax receipts before the resulting drag on productivity brings it back down toward 18.5%. The same thing happens with tax cuts: in years one or two, tax receipts relative to GDP fall before the increased productivity in the economy accelerates capital through the system bringing tax receipts back up toward the 18.5% long term average.

Given that, from the government's perspective of maximizing receipts, tax policy needs to be geared not toward progressive, regressive or flat, but toward whatever solution drives sustainable, long-term growth in GDP since tax receipts will basically be 18.5% of that. We know for a fact that higher taxes reduce productivity, reduce positive private incentives, and manipulate behaviors in ugly ways. Lower taxes do the opposite. For some reason, even though cutting tax rates increases tax receipts over time, certain people get pissed about this fact even though the government's take is bigger because of it.

My cousin's reply (he's a smart, great guy for anyone wondering):
I agree with the $50T and $25T numbers, they are within my $90T and $45T, the difference being assets and liabilities carried by other than private entities [referencing a prior email]. I think your 40% number may be a little brutal in the aggregate since it is off a base that includes cash and some safer investments.

Almost as brutal as the asset shrinkage though is the liability shrinkage. Of the $25T give or take $10-12T was in some kind of a securitization. If 25% of this naturally rolls over every year and there is no replacement than $2T or so is going to go away. There is no good way for this to happen.

I generally agree with your basic tax math but would look for other ways to help close the over all quality of life gap. That and other bad fiscal decisions and foreign policy mishaps by Republicans are what put me as the sole defender on this email chain of the esteemed [Uncle of TTB]. [This comment was referencing his bias toward left-leaning politics vs. my different tilt].

TTB's Cousin
My reply back that basically you can pick a less painful hit to the Private Asset Base, but it doesn't change the overall thesis that deleveraging is going to be enormous and painful because you cannot rationally pick a number high enough to avoid the problem. As I mentioned at the beginning of this post, I'm more and more convinced the 40% is reasonable.

I basically agree with my cousin that it would be nice to close the quality of life gap, but more important than the gap is the absolute level of quality of life. While the gap may be wider today than it was forty years ago (I have no idea), the absolute quality of life for everyone is much much higher. In any case, here's my reply:

Cash is a minor percentage of private assets in the US. Anyway, pick your number. -30%? I mean, the S&P’s down 55% from peak [today closer to -45%], so we have some cushion on the other asset side to play with. If it’s a 30% decline, then private assets are $35 Trillion and debt needs to decline by $7-8 Trillion which is a bit over half a year’s GDP. Point is, you can’t just wipe out 6-12 months of total economic activity in any way other than huge pain and we have barely started. All of this assumes that we do not over correct or land at a level of yet lower leverage.

The ideal is to absorb that pain over a big number of years, but it’s possible we eat it over call it a four year period which means GDP falls 10% a year for a couple of years before we’ve delevered merely to the leverage ratio we had at the beginning of this “crisis”. If we go to a more conservative position, which wouldn’t be shocking, the pain is worse.

During The Great Depression, nominal GDP declined 46% peak to trough. People don’t remember that fact, but just think about what that means for a minute. Lord willing that won’t happen again. But believe it or not, we have a lot more leverage relative to our asset base this time around, so I won’t say that it can’t happen, but I am hopeful it won't happen.

Sorry for the sour posts, but I do not see any other way. The government can print money until the cows come home with a hope of supporting asset values, but the resulting inflation will likely end us in a worse place than if we just let the correction happen naturally.


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