US Debt 372% to GDP

In this mornings mail bag we have this take on the current state of the economy by Bud Conrad/David Galland, Editors, The Casey Report which we hope that you enjoy.
While we aren’t contrarian for the sake of being contrary, more often than not that is the position in which we find ourselves. Today, with the media falling all over itself to paint a rosy outlook for the economy while simultaneously voicing encouragement to the new administration in its remake of the nation in previously unimaginable ways, it’s hard not to question our conviction that the worst is yet to come.
Could the economy really recover this quickly from the traumatic trifecta of a record real estate bubble, leviathan levels of debt, and a global credit collapse? We don’t see it as remotely possible, but yet… but yet… there for everyone to see are countless happy headlines and breathless exhortations that the worst is behind us.
So, is it Green Shoots or Greater Depression?
Getting the answer right is critical, because from it flow serious consequences to each of us. And not just in our investment portfolios but in how we organize our lives.
Looking for an evidence trail leading to the correct conclusion, Casey Chief Economist Bud Conrad once again put in very long hours digging through the data. Here’s what he uncovered, about the claims of green shoots, and what may actually be in store for the economy moving forward.
David Galland
Rather than accepting the many commentaries that our economy may be improving, let’s focus for a minute on the important forces that will play out over the decade ahead, and the minor improvements – from disastrous levels – that have given commentators such hope that the worst of our problems are behind us.
What Do the “Green Shoots” Really Look Like?
While some individual measures of economic activity appear slightly less dire than previously, it’s important to understand that most improvements are largely attributable to government intervention.
For example, at the onset of this crisis, commercial paper spreads rose to the point that this important source of corporate short-term funding had virtually shut down. Today, those spreads have returned to almost normal levels. But the bulk of this improvement is not due to a return of confidence in the economic system but rather to the Federal Reserve directly intervening in the market with several hundred billions of dollars.
And mortgage interest rates, which briefly dropped into the 4% range, did so not because of a surge in credit worthy borrowers or eager lenders… but rather because the Federal Reserve launched a program of buying $1.25 trillion of mortgage-backed securities. Doing its part, the Treasury has poured billions into Fannie and Freddie and provides guarantees for their mortgages.
In these and many other instances, the “green shoots” that optimists have spotted are really just the visible manifestations of the massive interventions by an increasingly bankrupt government.
Indeed, the massive fiscal stimulus provided by the federal government – and by the Fed, which has slashed interest rates to near zero, purchased mountains of toxic waste, and bought up Treasury debt with billions in freshly printed money – are unprecedented in the history of the U.S.
But even a cursory review of key metrics reveals continuing declines in housing prices, rising unemployment, and slowing consumption as measured by falling retail sales, GDP, and the collapse of world trade. Sure, housing unit sales recovered a little recently, but that’s due mostly to the distress sales of foreclosed homes and houses worth far less than the outstanding mortgage. These are not signs of a strong economy.
The only rational conclusion to be drawn is that the crisis is far from over and that we are not likely to see a strong recovery anytime soon. In fact, things are likely to get much worse before they get better.
The massive debt expansion that played a crucial role in creating the disastrously overleveraged economy is not shrinking. As you can see in the chart above, it’s growing ever bigger.

Can the Fed Handle This?

There is no doubt this will go down as the year of the credit crisis. Although I do believe we have been in a situation like this before, not even the most brilliant can say they know what will happen based on past events. Politicians are running scared as their constituents are ready to tie them to the closest tree, and the big banks have become the center of what has become viewed as evil. Even though we do not have a sure indication, the term depression is being used by many. One thing that is worrying, is the revising of GDP that seems to happen every month. Right now it is believed that GDP could decline by 2%, which isn't as bad as it could be, but they aren't done lowering just yet. We could even see a number as high as 10% unemployment by the end of 2009. The number will probably be closer to 8%, but it is still a possibility if the stimulus plan doesn't work. The United State's financial system didn't almost drag the US economy to the brink of failure, but it almost took the world with it. Unlike 1929, where the US was a more protectionist society, the Great Depression did not have the effect on the rest of the world.
More pressing are the problems down the road. The timing of this crisis seems terrible as long term problems are facing the US and their economic situation. The current debt situation looks to get dire as Social Security and Medicare funding increases. The baby boomers are just starting to retire, leaving a much smaller population to take care of them. Although many will keep working, it still is a big problem going forward.
The date was September 15th , Lehman disclosed they were filing for bankruptcy. Barclays tried to purchase them with help from the Fed. This was declined as the Bear acquisition by JPMorgan was very unpopular with the US taxpayer. Lehman turned out to be a major mistake as investments in the company caused ripples through the industry. Not only did Lehman fail, but any company with investments in the company including bondholders looked to be left holding the bag. Soon after, some money market funds began to talk of lowering net asset value to under one dollar. This caused over a $120 billion of money fund withdrawals in one week following (iMoneyNet). The $1 net asset value was guaranteed by the Exchange Stabilization Fund but commercial paper was in turmoil as no one wanted to buy paper they new didn't have a true value. This was the beginning of investors not knowing what things are worth and it continues to be the problem today, even though it has gotten somewhat better.
One thing has been clear over this short time frame and that is no one is sure what to do. Henry Paulson wanted to try something new in this scenario. The reason for trying something new, was the fact that Japan never did figure out how to get out of this mess when it happened to them some two decades ago. So what is the answer? It isn't so much what the answer is, my contention is what the answer isn't, but I will get to that later.
To help shore up the bank's balance sheets, Paulson took $125 billion of the taxpayers money to make investments in some of the bigger banks. Initially, he just asked for $700 billion to buy mortgage based assets that the banks were not disclosing and holding on to, stretching out the pain with respect to each earnings period. This was scary for the investor, as there was no way to know if any of these major institutions were still viable. Shortly thereafter, European countries began to make capital injections into their banks. The US has not done this as they believe that capital injections should only be made with respect to institutions that are failing. I do believe that much of this is a good idea, as we do not want the financial system to fail. Opinions of different economists have mortgage based losses being anywhere from one to three trillion dollars. This all depends on the real estate market and its ability to bottom. As many of the larger markets of Las Vegas and Miami have just been crushed due to overvaluation of assets, it is hard to know when this will slow down. I believe that Bernanke has used all of the tools at his disposal, from making it very easy to get money from the Fed window, to the coordinated rate cuts with Europe. The fact that they place the Fed rate at almost zero, was a measure I believe to be almost too much but that also will be talked about a little later.
The main concern of this process is the increase in debt of the US. We have already been running at a deficit for some time, as the average person has more debt than equity. It also seems to be the way the newest generation seems to be respect to the future and what they will buy now. Many have had the ability to get zero down loans on vehicles at zero percent, for in some cases up to 84 months. Home loans have been very low with respect to interest and many purchases have been made on the premise of I will get a raise and it will be easier to make ends meet, or even revising their loans and taking out the amount that the appraiser will increase the value of the home to. When the $700 billion was passed Congress raised the ceiling of the national debt to $11.3 trillion. That increase wasnt the only one this year, as they had just raised it to $10.6 trillion. More bad news is that the national deficit had just risen to $455 billion in 2008. The Congressional Budget office states that 2009 has it at $700 biliion for 2009. If this number isnt enough, long term we have responsibilities of $53 trillion to Medicare and other beneficiary benefits. With all of the bailouts to those like Fannie Mae and AIG will probably bring that number to $56 trillion. Some have stated that Social Security will start paying out more than it gets from revenue in less than a decade. The finance shows are starting to talk of a flight from the dollar as many have been getting in. What if currency does not continue to be a haven. The fact that US T-Bills are still the safest and many countries own them as their economies move much more than our own. What if T-Bill investment decreases all together. Almost all of the major industrial countries are in crisis, so where is the safety. Even with the US having a AAA rating, they may just be the best of the bad. I do believe that the US is safe, but the upcoming deflation of curency could cause inflation that would make the Reagan era look small.
All of this money pumped into the system is supposed to do one thing, promote lending. It is difficult to believe that trying to increase lending will help our current situation. The large amount of lending has been what has gotten us here. We see many of the people qualifying for loans are the ones that can't pay for their home and vehicles. So why give more? The current banks are taking the money given to them and not lending it. They have used it shore up their balance sheets which is good. It seems to me that we shouldn't try to get them to lend, but if the credit markets don't ease it could last for a very long time.
I believe the main issue with our current situation isn't now but the future. If we have hyperinflation, it will affect our country somewhat. It will really affect those in emerging markets. Everyone thinks of gold with respect to inflation, but we are the number one supplier of food to the world. The price of wheat, corn, and soybeans will go through the roof, and we will be looking at a world that is starving. The price of food could see massive increases in price, not to mention, the US's problem with oil pricing. Hopefully the Fed is right.