Tuesday, April 27, 2010

Economics in Two Charts

With the stock market back over 11,000, many folks are treating our economic problems as if they are now in the rear view mirror, and that while job growth and economic activity may remain sluggish, it is inevitable.

Let me say that I sure hope so. Let me also say that I frankly doubt it. Two charts from Nathan's Economic Edge help explain my lingering pessimism.

Chart One:

While the economic collapse of the last two years was predicated on several problems (Investment Banks, Fannie/Freddie, MBSs, CDOs, CDSs, etc.) well upstream of the American home buyer, the dominoes did not fall until people stopped being able to afford and/or re-finance their mortgages. For well over a year now, we have been in a payshock lull, but the latter half of this year and much of next year will present a tough challenge, as a great number of homeowners need to sell their homes, re-finance their mortgages, or suddenly start earning a lot more money in order for the country to avoid another shockwave of delinquencies and defaults. Are there enough buyers, is there enough liquidity in the mortgage market, and will the jobs come back in time?

If we look to what staved off Great Depression II in 2009 and 2010, it was debt. The U.S. Government took on record amounts of debt and bailed out corporations, homeowners, and the general economy with record amounts of federal stimulus spending. Yay, so the government and debt can save us again, right?

Chart Two:

For detailed discussion, debate, and variations of this chart, you can read this post on Economic Edge. The chart is not perfect, but the main conclusion that can reasonably be drawn remains. An increased debt load has diminishing returns.

In the short term, debt functions like money, as it can be used to buy stuff, bailout companies, hand out tax credits, whatever. This is why Keynesian economic theory advocates aggressive debt-spending in response to financial crisis, it is seen as an investment into the future, with the government being the investor of last resort. Monetarists also use debt as a positive tool, targeting interest rates on debt as a way to contract or expand economic activity and "regulate" the free market. (Think about that for a while.) That is why the monetarist response to financial difficulty is to lower interest rate, making debt cheaper. Both approaches were used very aggressively under both the Bush and Obama administration. However, both the Keynesian and Monetarist theories fail to account for the effect of both public and private debt in the long run. The chart above proposes that there are real diminishing returns on debt. This makes common sense, but has largely been ignored by modern economic theory. Instead of any reliable "multiplier effect" models, the chart posits that while in the past $1 of debt did indeed result in positive marginal productivity, the long trend line show diminishing returns. Furthermore, given our current debt load, any future debt spending may likely result in break even or even negative returns. We are potentially at the brink of debt saturation. And as the chart implies, a debt-saturated economy incurring additional debt would not stimulate any beneficial activity, and may even cause additional harm.

On the more hopeful side, and the title of this post aside, economics can not be reduced to two simple charts. There are countless factors that will determine the future of our incredibly complex economy. Still, it will be interesting to watch the mortgage market over the next two years. Not only would another round of bailouts and stimulus be politically difficult, they could also be economically crippling.


John said...

Ah, here's where investing becomes interesting and where the folks at Goldman Sachs and elsewhere can make a lot of money! Is the economy improving for the long haul? Maybe. Are we doomed to fall because of that chart and other factors? Maybe. The people who evaluate correctly stand to earn a lot of money because of this uncertainty.

I respectfully argue that debt is not itself bad. Debt (long-term and short-term) only becomes bad when the principal and interest payments on it become too large in relation to the debtor's overall income. Until that point, debt can be a very useful tool.

Justus Hommes said...

I also don't see debt as inherently bad. I re-read my post to make sure, and don't think I made that argument.

I would parse out public debt for caution, however, as when it comes to government income comes mostly via taxes and inflation. To make those principal and interest payments, government must choose between the political difficulty of raising taxes/cutting government service and negative economic and social consequences of raising inflation. And since politicians are spineless vote-panderers that care more about their short term prospects for re-election than the long-term interests of the country, inflation is usually the easy choice.

As an aside, an interesting feature of this economic cycle is that private (household and business) debt has been collapsing at an unprecedented rate, causing some folks to see the dangers of debt deflation. In a debt-deflation scenario, it doesn't really matter how much money the government attempts to "print" into existence, because it is not being multiplied throughout the banking system and general economy in the form of debt/credit/fractional reserve. The lack or private debt further exacerbates the problems with public debt, as economic activity is strangled and government receipts shrivel. It is a lovely picture of utter gloom.

I personally have not idea what will happen, and if I were to venture a take on the big picture, I would guess that we get relatively lucky with the forces of inflation and deflation somehow managing to offset each other, and our economy will for several years to come continue looking pretty much as it does right now, for better or worse. However, if I were playing the stock market game based on the short term, and the housing market sees continuing downward pressure, I would recommend getting mostly out of stocks at the current highs and by late summer be sitting on the sidelines or even ready to short.

Mr. Winston said...

I'm not so sure I understand the first chart and could not find it on the Economic Edge blog.

Justus Hommes said...

Mr. Winston, the first chart was in a post at Economic Edge a few days ago here, but originally comes from:


My understanding is that the chart shows the combined total loan balance of all mortgages that will "reset" to a higher payment, broken down by quarter. Then, within the bar for each quarter, we get an idea of the type of loan that will experience the reset, or payshock. Also see the journal article abstract here by the author (Laurie Goodman) of the chart .

Anonymous said...

John, in the context of the current economy I would argue that debt is itself bad. I think it is pretty well documented that a significant amount of personal debt is too high in relation to income. How many trillions is our national debt now? How does that number relate to our government's resources and ability to effectively pay it back? The debt and interest don't seem to be shrinking.

Justus Hommes said...

I do agree that using debt as a tool to increase non-necessary personal consumption is very harmful. Credit Cards and HELOCs were used used by all too many as yuppie food stamps.

John said...

My friend, I think debt is only bad if someone incurs it with no realistic chance of paying it off. So, to me, reasonable debt for education or buying a house can be wonderful. For many, it would take a decade (or likely more) to pool the resources necessary to own a modest house free of a mortgage, but debt allows people like us pre-40 to own a home and raise a family in it in the present. There could be all sorts of other examples because the value judgment is, of course, left to the individual as to when incurring debt offers the best long term value.

That said, I fully agree with you on the national debt example and our host in referring to credit cards as yuppie food stamps. Incurring debt that cannot be reasonably paid off is bad for the debtor. So, perhaps, we are agreeing but emphasizing different aspects of the same position.