Forgive us our debts, Part 2

A very stimulating response from "Caronte" to the earlier post on debt reduction, so I've taken the liberty to bring the argument out front here.

Caronte, you say:

Suppose it is believed with absolute certainty that every 50 years, say every year divisible by 50, all debts are forgiven. There would follow a bunching of loan demand as the forgiveness date nears, while willing lenders would simultaneously vanish. The market would no longer match credit demand and supply, total welfare would suffer. Debt forgiveness would only avoid this problem if it was done by stealth, unpredictably, once and for all and never again. Like forgiveness of tax evasion or illegal buildings. Difficult to persuade debtors, (or builders, or taxpayers), that forgiveness would not occur again. Lots of people would be encouraged to borrow beyond what they can afford (or evade tax) – the moral hazard implication. Unsustainable indebtedness would multiply rather than disappear. Moreover, a defaulting borrower does not need forgiveness if she genuinely cannot pay: can’t pay, won’t pay, period. If the defaulting borrower has some residual wealth, though less than the outstanding loan, who is to deprive the creditor of that? What legal or moral right would support state action without creditor compensation?

Would “debt cancellation (or rather, reduction) … be a suitable punishment for the principal offender”? True: “the relationship between mortgage lender and borrower is unequal. You have to live somewhere, and if you don't buy, you have to rent - and rents will tend to reflect the purchase price of houses.” No more than the relationship between employer and worker. There are various way to reduce this inequality, workers can form Trades Unions and cooperatives, and borrowers can found building societies – until New Labour wickedly de-mutualised i.e. privatised this form of social property which was not theirs to privatise. But the main reduction of the inequality comes from competition among lenders (and among employers).

“By adjusting the ratio of deposits to loans as it suits them, lenders can multiply the money supply”. True, there is a credit multiplier at work when banks re-lend their deposits and get some new deposits as a result. If they were prevented from re-lending – by law or by contract – they would act solely as custodians (as in the early days of gold-money) and would charge depositors for the service instead of paying interest. And any act of individual saving would instantly reduce total demand by the same amount and cause unemployment. Besides, the ratio of deposits to loans is regulated by law and is variable at will only when it is higher than a prudential limit. And banks face the consequences of their bad loans, they can go bankrupt and their shareholders can lose all their capital. That’s punishment enough. As long as they are competitive, there is not much of a reason to “punish” them by forcing them to remit those bad loans that still have a residual market value.

“Rather than prop up the worst of the lenders, let them go down. Why should the taxpayer assume the burden?” Absolutely right. “Pay off the depositors” – if the bank can, or if there is a state guarantee. But why “shrink the lending book” by debt remission? If mistakes are always to be automatically corrected ex-post when they are revealed as such, the market disappears and with it all the conceivable advantages that it brings.

An Australian economist whose name now escapes me once wrote an article mocking the theory of general economic equilibrium – with its complete system of futures markets – by imagining a system of “past” markets in which economic agents could undo their past transactions that with the benefit of hindsight turned out to be a mistake. Just imagine. Debt remission would have some of the same effects.

I say:

Caronte, welcome, and many thanks for the length and thoughtfulness of your response. I don't pretend to have your economic expertise, but I still think there's a debate to be had. I'll try to tackle some of your points, not necessarily in strict order.

I suppose that in ancient Israel, the economy was not so monetised as today, so the advent of the year of Jubilee may not have been so disruptive as it would today. I don't really advocate a periodic debt cancellation - though I'm beginning to wonder about the necessity of charging interest. (Isn't it the case that some Swiss banks do in fact charge you for looking after your money securely, instead of making investments with it or lending it out to others?)

Competition between lenders may help keep down interest rates, but it's the ballooning of asset prices - and the consequent increase in the size of mortgage required - that causes the damage. So many are now locked into monster mortgages that a significant rise in interest rates - which otherwise might be appropriate for tackling inflation - is politically very unfeasible.

I argue that the price of houses is pretty much beyond the buyer's control, except that there's a point where a purchase is either not affordable (we seem to have reached that stage) or, as with subprime, fudged at the outset with disastrous consequences later. So I suggest the expansion of credit (for which, as you say, regulators also share responsibility), and the terms set by fee-hungry lenders and intermediaries, are more to blame than the family that wants a roof over its head it can call its own. Finance for cars and consumer goods is something else; a house is a necessity, and surely, owning one is not an unreasonable aspiration.

Banks should be, but are not being made to face the consequences - look how governments are propping-up Northern Rock and Bear Stearns.

Debt reduction does not seem unreasonable to me. If a life insurance company fails, the book of life business can be passed on to another provider, who is only required to underwrite 90% of the outstanding life cover. So why not for lenders who (through greed and stupidity) have gotten their sums wrong? A 10% reduction in the capital only represents a couple of years' interest. Better a borrower who repays a reasonable proportion of the loan, plus interest, than simply mail back the keys and leave the bank with illiquid stock it doesn't know how to manage.

This is not a problem limited to a single bank -and anyway, there are far fewer these days, and they are much larger, so one failure could really rock the boat. At worst, we could now be facing the prospect of mass bankruptcy, the crash of the credit system and general economic carnage. It's worth coming up with some fudge to keep borrowers and lenders going.

Here in the UK, you can enter an agreement with creditors and as long as you keep up the scheduled payments, interest charging stops altogether. Maybe that would be another way forward - the monthly repayment would be lower and the borrower would see his equity in the house increase over time.

We've been watching enslavement by money-owners who have been licensed to print almost unlimited amounts of their own money, but the poor man only feels it going past and can save none, so remains in debt-bondage. Better any reasonable rearrangement, than "I owe my soul to the company store".

Market timing

A very useful piece by John Mauldin considers long-term returns. He quotes findings by Ed Easterling at Crestmont Research, about what would have happened had you retired and invested $1 million to take $50,000 a year, rising annually with inflation. He looks at 78 different 30-year periods since 1900 and works out whether your money would last as long as you:



The forecast price-earnings ratios of the S&P 500 for 2008 range from 18.69 to 22.20. This does not bode well for long-term retirement investments made now. If the p/e ratio from the current c. 20 to 16, this would imply a share price decline of 20%, and even then you'd outlive your income in 30% of cases. A p/e of 12 requires shares to drop now by 40%, and that still means a one-in-five chance of running out of cash.

It looks as though, rather than fear a major crash, we should hope for one - as long as we're in cash or something else that's relatively safe and liquid.

Forgive us our debts

In one version of the Lord's Prayer, the word "debts" replaces "trespasses", and this is in keeping with the etymology of "redemption". The ancient Jewish law forbade perpetual debt-slavery for fellow-believers, and even provided for ceremonial debt forgiveness every 50 years (which, I imagine, had a feedback effect on the terms and length of loan agreements).

"Hatfield Girl" gives a very vivid picture of our slow slide into dingy, shabby poverty, and it has to be every sane person's earnest wish that we (or our fellow citizens) don't return to the conditions so many suffered before the Second World War. Yet what is causing all this but the heavy chains of debt?

A disclaimer: I often feel that I not only know nothing, but never shall know anything, despite much effort. Then I see how the world is going, and wonder who knows better.

Having said that, I'm trying to work out why, as Karl Denninger says, we don't make the banks eat some of the debt they laid on us. In the comments to the Hatfield Girl piece linked above, "Caronte" refers to "moral hazard", a point I entirely accept. But I say that debt cancellation (or rather, reduction) would be a suitable punishment for the principal offender.

In our society, the relationship between mortgage lender and borrower is unequal. You have to live somewhere, and if you don't buy, you have to rent - and rents will tend to reflect the purchase price of houses.

So what determines the price of houses? Supply and demand. And a major element of demand is how much money is available. By adjusting the ratio of deposits to loans as it suits them, lenders can multiply the money supply, as everyone knows (I say everyone, but actually I don't think the public is fully aware of the simplicity and enormity of this scam). Since 2000 or so, the money in the economy doubled, and so, un-oddly I think, did the price of houses.

The lender can decide how much to lend into the market generally, and consequently influence it; the buyer cannot decide, on an individual basis, to halve the value of the type of house he wants in the area where he needs to live.

So by what right should lenders inflate asset prices, fix on them loans of money they created virtually ex nihilo, then deflate asset prices by reducing lending in difficult times, and expect the borrower to bear the full weight of the consequences?

The borrower may have colluded with the lender to take on an unsustainable debt (or one that exposed the borrower to excessive deflation risk), but for reasons already given I suggest it was a shotgun marriage (or a mass marriage, like those Moonie wedding rallies) with the lender handling the Purdey. For subprime borrowers, I think it's fair to argue that the class of people involved means that the lenders had far better knowledge of the implications, and so are far more culpable.

Rather than prop up the worst of the lenders, let them go down. Why should the taxpayer assume the burden? Pay off the depositors, but shrink the lending book - which is mostly funny money, less substantial in its origins than candy floss - a drop of ink on 80-gram paper.

To quote the inscription on the statue of Justice above the Central Criminal Court, "Defend the children of the poor and punish the wrongdoer." The trespasses of the mighty are less to be forgiven.

The silent watchdog

Yet another important post from that heroic toiler (an oxymoron for classical Greeks), "Tyler". He looks at the economic implications of our ageing population and demonstrates that public expenditure cannot continue as projected.

The long-serving Comptroller Generals, both in the USA and here the UK, have recently retired. The difference between them is that the American, David Walker, has spent two years on an increasingly well-publicised Cassandra mission to warn the public of future dire financial dislocation, because of unfunded liabilities such as medical care and pensions. I may be doing a disservice to Sir John Bourn, but I can't remember any media fuss about him going on such a tour here.

Looking at the website for the National Audit Office, I see that in the FAQs, the spelling of "comptroller" comes second, after a dry summary of the NAO's role. However, the "find" option on my Windows toolbar can find no occurrence of the following words in that web page:

disaster
bankruptcy
poverty
IMF
inflation

Some barking from its kennel would now be most welcome.

In the know

Marty Chenard states something I've suspected, which is that a bear market is when the experts sell to the amateurs. This article seems to confirm that we are indeed in a bear market; on the other hand, Clif Droke thinks "an interim bottoming process is well under way". I like that "interim" - there's a hedge, if you like.

Housing stall, after all?

Looking at the economy now, we have to go well beyond subprime, and consider the general value of housing. Karl Denninger repeats that, in the long term, average house prices are three times income, but at the same time observes that they are "sticky". No-one wants to crystallise a loss, and you have to live somewhere, so why sell now?

If the financial victim next door has to sell his house at a 50% discount, that's all the more reason for you not to sell yours. If no-one sells voluntarily, how do you determine a real, as opposed to forced-sale value? So one effect of the housing drop could be a general slump in sales - with maybe a rise in home swaps for those who need to go to a different geographical area, perhaps for job reasons.

But what about people caught in negative equity? Here in the UK, ditching the house for less than the outstanding loan could leave you being chased for the balance, for years, unless you opt for bankruptcy. However, in the USA, many mortgages are on the roof but not on the borrower, leaving the lender short if the homeowner mails the keys back. Denninger has said more than once that borrowers need to consider this option solely on its financial/legal merits, as he thinks many lenders lost the moral argument when they knowingly advanced far too much to people who they knew couldn't maintain the loans. Now this could really upset the applecart.

Michael Panzner features a piece by FT columnist Martin Wolf. Wolf wonders what may happen if a high proportion of negative-equity homeowners default. The economic impact may be closer to Nouriel Roubini's $3 trillion, than to Goldman Sachs' more sanguine $1 trillion (the latter itself is a massive increase on the sort of figures bandied about before Christmas). Wolf sees two options:

There are two ways of adjusting the prices of housing to incomes: allow nominal prices to fall or raise nominal incomes. The former means mass bankruptcy and a huge fiscal bail out; the latter imposes the inflation tax.

But either option is so unattractive that (despite Denninger's image of paddling furiously as we head for the waterfall) there is a very strong incentive for fudge and delay. We've seen central banks pump many billions into the system in the last few days; and the ratings agencies seem to be trying their best to help maintain the status quo by not downgrading lenders as quickly and severely as some think they deserve. But again, housing is intrinsically illiquid, and houses aren't turned over rapidly like shares, which is why we have "mark to model" instead of "mark to market". What's the rush to crystallise a terrible loss now? Better a Micawberish hope that "something will turn up" than a grim Protestant insistence on an immediate collapse which would benefit very few people.

Assuming wages continue to rise over time, the gap between prices and incomes will lessen. If the homeowners can somehow be reassured that the government is determined to support house prices, then the sell-to-rent speculators could be caught out in their attempt to "short" the housing market. Can they be sure that, having sold their nice house, they can buy another such in the right area for much less, later? What will they do meanwhile?

The real threat is this "jingle mail", and the potential consequences seem so dire that something creative may be done. Bankruptcy rules might be modified to protect lenders; maybe portions of recent loans may be written-off. How about part-ownership, part-rent, as with UK housing associations - having escaped the trailer park, many first-time homeowners may want to keep their foot on that first rung of the ladder. Not everyone will want to pour engine oil into the carpet and trash the light fittings.

So I think we will have fudge, delay and attempts at more creative solutions, and a long stall in the housing market. Unless there's another hammer blow that the system simply can't take, such as an explosion in the financial derivatives market, as arch-doomster Marc Faber expects and (in his inherited Swiss Protestant way) hopes. In that case, every sign we've seen so far is that our governments will run the money-presses white-hot rather than face major deflation. We all have an incentive to paddle away from the brink.

Put your hand in a parting wave

Frank Barbera discusses the implications of Elliott Wave Theory for the current stock market and concludes, like Karl Denninger, that there's at least as much bad news ahead as we've had already.

Unbelievable, unimaginable

The problem with looming economic disaster is that you look out the window and since what you see is normal, you wonder what that mad Cassandra is wailing about.

Michael Panzner reproduces an article by Paul Farrell in MarketWatch about the absolutely enormous international derivative market, currently estimated at $516 trillion. Those numbers are beyond imagining, but if 2% goes bad, that's equivalent to 20% of the world's annual GDP up the chimney.

Lessons from Japan

Krassimir Petrov looks at the Japanese experience of deflation - 17 years and counting. A monetarist view would require the following steps to end it:

• Condition 1. Bad loans made during the boom years must be written off as losses during the bust. This cleanses the banking system from the toxins of the boom.

• Condition 2. Weak businesses should be liquidated during the bust, rather than propped up by the government or the banks. These bankruptcies and liquidations shift scarce resources to more productive uses

• Condition 3. Finally, Interest rates must rise sufficiently to restore proper valuations in the capital markets, and therefore allow stocks and bonds to fall in value relative to consumer goods. This realigns properly the price ratio of capital goods to consumer goods.

Now, I suppose, it's our turn.

Money has poured out of Japan over the years, looking for better yields elsewhere, but Petrov is not at all sure that when the "carry trade" reverses, the Japanese market will rise. He thinks a more interesting bet is on the rise of the Yen in the foreign exchange market. And that's a poker game I don't have the confidence to join.

Pure gold

Karl Denninger offers a couple of very valuable insights today:

1. He thinks that we're only part way through the stock market decline:

Have you ever noticed that the "crooners" on Television never tell you to get out at or near the top, and call it a "buying opportunity" all the way down? Well gee, the last time they did this it only took 7 years before you were back to "even", and of course that's before price inflation ate up all your money.

I think he's right - mostly, the financial sections in the papers seem to me hardly better than celeb gossip.

2. Following on from this, he offers a technical tip on spotting turning points between bull and bear markets

... you buy the SPY (or a S&P 500 mutual fund such as VFINX) when the 20 week moving average crosses the 50 week moving average by more than 1%, and you go to cash (or treasuries) when the 20 week moving average crosses the 50 week moving average in the downward direct by more than 1%.

Being in the right asset class at the right time, as judged by this measure, beats those who stay in the market all the time. Denninger does warn that although it's been true for the last 20 years, it may not hold true forever.

Why safe investments aren't

Michael Panzner's latest explains a point I've learned and repeated here before: "refuge" investments like gold are not as safe and predictable as you might assume. Borrowing money to invest boosts prices, and then when credit becomes tight, forced sales can deflate prices just as rapidly. We're all in a bouncy castle, like it or not.

Property slump or stall?

Karl Denninger says house prices over the last 100 years have averaged three times income. What's the implication for us?

This BBC survey says the average semi (a standard unit of housing, one would think) is "worth" slightly over £200,000; official statistics put household income at £33,492. So houses cost around six times earnings.

That suggests a 50% drop is due. But as Keynes observed with wages, house prices tend to be "sticky downward": no-one is in a hurry to realize a big loss on their home equity. Death, divorce and redundancy may force some sales; others may choose to wait, or go for house swaps.

Or wages could double. Up till recently, it was a standard assumption that "inflation" would run at 2.5% p.a. and wage increases 2% above that. Using the "Rule of 72", it would take 16 years of 4.5% wage increases to double nominal incomes.

Whether wages will always rise in real terms, is another matter. One of the effects of globalization is to hold down wages in the developed countries; and food and energy costs look as though they will continue to rise as the rest of the world gets richer and more populous.

Marc Faber speaks on the crisis

Video here on Bloomberg. Summary and comment on Contrarian Investor. Some points he makes:

Bernanke's policies will destroy the dollar; he should have gone to Zimbabwe. Property assets in a bubble, but bonds (except maybe for some carefully-researched junk bonds!) also likely to be a victim of inflation. Emerging markets worse than the Dow. Deflation may hit the dollar through devaluation, rather than the nominal value of US equities. Commodities (e.g. gold) were at an inflation-adjusted 200-year low in the late 90s, so even after the recent rises they're not overvalued. Derivatives (NOT the packaged ones) will blow up in the next 3 - 6 months. He hope a major bank will fail and reintroduce discipline into the system.

Have you noticed how cheerful gloomy types get when disaster hits?

Another toiler in the vineyard

Safe Haven features an article by "Randy", who predicts that the American economy will go haywire. The good news is that, within a generation, poverty will make the US economically competitive again.

That's not an ironic comment. It seems to me that America's most precious heritage is not her wealth, but her love of liberty and her distrust of power. She has been seduced by Mammon and Empire, and the undoubted difficulties we face may turn out to be the last-minute rescue, the ram caught in the thicket.

Cash is king

Robert McHugh confirms my feeling: sit it out, hold cash.

Deus ex machina

You know you're in trouble when you have to appeal to the Great Leader to do something. Karl Denninger publishes an open letter to the President, the Presidential candidates and others.

1. He complains that 23A exemption letters and the recent TAF facility are being used to hide the scale of banking problems from the public.
2. He points out that over the last 100 years, local house prices trend to 3 times median local income (work that out for your own house).
3. He lists action points to make the system transparent and honest - even though some lenders will be immediately destroyed, like the little slips of flash-burn paper used by spies in Sixties movies.

Being right is not nearly enough - work it out for yourself:

1. Imagine the conversation between interns on receipt of Denninger's fax;
2. List the not-to-be-published reasons why nobody who could solve the problem, will;
3. Compose the official reply.

Now, head for the tree line.

Another Ranter

Alex Wallenwein goes schlock Gothick:

Employment figures, the Thornburg collapse, Carlysle Group troubles, sky-high oil prices, rampant inflation, the dollar-crash, and neverending Fed bailouts of fast failing super banks are pounding the stake deeper and deeper into the global debt-vampire's heart. He will find his much-deserved rest before long. Unfortunately, the portfolios of careless and gullible retail investors, consisting largely of Dracula's debt-spawn, will die along with their master.

I'd give him a "Highly Commended" in the Sackerson's Prose Prize competition for that first, rolling sentence. But he gets pretty apocalyptic, too:

The next Dow-bottom will plumb depths not seen since the early 1990's, maybe even the 1980's!

The early 90s saw the Dow around the 3,000 - 5,000 range. Eat that, Robert McHugh.

Then he shoots for the moon:

... gold can easily go past $3,000 per ounce this year

- and makes a reckless recommendation:

If anyone still has money in any stocks or mutual funds, it's time to exit.

Overstated, I think - but completely wrong? Maybe not.

Another 42 stars?

"Deepcaster" continues to hint at the operations of "The Cartel". His theory is outlined in this post of August 11, 2006. In a nutshell, there's a plot (a) to dissolve the US and make a new entity by combining it with Canada and Mexico, and (b) ruin the dollar in order to replace it with the "Amero", presumably to recommence the thieving by inflation. So it's like what some think the EU project is about.

Except I don't think the EU or its North American equivalent are driven by sinister motives; just venal ones. Concentrating wealth and power makes very juicy opportunities, provided you can simplify the command structure. All that consulting the common people and getting their agreement is so tedious.

America grows. She acquired 29 states in the nineteenth century and five in the twentieth. Where next? Canada has 10 provinces and 3 territories; Mexico has 31 states and one federal district; Greenland is owned by Denmark but has been granted home rule. But Canadians, Mexicans and Greenlanders may have their own views about assimilation.

Democracy is inconvenient, by design. I think the thirteen stripes on "Old Glory" remain there, not just as a historical quirk, but to remind the Federal Government that it's very important to say "please" and "thank you". Even in the first go at making the nation, Maryland, Delaware and New Jersey chose to delay the ratification of the Articles of Confederation, until certain issues had been resolved to their satisfaction.

Here's to the awkward squad.

The Grand Union Flag of 1775, flown by John Paul Jones

Survivalism

Michael Panzner finds another useful article, this time by Laura Coffey on making contingency plans for losing your job.

I sent a circular to my clients in the late 90s, urging them to take out redundancy insurance, because I thought the coming stockmarket crash would be followed by recession; but of course I didn't anticipate that the government would use monetary inflation to defer the reckoning (and, I now fear, make it worse). Articles like Coffey's are straws in the wind, I think.

Diversity, dispersion and disconnection

Karl Denninger continues his heroic (it's always lonely out in front) campaign to call the banks and the regulators to their reckoning. As he points out, we're all tied together, and instead of making it better, that makes it worse, as non-Americans will find out:

The dollar will bounce around before starting to take off. So far, we've not seen people figure out the "rest of world will be f***ed", but if you think the exchange rate problems won't lead to that, you're sadly mistaken. Beware.