Debt Induced Recession is a Scary Possibility

Economic Overview ... No Recession but No Jobs Either

Recessions are terrible things. Europe is entering one and the U.S. is teetering close to the edge as well. And Asian countries, including China and Japan, are having problems, too. See Euro-Zone Data Deepen Gloom and Sharp Slowdown in Asia Sounds Ominous Warning.

Pretty much the whole world is in financial trouble, and there's no short term fix at the ready. My strong view is that we're going to have to work our way through this mess over a number of years. That said, the U.S. is best positioned in the world to do just that, assuming our politicians don't do too many dumb things in the months and years ahead.

Debt Induced Recessions

While all recessions are bad, debt induced recessions are even worse. That's because something even worse --- "debt deflation" --- can result therefrom. {We won't go into a detailed explanation of debt deflation here, but please bing or google (1) Irving Fisher, (2) Hyman Minsky, (3) debt deflation or (4) financial instability hypothesis if you're interested in knowing more about the scary possibility for the world's economies, including ours.

In brief, here's what happens when debt induced recessions lead to debt deflation, as occurred in the 1930s.

Prior to the debt induced recession and during the expansion phase, the economy grows at rapid speed and asset prices appreciate rapidly (i.e., land, homes and other asset prices). This is caused largely as a result of people borrowing at extremely low interest rates in a period of both cheap and easily available credit.

As a result, asset prices increase rapidly, and new borrowing by new buyers takes place to bid up prices even more. Pretty soon price appreciation is deemed to be a "can't miss sure thing" and the cycle accelerates.

Fear Replaces Greed

This greed cycle continues until a few people begin to become fearful that prices and/or debt have gotten out of hand. Then the selling phase of the cycle begins and prices start moving down. When selling picks up and becomes widespread, panic often ensues and prices collapse. This begets more selling and even lower sale prices.

However, one price doesn't change throughout all this. The debt taken on previously stays the same.

There is, to put it politely, an imbalance between debt owed and the present value of the assets on which that debt is owed. The lender has a valid claim, but the debtor can't repay the debt owed. Thus, the lender seizing and selling the collateralized assets won't satisfy the loan obligation or retire the debt.

Then when downturn continues, the recession comes along, unemployment results and the lender and debtor are in even worse shape. But they're stuck with the principal amount of the loan.

(As an example, our last-in "underwater" borrower bought "at the top" an asset priced at $100 and now owes $100. But then a selling stampede begins, prices decline and now the last-in buyer can only sell what he bought for $70, $60, $50 or less. But he still owes $100 and can't repay the bank loan. So he's stuck and if he loses his job, he's more than stuck. But so is his lender.)

The Excessive Household Debt Problem in General

"Underwater" home mortgages in the U.S. are currently estimated to amount to $1.2 trillion of more debt owed than home values. Outstanding student loans are now roughly $1 trillion, and credit card balances are almost another $1 trillion. That $3 trillion, plus the interest thereon, is a whole lot of money unavailable for consumer spending.

Someday--somehow--someway--someone will have to repay these loans. In simple terms, even if formal default occurs, the loans will have to be repaid in some way. And whether repayment is made in stable money, cheaper currency, higher interest rates, loan forgiveness or by whatever means, those loans will be repaid with future economic output. But that future output which will be used to pay back the loans won't also be available for future consumption.

Thus, there's at best a long slog ahead for the U.S. and the rest of the world, even if we stop the debt hole digging now. Which we're not doing, of course. At least not yet.

And future consumption will be restrained as the world "deleverages." And if prices go down further from here, then the more we pay, the more we'll owe as future price declines accelerate.

That's the scary part about debt deflation. We'll be repaying in inflation adjusted dollars more than we borrowed initially while being less able to repay what we borrowed.

So debt deflation avoidance is or should be our biggest priority financially.

How We Got Here ... Europe and the U.S.

The politically "progressive" way of borrowing to spend more than we make, then promising more spending, then borrowing more, then promising more, and then growing the size of redistribution programs further to save us from ourselves and so on is exactly how we got here.

We've followed Europe right to the edge of the redistributionist and entitlement financial cliff. Now they're likely going over the edge, but we can still pull back and reverse course. Let's hope we all sober up and do just that.

To repeat, European countries have long been socialistic societies with well intentioned but ineffective "progressive" governments. The progressive movement may sound good on the surface, especially if we believe we can pass on the problems of repayment to future generations. But that pass-it-on game either has ended or is very much in the process of ending.

Both there and here, too. It's time for everybody to sober up.

Similar to Europe, the U.S. has become more "progressive" over the past several decades as underfunded entitlement Social Security, Medicare, Medicaid, student loans, education spending and now ObamaCare initiatives have become fixtures of American society.

Summing Up

First, let's all get real. In this regard, nobody wants to pay higher taxes, and in fact higher taxes anytime soon would slow consumer spending even more than its already current anemic level.

Second, public sector union leaders, progressive politicians and the "greens" continue to promote a factually failed system of big and unpaid for redistributionist entitlement government programs.

Third, no matter how much more taxpayer funded government "stimulus" money is spent on government "investments," the real economy will not be favorably impacted in any meaningful manner. In the long term, the cost-benefit trade will be a bad one in all cases.

The message is straightforward. Let the taxpayers keep and spend MOM instead of continuing down the government knows best OPM route to financial ruin.

That's because the debt owed to foreigners will only get larger, larger and larger, making the nation's external debt hole deeper, deeper and deeper.

A Few More Things

FINALLY, WE'RE ALL GOING TO RELEARN THAT THE EMPEROR HAS NO CLOTHES.

THAT THE GOVERNMENT AND THE POLITICIANS (BOTH REMOCRATS AND DEPUBLICANS) HAVE NO SOLUTIONS.

THAT THE REAL PROBLEM SOLVERS MUST BE WE THE PEOPLE.


BUT REMEMBER THIS, TOO ........ WE'LL BE FINE IF WE HEED THE WAKE UP CALLS AND THE ALARM BELLS NOW SOUNDING FROM ALL AROUND THE WORLD.

As we've said previously, Europe has a lot to teach us. Let's all pledge to be "A" students.

Thanks. Bob.