Today's Market Observation  12.24.2009  Mon  Tue  Wed  Thu  Fri  Eckert Archive

To Our (Dis)Credit

Part 2

by Richard A. Eckert, cfa | december 24, 2009

Click here to read the first installment: Part 1

So, what’s so wrong with a little credit?

Once more, as long as it is used to finance the manufacture or acquisition of capital goods, nothing. However, I also observed, later on “changes in real wages—which have trended flat to down over the period displayed in Exhibit III despite reported increases in productivity—provided no support to increases in real consumption and, most probably, exerted a drag.” This begs the question, “If personal consumption accounts for the largest portion of GDP and real wages are not providing any support to increases in personal consumption—and, in fact may be exerting a drag—is it not appropriate to infuse the economy with enough credit to augment languishing real incomes and lift personal spending to the point that positive changes in GDP are once again recorded?”

The issue with credit, even in a “normal recession”—i.e., one that merely represents the cyclical trough in the business cycle and, not the product of structural changes to the economy—is that while it can temporarily stimulate demand for consumer goods, allowing incremental purchases to be financed at low rates by even those unemployed or just marginally attached to the workforce, those purchases, just like the money used to make them, are borrowed. Assuming that individual consumers are only going to generate a certain amount of income and that those individuals can only spend what they earn in a lifetime, using credit to fund current consumption only borrows it from the future. This assumption requires the use of a couple of other supporting—and simplifying—premises. The first is that monetary stimulus does not alter the sum of money earned in a lifetime. I am confident this particular assumption holds and will stand the test of time. Call it a naïve faith in fate, but I believe that most individuals are destined to earn a fixed amount of income over their lifetimes and that very few intervening events are going to change that. The second simplifying assumption is that most individuals do not want to bequeath to their heirs a legacy of debt, even if this is, most assuredly, what we will do collectively, as a nation. 

If one can buy into those assumptions, then it is easy to conclude that credit does not increase total lifetime consumption; indeed, it can only accelerate the buying decision, pulling forward a particular purchase in time. But a dollar of borrowed money spent today = a dollar of debt service in the future. So credit merely displaces that spending in time, reducing future consumption by the amount spent on borrowed money today. And, to the extent there is an interest component to that credit—and almost all debt requires the payment of interest (it is, after all, the “rent” for living in debt)—it can crowd out future spending, replacing it with interest payments, and reduce total lifetime consumption.

If credit, when used for consumption purposes, can only alter spending temporally—and actually reduce total lifetime consumption individually and in the aggregate for American consumers—what permanent benefit can it bestow on the economy? The answer is none. In fact, because it creates the potential for negative comparisons in GDP and other measures of economic activity going forward, it forces those encouraging the use of credit—i.e., monetary policymakers, myopic elected officials and, of course, credit intermediaries—to continue providing incentives to consumers to use credit. They must push rates and underwriting standards ever lower and make borrowing easier, simpler, and faster. And, when necessary, the Fed must provide liquidity directly through quantitative easing and various purchase facilities. Fiscal authorities must weigh in, too, cutting taxes and providing credits to those buying, for instance, new homes and cars. Each round of stimuli has to contain more numerous and more powerful incentives as they must overcome—at least temporarily—the increasingly burdensome tolls that higher food and energy prices (not captured in the real wage deflator, a measure akin to core CPI), the need to save (particularly among baby boomers), and debt service exact upon a stagnant real wage base.

The bottom line is, monetary and fiscal authorities must do everything in their power to keep pulling purchases forward from further and further in the future so that positive comparisons with previous measures of economic output can be reported in the here and now. Yes, at some point they will leave the future bankrupt and bereft; households will have to spend every dollar of free cash flow—and maybe then some—on debt service, leaving nothing left over for discretionary spending (or possibly even food, gas, home repairs?). But the future is of little consequence for those wishing to get re-elected or re-appointed every 2 years (Congresspeople), 4 years (presidents and other executive officers), 5 years (Fed chairmen) and 6 years (Senators). 

All of which explains how the U.S. economy came to take on the pathology of drug dependence. Once policymakers, lawmakers and lenders started down the path of “easy credit”, it became difficult, if not impossible, to turn back. Certainly not without losing face and jeopardizing re-election or re-appointment. Or knowingly sending the economy into recession. 

Collateral damage

The benefits to encouraging the use of credit for consumption are temporary and short-lived. However, only the ever higher wall of debt service requirements—which create serious headwinds for future efforts to “jump start” the economy—left in the wake of such stimulus are permanent. Making credit widely available at low cost and on “user-friendly” terms can provide a near-term boost to economic activity, generate positive statistical comparisons, get politicians re-elected and Fed chairmen—along with cabinet level officers, regulators, and other members of the executive branch—re-appointed.  But only at the ultimate expense of beggaring the future.

Indeed, the consequences of using credit as a short-term “fix” for a sluggish economy are not just long-lasting, but also pernicious and insidious. I say insidious because the issues associated with leverage are not recognized until long after the party is over and the euphoria subsides. Most observers of the U.S. and global economy and capital markets participants would now admit, I believe, that the current crises are rooted in the leverage. Yet that leverage was two-and-a-half decades in the making. Furthermore, the response of the Obama administration, Capitol Hill and the Fed to this “crisis of leverage” has been to encourage—and, in some cases, coerce—new lending. Talk about insidious. Elected officials and Fed policymakers have been using monetary stimulus, in the form of widely-accessible, low-cost credit as a panacea of sorts—even in mild recessions such as that of 2001—for so long and so autonomically that they could contemplate no other means of addressing the most severe economic crisis since the Great Depression.

Although I deem the “legacy of debt”—stealing from and reducing future consumption—to be the most serious consequence of the use of credit for near-term consumption, there are other ramifications of nearly the same gravity. Outlined below, they cannot be considered mere collateral damage. 

1. Discourages saving and investment. Credit panders to certain of the baser instincts, like the desire for immediate gratification and the disdain of any thought about the future (“we’ll cross that bridge when we get to it!”). Why work and save for a purchase, like a home or car or vacation, when credit allows one to buy it today? The payoff to savings and investment are in the unknown future that, instinctually, many human beings prefer not to think about; the rewards of current consumption are immediate, tangible, corporeal and certain, even if ephemeral. Another consideration is that by pulling down the yield curve so that the front end nudges 0%, the Fed is, for all intents and purposes, punishing those who wish to save. 

2. Discourages work. See 1) above. Why earn the money to buy something when one can use credit? For some extremely short-sighted individuals—e.g., subprime mortgage borrowers, serial refinancers sucking out every dollar of equity in each new refinance—credit can become a seemingly compelling, if delusory answer to all of their financial needs.

3. Inflates the prices of goods and services. The Fed has essentially flooded the capital markets and financial system with low-cost liquidity and made it widely available to credits that had never theretofore enjoyed such access. Sooner or later, this liquidity has to place upward pressure on prices (for reasons discussed in this section and in 4), 5) and 6) below, that pressure has not been reflected in wages). When prices rise faster than wages, such pressures reduce purchasing power and lower standards of living.

And I believe this is exactly what has happened over the last 25 years. But, I find myself in the minority. Notwithstanding sharp increases in M2—surging as it has at a CAGR of 5.1% over the last 22 years and 6.2% over the last 10—and empirical evidence to the contrary, the official statistics on inflation and prices reported by the BLS, which have been nothing but benign, dominate all discussion. How do I reconcile published inflation and price statistics to my belief that the U.S. has, in fact, been living with high single-digit to low double-digit inflation over the last 20 years? Arriving at an explanation to this apparent paradox is outside the scope of this piece. I can only assure readers of To Our (Dis)Credit that it will be addressed in a future contribution to M.O. I am confident that when combined with empirical data, a close examination of the rationale and assumptions behind changes made to the methodology used by the BLS to calculate CPI will vindicate me on this score.

4. Inflates the market (paper) value of financial assets, many of them speculative in nature. The rising tide of liquidity created by easily-accessible, low-cost credit eventually gets soaked up in not only the cost of ordinary goods and services but financial assets. Once again, I include in this category homes purchased as an investment (even if they are owner-occupied) and equities (even if they are purchased in the primary market). Neither of these investments has any intrinsic value (unless homes are bought as shelter/rental property or a controlling stake is purchased in a publicly-traded company). And the investor is 100% dependent upon the “kindness of strangers” or a “bigger fool”, a third party willing to attach a higher value than he/she paid to the reported earnings or cash flows of the underlying property or company, for any sort of return. The markets in which such assets then trade resemble not so much an exchange as they do a “casino”.

Because the returns on the investment in such an asset do not depend on the capital goods or income produced—only the multiple other investors are willing to apply to the earnings/cash flow/book value of the asset in question—they can only be characterized as speculative in nature. Yet, ultra-low rates and the omnipresent pitch that stocks/real property can serve as an effective inflation hedge have all but compelled individual investors to invest in these speculative instruments. (As an aside, when has inflation ever exhibited anything but an inverse relationship with equity returns?) Traditional savings are penalized. 

5. Places downward pressure on real wages. By simultaneously placing upward pressure on the denominator, something akin to core CPI, and downward pressure on nominal wages, an accommodative monetary policy tends to place downward pressure on real wages (see Exhibit III). This appears to be counterintuitive on a cursory first pass. But, upon deeper reflection, one realizes that this is exactly what has happened. Reported inflation statistics have been benign and the artificially inflated values of their 401ks and homes make American consumers feel rich, thereby distracting their attention from the lack of real wage increases. I mean really, if one’s home is 2.5x-3.0x what one paid for it ten years ago, is one going to notice that those 2.5-3% “merit increases” are no longer keeping up with hikes in the cost of groceries, gasoline, toiletries, public transportation, health care, and day care? 

This is the so-called “wealth effect”. It not only reduces the motivation of individual employees to demand wage increases that are fully reflective of increases in their costs of living, but it also keeps those individuals spending, even in the absence of such wage increases. Easy access to credit only reinforces the “wealth effect”.    

6. Places downward pressure on total compensation. The “wealth effect”, which, once more, has its genesis in the “easy money” policies of the last two and a half decades, also makes it easier for employers to substitute 401ks for defined benefit plans and managed health care plans for indemnity benefits. 

7. Masks contraction in the economy. To my way of thinking, the nearly 9-fold increase in total U.S. debt (7.8% CAGR)—and a nearly 10-fold increase in household debt (8.2% CAGR)—since 1980 is prima facie evidence of a shrinking economy. In my mind, it has become patently clear that consumption has exceeded production and has been papered over with the cheap credit. Because income from credit products shows up in GDP as the gross value added from the financial services sector, it makes a positive contribution to that measure, which has allowed the BEA to report increases in nominal and real GDP that have compounded at 5.9% and 2.9%, respectively, over the same timeframe.

Exhibit VI

Exhibit VI “normalizes” GDP reported from 1980 thru Q3 2009 for what I consider the outsized contributions of the financial services sector over that timeframe. Up until 1980, the gross value added of the financial services sector contributed no more than 15% to total nominal GDP—15.2%, to be precise (see Exhibit V). By the beginning of this decade, that figure was over 20%. Exhibit VI assumes the “normal” contribution of the financial services industry to GDP in a healthy economy is 15% and eliminates anything above that from the calculation of year-over-year changes in GDP from 1980 to 2008. The “normalized” changes in nominal GDP are then juxtaposed against the reported changes. 

Before drawing any conclusions about whether or not the U.S. economy has been growing over the last 30 years, I would admonish Market Observation’s readers to recall that: 1) the gross value added calculation starts with a figure akin to final sales or revenue of the industry in question; and 2) a large portion of the revenue reported in the financial services industry consists of nothing but capitalized mortgage servicing rights and residual income—or the mark-up of lower-rated ABS/CDO tranches that banks and broker-dealers couldn’t sell and had to retain—mark-to-model calculations, interest accruing on loans that were never repaid (and never reserved for, properly marked-to-market or impaired). How real were those numbers and the assumptions that went into them? Today’s losses are actually nothing but a correction, a revision, a true-up of the bogus assumptions and calculations used to report those record revenues and profits earlier this decade. I don’t believe I’ve seen any proposal by the BEA to adjust GDP numbers for this “restatement” of these previously reported revenue items. 

8. Swells the ranks of credit and other financial intermediaries. See “Where has our capital stock gone?” in Part 1 of this article, published in the 12/15/2009 edition of Market Observation. 

9. Depletes a nation’s capital stock. When debt-fueled consumption exceeds production for an extended period of time, a nation’s capital stock is depleted. When a consumer purchases and consumes a consumption good, that consumer also consumes capital goods, which do not have an indefinite useful life span and, therefore can wear down or become obsolescent. Even educations must be brought up-to-date as new research and new discoveries add to the store of human knowledge. Capital goods must be replenished, refurbished, replaced, repaired, maintained, upgraded, enhanced, and improved if they are to continue producing other capital and consumption goods, thereby generating the incomes that serve as the basis for future consumption and saving. And the capital stock must be expanded if income and standards of living are to continue to rise.

But, over time, outsized consumption can result in a production imbalance as production becomes tilted toward consumption goods and away from capital goods. As consumption goods are increasingly favored over capital goods, new production fails to keep pace even with the wear and tear of time on the existing capital stock and improvements in the means of production. So, not only is the existing stock not enlarged, but it is not even replenished. Instead, it is allowed to fall into disuse, disrepair and obsolescence.

Reinforcing this trend toward depletion are debt service requirements incurred when financing current consumption with credit. These requirements displace both future consumption and saving. The misfortunate byproducts of such borrowing and spending discussed in 1) – 5) of this section can also accelerate depletion of an economy’s capital stock as they all tend to make fewer and fewer resources available for the replenishment of and additions to those assets over time.

Epilogue

In sum, we have argued that credit does have a legitimate and useful role in an economy. But, if and only if it is used to finance the acquisition of capital goods, wealth-generating assets capable of producing other capital and consumption goods, AND the incremental returns from the deployment of that capital exceed its cost. Credit has, in fact, reprised this role time and time again throughout the course of human history, helping build ancient empires and modern nations, including our own.

On the other hand, when credit is used to finance current consumption, it can be…well, consumptive. I can think of few scenarios in which the use of borrowed money to immediately satisfy an individual’s—or a nation’s—needs, wants, and desires can come to any good. The biggest issue with such use of credit, in my estimation, is that it merely moves a purchase up in time. Both the money used in the purchase and the purchase itself are borrowed—the latter being borrowed from the future. Repayment of the debt will displace spending in the future and, to the extent there is an interest component to that debt, it will crowd out future spending. Income that would be spent or saved will have already been committed to interest payments.

When a government and its central bank use credit—or encourage (exhort?) its use via monetary policy, tax policy, social policy (e.g., boosting the homeownership rate)—in an effort to “kick start” a stalled economy, they start down a “slippery slope” from which they may eventually despair of ever clawing their way back to the top. While such policies may temporarily stimulate demand and spending and impart new momentum to reported increases in GDP and employment, they do so at the expense of future spending, saving, investment and output. Therefore, they have the potential to create negative comparisons in officially reported statistics going forward. To keep reporting meaningful improvements in these data series, then, elected officials and Fed policymakers must continue furnishing stimulus—more or less on an ongoing basis—and one can bet that it is not in the form of investment in infrastructure or sponsorship of new technologies. No, since the end of the Cold War and wind-down of various space programs, stimulus has taken the form of increasingly easier access to increasingly cheaper credit on increasingly looser terms.

The bottom line is that, to continue reporting positive comparisons with previous measures of economic performance, government and Fed officials must do everything in their power to continue pulling forward purchases from further and further in the future. The considerable (of historic proportions?) stimuli now being applied to America’s housing markets offer a textbook example of this phenomenon. Notwithstanding the substantial incentives provided new and existing homeowners—tax credits and subsidized (via Fed purchases of agency debt and MBS) mortgage rates—the actual number of existing homes sold through the first 10 months of 2009 exceeds that of the first 10 months of 2008 by only 42,000³ (using YTD figures and comparing them to the same period in the previous year takes seasonality out of the equation), a gain of just 1%. On the same basis (actual number of homes YTD), new home sales fell nearly 25%⁴ from the comparable period a year ago. These declined even more sharply in September before it became clear the federal government would extend the tax credit and expand eligibility in November. Given that prospective homebuyers—those that would have bought homes between early 2009 and early 2011 will have been exposed to these incentives for nearly 1.25 years by the time the Fed is scheduled to stop its MBS purchases in March and the Federal government end its tax credit in April, is there any doubt in anyone’s mind these incentives (direct and indirect) will be extended and expanded upon once again, in a desperate effort to pull sales forward from 2011 - 2013? 

Although continuing to borrow from the future only hastens the arrival of a day of reckoning, when the level of outstanding debt forces American households—and perhaps American businesses, financial institutions and government—to not only spend every dollar of discretionary income on debt service, but even to weigh tradeoffs between those debt service requirements (or among them) and the “necessities of life”, it appears to be of little concern to government officials and policymakers, the time horizons of whom extend only to the next election or (re)appointment confirmation hearings.

Other toxic side effects I perceive in the use of debt for consumption purposes are that it: 1) discourages saving and investment; 2) discourages work; 3) inflates the price of goods and services; 4) inflates the market (paper value) of financial assets, many of them speculative in nature; 5) places downward pressure on real wages; 6) places downward pressure on total compensation; 7) masks contraction in the economy; 8) swells the ranks of credit and other financial intermediaries; and 9) depletes the nation’s capital stock. 

Most disturbing to me about the surfeit of credit and the deficit of genuine saving/investment in the U.S. is that we will, collectively, bequeath a legacy of debt to our heirs while simultaneously depriving them of much of the wherewithal with which to service it. At the same time we continue to shovel more loans on to a growing mountain of borrowings, we are burrowing through our capital stock. I find myself increasingly uneasy about the decisions we have, essentially, already made for our posterity, limiting the opportunities and alternatives available to them because of the need to gratify our wishes and desires immediately and to fulfill the unprovisioned promises we made to ourselves. They will almost certainly have to pay higher taxes and higher prices (the Fed can’t keep printing money and the Treasury can’t keep borrowing it without inflation rearing its ugly head) while coping with lower incomes (at the very least on a constant dollar basis) and lower standards of living.

Yes, in almost every respect, I feel we have truly discredited ourselves.

Rich Eckert

Copyright © 2009 All rights reserved.

contact information

Richard A. Eckert, CFA | (415) 674-4996 | San Francisco, CA
Email | Observation Archive | Other FS Editorials