The Great Debt Crisis Begins

There is growing talk on Wall Street about the possibility of a recession. Since the beginning of the year three Wall Street firms (Merrill Lynch, Morgan Stanley and Goldman Sachs) have all stated they believe we are either in a recession already or are very close to a recession. In other words, it's no longer a matter of if a recession happens but when it will happen and how long it will last. In response to these developments, various presidential candidates have proposed various solutions. However, none of these will work, largely because this is not a typical slowdown caused solely by slowing consumer spending or business investment. Instead, it is a slowdown caused by inflated asset prices and a nation gorging on debt. As a result, it will probably take a lot longer to come out from under this problem.

A recent Los Angeles Times Article stated the basic problem thusly:

What makes bubbles so dangerous is that their consequences, when they burst, are wider, often more damaging, and certainly more unpredictable than those of ordinary downturns.
"We are more prone to bubbles than we used to be," said John H. Makin, a former senior Treasury official with several Republican administrations and now a scholar with the conservative American Enterprise Institute in Washington.
"The old-fashioned recession, where the consumer ran out of gas or there was an economic policy mistake, doesn't seem to occur much anymore," said Alice M. Rivlin, a former vice chair of the Federal Reserve and Clinton administration budget director. "As we've seen from recent events, bubbles seem to be playing a bigger role."
The basic problem faced by the US economy right now is excessive debt caused by recklessly low interest rates from the Federal Reserve. Here is a chart from the St. Louis Federal Reserve of the effective Federal Funds rate since 2000.

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Notice the US had record low interest rates for a period of nearly three years. This led to a debt binge of mammoth proportions. Here is a chart of total household debt outstanding from the St. Louis Fed:

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Notice the amount outstanding increased from around $8 billion to a little shy of $14 billion within a period of seven years. That's approximately a 75% increase in total household debt outstanding.

All of this debt has to go somewhere; it doesn't just exist in a vacuum. To accommodate this increase in total debt, we've seen a huge increase in structured financial products. In and of themselves, these are not bad devices; they have been around for approximately 25 - 30 years. However, they were used very recklessly over the last 7 years, and especially over the last 3-4 years. The short version of what happened is simple: lending standards deteriorated to the point where literally anyone could get a loan. These loans were then sold to investment firms, who pooled them together and carved them into various bonds, which were in turn sold to large institutional investors like pension funds, insurance companies and hedge funds. The idea underlying structured financial products was that risk was spread out to the point where the bonds were more or less insulated from default problems. However, when defaults skyrocketed higher than anticipated, we discovered that the risk wasn't contained nearly to the degree we thought. Instead, everybody started getting hurt.

Right now the Federal Reserve is treating this situation as a "liquidity crisis", meaning they are literally throwing money at the problem. They are hoping that by flooding the markets with money the money will get spent in the form of loans and credit. However, the market has ample liquidity. The problem is we are in the middle of a debt crisis:
During a liquidity crisis, the issue is one of supplying money to those who, for whatever reason, have suddenly shortened their time preferences. Mr. Practical, writing on Minyanville's Buzz & Banter, characterized it this way:
Suppose there is a rumor that a large bank has made a bad loan. Because banks lend out more money than they have on deposit - this is called a fractional reserve banking system - if everyone goes to the bank and demands their money at the same time, a liquidity crisis can occur because the bank does not have enough cash on hand to satisfy the demand from its depositors. The Federal Reserve will then step in and provide liquidity, allowing the depositor demands to be satisfied. If the rumor of the bad loan proves to be false, then the issue is one of liquidity. Time preferences soon return to a more normalized state, depositors return, everyone feels better. But, if the rumor turns out to be true, it doesn't matter how much liquidity the Fed provides, the bank will go bankrupt.
Similarly, the issue today is not one of temporary liquidity, time preferences being shortened out of a temporary risk aversion. The issue is too much debt supported by too little value and income generation. As a result, time preferences are retreating, risk aversion is growing, and access to credit is diminishing.
Here's the basic problem. All of that debt in the household debt chart assumes a certain asset value. Here's a simple example. Suppose a bank makes a $100,000 loan for a home valued at $100,000. If the home appreciates in value, everything is fine. However, let's assume the home's value decreases to $90,000. Now the loan is inherently less valuable because the underlying asset has decreased in value. If this situation persists or worsens, the lender will have to devalue the loan to some degree to reflect the lower asset value. Now, take this situation and apply it to the entire US economy and you get an idea for what exactly is going on right now.

To make matters worse are two inter-related issues. First, the US economy is very much based on credit creation. As a result, the financial sector sits at the center of the US economy. Here is an overly-simplistic (and poorly drawn) demonstration.

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Basically, the financial sector acts as an intermediary between consumers and business, pooling deposits and investments and funneling those to business in the form of credit. Also note the financial sector provides credit to consumers in the form of credit card, consumer and mortgage loans. In other words, when the financial sector takes a bit hit, it impacts the entire economy.

The second problem is the accounting nature of the financial system. It is essentially based on a "fractional reserve" system. All this means is financial firms have to have a particualr asset to loan ratio. For example (and hypothetically) this means financial firms must have say 10% of their total outstanding loans in assets. Now, suppose the value of the assets on their books starts to decrease. The financial firms ability to make loans is diminished. This is why all of the writedowns announced by literally every financial firm out there is so important. It means their ability to extend credit is diminished. As a result, the ability to borrow in the economy at large is diminished, which is devastating to an economy like the US' which is heavily dependent on credit creation to function.

In summation, the US economy is at the beginning of a huge problem. The economy depends on credit creation. However, the financial sector is hampered in that ability right now because the value of assets backing outstanding loans is decreasing. This lowers the value of outstanding loans, which in turn limits the financial sectors' ability to extend credit. So long as the US economy is experiencing deflation this process will continue.

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