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Monday, February 28, 2011

Debt Crisis Alive and Well

Expected Returns

Debt Crisis Alive and Well

February 28, 2011 11:26 am

I continue to be absolutely convinced we are going to see some crazy events worldwide. As usual, this crisis will expose everyone’s inherent biases. It is interesting that there is civil unrest in Wisconsin arising fundamentally from their poor fiscal position and people are still not getting the point. Those who said such events were impossible in the U.S. are now putting their heads in the sand and acting like nothing is happening. Biases are a funny thing. This is why most people have no business being investors because the markets punish you indiscriminately for biases.

The facts are starting to come out in the light of day. This is a structural debt issue. The city of Providence has preemptively sent termination notices to all teachers until they better understand their fiscal position. Federal employees are already seeing pay freezes. State employees in Wisconsin are protesting because their God-given right to perpetual raises and generous pensions is in danger. New Jersey public employees made a huge fuss over paying (gasp) 1.5% of their salaries towards their pensions. Real estate prices shot right back down in 2010 after a temporary bounce in 2009 that had everyone calling for the bottom. How many people are seeing this crisis through clear eyes? Not many.

Housing Pain Continues

The housing market is so crucial to understand in the current debt crisis. Most private debt is in the form of mortgages, whose issuance exploded in the past couple of generations. What I find fascinating is that people essentially borrowed forward their whole life’s earnings and then celebrated the fact that they were perpetual debt slaves. The problem with being heavily leveraged is that you can’t handle a situation where asset values are not rising. In housing, falling home prices means having negative equity. Once this occurs, there is pretty much no incentive for homeowners to continue making payments.

The real estate crisis in the U.S. is still alive and well as 27% of homeowners are underwater. In Las Vegas it is 87%. Washington D.C. was one of only 2 cities in the 20 city Case-Shiller index that showed a price increase in December. This is not a good sign: the government is obviously not contracting as much as it should.

False Recovery

As I often point out, the mainstream financial media has a very flawed way of viewing the world. There is this tendency to celebrate rises in consumer spending without adequately accounting for inflation. Furthermore, there is no attempt to think at a higher level and distinguish between different types of spending. In the beginning stages of a loss of confidence in the currency, the velocity of money will increase, which will create the illusion of an economic recovery. The media is so confused by the fact that gold is trading near its all-time highs when they really shouldn’t be. Not all increases in consumer spending evidence an economic recovery; sometimes it is the exact opposite.

Most people believe a loss of confidence will impose deflationary pressures on the economy as people hoard their wealth and scale back on spending. But this is true only when people have confidence in the fundamental long-term value of the currency. The movements in assets are sending a very obvious message that people are starting to hedge against inflation. While most people underestimate the extent of the debt crsis, most Americans generally understand we have a debt problem. Our politicians may push back fiscal reform indefinitely, but the markets will always warn of problems before the government recognizes them.

The full ramifications of this debt crisis have not been felt. States are deferring pension funding and praying that the problem goes away. Depressed housing is providing no benefit to state coffers. Has anyone in government modeled a scenario where growth assumptions are not out of this world? What if real estate is depressed for 10 years, then what? What if higher rates of taxation send young American talent abroad to more economically friendly jurisdictions? What if higher levels of corporate taxation make American corporations uncompetitive globally? These are risks that our leaders never address. The day of reckoning is coming and our leaders need to wake up before its too late.

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