Friday, March 13, 2009

Over Leveraged American Consumer Needs the Big Inflation

Yesterday's big headline was about the 18 percent drop in Household net worth in 2008. Amazingly, household net worth dropped by $11 trillion. This effect was caused by the double whammy--drops in both the price of homes and the stock market.

I found this interesting chart over at Calculated Risk.

The chart shows Household Net Worth as a percent of GDP. If you look closely you will notice three things.
  • The first big spike up in household net worth occurred during the Internet stock bubble (1996-2000).
  • The second big spike up in household net worth occurred when both stocks and housing prices were rising fast (late 2002- late 2007).
  • And third, the trend since 1952 is for household net worth to range between 300-350 percent of GDP.
What we are seeing here is the bubble bursting and overall net worth returning to a more normalized state. So while consumers might be feeling "poor" at the moment--in historical terms--this is not true.
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Today, I am reading about Household Debt as a Percent of GDP in the Wall Street. This chart is more worrisome.

When you marry the information on these two charts you can come to a simple conclusion--much of the increase in household net worth was fueled by the taking on of debt by consumers. We have been reading about the over leveraging of companies like Bear Stearns, Lehman Brothers, and AIG; but, not so much about the over leveraging of the American consumer. What is true is that consumers experienced a short term burst in net worth that was fueled by debt. But, now these debts need to be repaid and the consumer will no longer be able to borrow from "peter" to pay "paul". In other words, consumers won't be able to refinance their home and take the proceeds and spend them on houses and cars. They will now have to pay down the debt the old fashioned way.

It should be clear, after looking at these two charts that Household Net Worth has already corrected to a more normalized level--this is a good thing. It should be clear that consumers have a long way to go before they reach the point of more normal leverage on their personnel balance sheets. Many consumers are leveraged beyond their means. Not a good thing.

Retail sales account for two thirds of GDP. It should be clear that consumers are going to need to reduce debt before they can get back to buying houses, cars, and stocks. This means that it is going to be a long time before we see a return to robust gains in the GDP. Not a good thing.

Superimpose on top of these charts: rising unemployment and the sharp rise in government spending. As financial institutions deleverage and consumers face a long period of deleveraging--the government is leveraging up its balance sheet. Another credit bubble waiting to burst? Not a good thing, although necessary.

My guess is that a year or two down the road we will see the stresses from this new bubble--government spending. This will occur as the government finds difficultly financing its debt in the world markets, consumers start to default on credit cards in greater numbers, and the reality that there is no short term fix to a problem that has been building since the early 1980s.

Inflation is a likely to rear its ugly head soon, see (Reserve Balances held by the Federal Reserve Bank are going off the chart). Actually a good thing if you are in debt. You pay back debt with cheaper dollars. This reminded me that I started paying on my student loans in 1978. Loans I took out while I was in college and started paying after graduate school. When I made my last payment in 1988, I was paying with dollars that were worth about one third of what they were worth when I borrowed them (value of a dollar 1988 versus 1970). You might think to yourself right here--big inflation is the way out of this trap. Seems right to me.

My final advice here is straightforward--don't get carried away by the madness of the crowd. You will have plenty of time to buy great stocks at low prices.

Special thanks to Calculated Risk--Fed: Household Net Worth Cliff Dives in Q4, and the Wall Street Journal--Is Debt Ready for a Dive? Both articles are worth reading and considering.

Bob DeMarco is a citizen journalist and twenty year Wall Street veteran. Bob has written more than 500 articles with more than 11,000 links to his work on the Internet. Content from All American Investor has been syndicated on Reuters, the Wall Street Journal, Fox News, Pluck, Blog Critics, and a growing list of newspaper websites. Bob is actively seeking syndication and writing assignments.

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