U.S. and UK on brink of debt disaster

January 20, 2009

John Kemp Great Debate-- John Kemp is a Reuters columnist. The opinions expressed are his own. –

The United States and the United Kingdom stand on the brink of the largest debt crisis in history.

While both governments experiment with quantitative easing, bad banks to absorb non-performing loans, and state guarantees to restart bank lending, the only real way out is some combination of widespread corporate default, debt write-downs and inflation to reduce the burden of debt to more manageable levels. Everything else is window-dressing.

To understand the scale of the problem, and why it leaves so few options for policymakers, take a look at Chart 1 (https://customers.reuters.com/d/graphics/USDEBT1.pdf), which shows the growth in the real economy (measured by nominal GDP) and the financial sector (measured by total credit market instruments outstanding) since 1952.

In 1952, the United States was emerging from the Second World War and the conflict in Korea with a strong economy, and fairly low debt, split between a relatively large government debt (amounting to 68 percent of GDP) and a relatively small private sector one (just 60 percent of GDP).

Over the next 23 years, the volume of debt increased, but the rise was broadly in line with growth in the rest of the economy, so the overall ratio of total debts to GDP changed little, from 128 percent in 1952 to 155 percent in 1975.

The only real change was in the composition. Private debts increased (7.8 times) more rapidly than public ones (1.5 times). As a result, there was a marked shift in the debt stock from public debt (just 37 percent of GDP in 1975) towards private sector obligations (117 percent). But this was not unusual. It should be seen as a return to more normal patterns of debt issuance after the wartime period in which the government commandeered resources for the war effort and rationed borrowing by the private sector.

From the 1970s onward, however, the economy has undergone two profound structural shifts. First, the economy as a whole has become much more indebted. Output rose eight times between 1975 and 2007. But the total volume of debt rose a staggering 20 times, more than twice as fast. The total debt-to-GDP ratio surged from 155 percent to 355 percent.

Second, almost all this extra debt has come from the private sector. Take a look at Chart 2 (https://customers.reuters.com/d/graphics/USDEBT2.pdf). Despite acres of newsprint devoted to the federal budget deficit over the last thirty years, public debt at all levels has risen only 11.5 times since 1975. This is slightly faster than the eight-fold increase in nominal GDP over the same period, but government debt has still only risen from 37 percent of GDP to 52 percent.

Instead, the real debt explosion has come from the private sector. Private debt outstanding has risen an enormous 22 times, three times faster than the economy as a whole, and fast enough to take the ratio of private debt to GDP from 117 percent to 303 percent in a little over thirty years.

For the most part, policymakers have been comfortable with rising private debt levels. Officials have cited a wide range of reasons why the economy can safely operate with much higher levels of debt than before, including improvements in macroeconomic management that have muted the business cycle and led to lower inflation and interest rates. But there is a suspicion that tolerance for private rather than public sector debt simply reflected an ideological preference.

THE DEBT MOUNTAIN

The data in Table 1 (https://customers.reuters.com/d/graphics/USDEBT3.pdf) makes clear the rise in private sector debt had become unsustainable. In the 1960s and 1970s, total debt was rising at roughly the same rate as nominal GDP. By 2000-2007, total debt was rising almost twice as fast as output, with the rapid issuance all coming from the private sector, as well as state and local governments.

This created a dangerous interdependence between GDP growth (which could only be sustained by massive borrowing and rapid increases in the volume of debt) and the debt stock (which could only be serviced if the economy continued its swift and uninterrupted expansion).

The resulting debt was only sustainable so long as economic conditions remained extremely favorable. The sheer volume of private-sector obligations the economy was carrying implied an increasing vulnerability to any shock that changed the terms on which financing was available, or altered the underlying GDP cash flows.

The proximate trigger of the debt crisis was the deterioration in lending standards and rise in default rates on subprime mortgage loans. But the widening divergence revealed in the charts suggests a crisis had become inevitable sooner or later. If not subprime lending, there would have been some other trigger.

WRONGHEADED POLICIES

The charts strongly suggest the necessary condition for resolving the debt crisis is a reduction in the outstanding volume of debt, an increase in nominal GDP, or some combination of the two, to reduce the debt-to-GDP ratio to a more sustainable level.

From this perspective, it is clear many of the existing policies being pursued in the United States and the United Kingdom will not resolve the crisis because they do not lower the debt ratio.

In particular, having governments buy distressed assets from the banks, or provide loan guarantees, is not an effective solution. It does not reduce the volume of debt, or force recognition of losses. It merely re-denominates private sector obligations to be met by households and firms as public ones to be met by the taxpayer.

This type of debt swap would make sense if the problem was liquidity rather than solvency. But in current circumstances, taxpayers are being asked to shoulder some or all of the cost of defaults, rather than provide a temporarily liquidity bridge.

In some ways, government is better placed to absorb losses than individual banks and investors, because it can spread them across a larger base of taxpayers. But in the current crisis, the volume of debts that potentially need to be refinanced is so large it will stretch even the tax and debt-raising resources of the state, and risks crowding out other spending.

Trying to cut debt by reducing consumption and investment, lowering wages, boosting saving and paying down debt out of current income is unlikely to be effective either. The resulting retrenchment would lead to sharp falls in both real output and the price level, depressing nominal GDP. Government retrenchment simply intensified the depression during the early 1930s. Private sector retrenchment and wage cuts will do the same in the 2000s.

BANKRUPTCY OR INFLATION

The solution must be some combination of policies to reduce the level of debt or raise nominal GDP. The simplest way to reduce debt is through bankruptcy, in which some or all of debts are deemed unrecoverable and are simply extinguished, ceasing to exist.

Bankruptcy would ensure the cost of resolving the debt crisis falls where it belongs. Investor portfolios and pension funds would take a severe but one-time hit. Healthy businesses would survive, minus the encumbrance of debt.

But widespread bankruptcies are probably socially and politically unacceptable. The alternative is some mechanism for refinancing debt on terms which are more favorable to borrowers (replacing short term debt at higher rates with longer-dated paper at lower ones).

The final option is to raise nominal GDP so it becomes easier to finance debt payments from augmented cashflow. But counter-cyclical policies to sustain GDP will not be enough. Governments in both the United States and the United Kingdom need to raise nominal GDP and debt-service capacity, not simply sustain it.

There is not much government can do to accelerate the real rate of growth. The remaining option is to tolerate, even encourage, a faster rate of inflation to improve debt-service capacity. Even more than debt nationalisation, inflation is the ultimate way to spread the costs of debt workout across the
widest possible section of the population.

The need to work down real debt and boost cash flow provides the motive, while the massive liquidity injections into the financial system provide the means. The stage is set for a long period of slow growth as debts are worked down and a rise in inflation in the medium term.

For previous columns by John Kemp, click here.

87 comments

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Astonishing analysis, to the very heart of the mess. It would be a real good thing if many of those decision takers learn about it. I really don’t know how there is still doubt of what did we wrong,

It is clear what the problem was: much more than a few bad mortgages. In the last two decades or maybe more the world grew lending without fundamentals and rationale. Every business made it so (the financial way). Of course when there is water in the sea you don’t know who is swimming without swimsuit, but you realize that when the wave pass.

Lending is an art, in which risk management is a core competence and tight credit management a fundamental. Everyone with a minimal credit background knows that there is no interest rate that could compensate high risk of default. But many didn’t take this and the output has yet to be seen…

Posted by Adrian | Report as abusive

Inflation is really the only way out of this mess. For example if my 30 year mortgage debt requires me to pay $2000 a month and I make $4000 a month- then that is tough. But if inflation goes wild and I start making $6000 a month because everything else goes up 50% –my business is making more because the product it is selling is selling for 50% more etc. than in a way I’m still making the same amount. BUT…my mortgage is still just $2000 a month, which is now managable.

The biggest problem with inflation is the people on fixed incomes. They better have some assets that will appreciate like a house etc.

Plus one of the real cool things about big time inflation is that I may actually get to live in a million dollar house. I’ve always wanted to live in a million dollar house so bring on inflation.

Posted by Bill | Report as abusive

If I were a bank I would certainly stop lending money. I would lose on the buying power of my assets and on the decline in market value from higher future rates. The present risk would be extraordinary. So if you like to see the U.S. economy crippled, I would print money like a drunken sailor and inflate to the moon. Financially engineering inflation demonstrates a lack of causal understanding indicative of the exiting Bush administration.

Posted by Don | Report as abusive

with inftation alone may be it is a solution. But what instead of inflation you have hyperinflation, with output or production, tending to zero, and prices to infinity?????”’

Posted by DOOMSDAY CLOCK | Report as abusive

Great article! Arguing for inflation is heresy but really the best antidote. A period of managed inflation would reduce the debt wagon and put it back on track. The question is how to increase inflation while avoiding that it spins out of control.

So if everything you paid for this month increased by 100 percent, and the national debt rises dramatically, you are better off precisely because of what? Too many folks are tinking around with text books rather than dealing with tangibles. That is part of the hopelessness of all of this. Those that got us into this mess who can think ahead even a few steps want to (get paid to) get us out.

Posted by Don | Report as abusive

Impressive article. They have to inflate and they know it. That is why all currencies are doomed. First we will get deflation, maybe for a year but after that all hell comes.

I guess by having high inflation the governments are forcing people to spend their savings otherwise all that money will be worth nothing! This is what we are continually told to do by them. Those on fixed incomes are really in trouble unless they protect themsleves. We really have got ourselves up a creek without a paddle.

Posted by D Rumsfeld | Report as abusive

Great article which penetrates to the heart. Pity about the inflation solution
John Kemp does not identify the level of inflation necessary to solve the problem. Low levels of inflation (up to 5%/annum) have seen us get into this mess. They are already factored in. So, we must be talking about 10%+ to make an impact.
That, effectively, is confiscating any savings locked in at low interest rates and reneging in relation to foreign creditors.
Too bad? No, the solution could be worse than the problem because:
(i) High inflation (especially if unexpected) discourages savings – and lack of saving is the cause of the problem in the first place.
(ii) Upsetting foreign creditors will lead to their withdrawal from the dollar, adding fuel to the crisis and pushing high inflation toward hyper-inflation.

I have lived through inflation and hyperinflation, several times. It is absolutely devastating for the economy and for consumption. The only reason that we haven’t crashed into an abyss at this point is deflationary processes. Even a minimal inflation now will kill the mass market. When an economy experience inflation, the real income lags real cost, i.e. the person above with the mortgage, hoping for inflation, should know that either his bank will change the loan contract in order to adjust its income with higher pace of inflation, or most likely – new mortgage clients will completely disappear, since banks will offer very high and adjustable only interest rates. Stimulus for loaners will be zero, and people will need to effectively buy cash property. In such situation property price always lowers a lot. Thus, that would be the very end of the broad house market. Ten years later will come social unrest, i.e. revolutions :). Believe me, you don’t really want that.

So, for me, the dilemma is this: do we want to rebuild the economy based on mass consumption, or not. Choosing not will bring us back in the Middle Ages, just with the difference of having modern technolies.

I support the author analysis, finally something publicly states that the mortgage bubble was a trigger, not the cause. The cause is the immerse shift of wealth from broad public to small percentage of the society, thus mass consumption for a while was feed by debt, and finally collapsed. We need very quick and aggresive shift of wealth, without the inflation though. The very similar thing happened in the World War Two, when higher income tax rate was 80-90%. That effectively was a shift of wealth from the higher tax margins through state consumption of military products to lower tax payers in 5-6 years. That put end of the Great Depression, some 25 years after it started. Now, the only differense is that most of manufacture is outsourced to Asia, and Asia will liekly bear the worst of current Depression – it is just a matter of time to start there.

Probably the very same effect of the war expenses would have huge infrastructure expenses, broad health care system, broad educational system and STEEPER taxes. Now, I don’t see how exactly wealthier people /these include retirement fund holders, small investor, etc./ will agree to have their wealth axed 75-80%. If that doesn’t happen, from my life experience, two ways are possible – cataclism, or hyperinflation and cataclism after that.

Don’t take me wrong. I am optimistic, and I am sure as a young man I can survive in any condition, and use these condition to gain wealth. Still, my principle is democracy and broad welfare, and our conservative political wings should understand that they’ve gone way too far.

Posted by maingain | Report as abusive

I’m not sure why the author focuses uniquely on the UK and US, much of the rest of the world is also in the same shape. Japan still suffers under the weight of the public debt they have from the 90s.

I also don’t understand his rationale for saying that inflation is politically acceptable but bankruptcy is not. I do agree with his analysis however and some day of reckoning in one way or another is inevitable.

Posted by Keith | Report as abusive

Well I think the author touched on the solution. Bankruptcies.
Having been through a fortune 500 Chapter 11 re-org I can say that they make sense economically but are stressful on workers. Most people don’t know what it means and think it means job losses. In reality Chapter 11 can mean big retention bonuses and job security.
Any other solution just repackages the debt under another name or owner. The debt does not go away. Chapter 11 effectively cancels the debt and a healthier company emerges with a new management team. Typically most staff keep their jobs and only management changes.
Bankruptcies are a vital part of the economy. Why on earth failing companies are “bailed out” by tax payers is beyond me. It is a corporate problem (except fanny and freddy) so it needs stay a corporate problem.
History will judge the bailouts to just delay and exacerbate the problem. At some point the boil has to be drained of puss. The longer you leave it the worse it gets.

Posted by EconoLube | Report as abusive

Lack of savings alone is not what created the problem in the first place. As the article states, its a combination of lack of savings and a huge increase in debt. If people didnt save, but also didnt increase their debt, the difference in GDP to debt would be negligible, and the GDP would arguably go up. But if people continue to increase debt, the GDP will stagnate or drop, as the debt spins continually out of control.

Posted by Jay W | Report as abusive

We’re pretty much doomed to repeat history until someone steps in and takes action on the root of the cause. This guy nailed it: runaway debt. It is too easy for a debtor to escape debt in this country. How many people do you think would abuse credit and over-extend themselves if their irresponsibility was actually a crime? Indeed, what’s the difference between the guy who walks away from $50,000 in unsecured credit card debt and the guy that robs a bank for $50,000? Answer, one goes to prison, and the other sits in “debt timeout” for 7 years until his scarlet letter disappears from his credit history. Then, it’s off to the races again.

There is a word for it: thievery. And those knuckleheads who pile our mailboxes with offers of easy credit are just as bad. They’re encouraging the problem.

It’s disgusting, and for all this talk of “hope” and “change”, I won’t believe a word until there are some real consequences for being a thief. And, “house arrest” for some punk like Bernard Madoff is not a real consequence.

Posted by Stephen | Report as abusive

Nice article!

Lobbying for inflation is definately short sighted though…you make a VERY incorrect assumption that your salary would go up in a time of inflation. I think if you look at salary/inflation history you will find that salaries do not go up in a synchronized curve with inflation, but stay rather stagnant (especially in times of financial distress, when employers make a point to pay people even LESS). This is one of the reasons debt has skyrocketed so out of control, people HAVE to borrow enormous amounts to keep their standard of living equivalent, while salaries don’t increase and money value is effectively depressed.

I am unemployed and the advice I am getting from people is ‘be ready to take a pay cut if you want a job’…problem is of course that I CAN’T take a pay cut and still pay all my debts. Even though I have perfect credit, I will end up defaulting on all or part (and lets be real, if I am forced to default, I will default on EVERYTHING I can because the damage will be the same as defaulting on part) if I am forced to take the cut that was suggested (40% pay cut).

If inflation does happen, not only will you be stuck at your current salary, but you will be unable to meet your basic needs, such as food costs. I have to admit that I was PRETTY excited when I first thought of inflating my debts away but when you look at the reality of the situation, you realize it is pretty grim and scary picture. Why do you think the government/fed is trying to walk that line of inflation/hyperinflation so delicately? Falling too far either direction, would be a disaster of historic proportions.

It would also behoove us to realize that what are government is advocating is that we ‘get back to borrowing’…insisting that there is a liquidity crisis and that it could be resolved if we would just borrow more…which, at this point in my life I find rather unpalatable.

Also, it is not banks that have stopped lending…America has been propped up by Chinese lending for so long that when they stopped lending, banks had no reserve to continue business as usual. Look at bank reserves in 2008, they dropped to NOTHING when the money stopped and the banking industry’s ‘duck, duck, goose game stopped’…

Poor American taxpayer…not only are they COMPLETELY strapped with the debt that they already owe…but the government bought all the bad loans and expects us to effectively ‘double pay’ our way out of this mess…I have kind of a bad feeling about exactly how THAT is going to work.

Posted by Kiki | Report as abusive

As several commenters have said, inflation may create more problems than it solves. Defaults are the answer. Current FDIC plans for the creation of a national bank, alias “aggregation bank”, to oversee bank credit defaults is the appropriate means. Banks are now being asked to reveal their loans and credit structures in preparation for this now.

Posted by RPW | Report as abusive

While the diagnosis is accurate the cure is only as affective in as much as getting the patient to walk but a few steps before he drops dead.
How do you let a little inflation out of the bag with so much debt already in the air. Within this environment are economic prospects lead by expectations and both are divisible by fear. With such a debt burden inflation expectations will grow into unbridled fear leading to a debt collapse.
Who in this audience believes government authorities can manage inflation expectations? This problem has grown beyond Paul Volkers methodology of reigning in inflation.
The world MUST turn 30 years of greed into rational action. Investors (debt and stock) must accept a historical low level of returns for some time to come in order to restore liquidity to the worlds economic system.

Posted by csodak | Report as abusive

Great article! I’ve been praying that inflation would reduce the value of my 80000 dollar student loan debt for quite some time.

Posted by Josef Hoffman | Report as abusive

@ bill.

You are deceived if you think high inflation will work to your benefit. Any inflation we get now, will be very destructive. We went through this process in the 70′s and devalaution, is a painful process.

Stagflation is coming where there will be a glut of unemployed, leading to deflation of flat wages, because of oversupply. And Inflation of core goods and commodities, because of the further debasement of the currency. In addition what drives this economy, is tvs,football games, video games, movies, luxury goods, hannah montana all things that are not necessary for survival, as such business will continue to fail as the economy adjusts to the new realities.

If you think your salary will go up. Wrong, look at Argentina, where they had a decent economy that was crushed by debt, forced a devaluation of the currency and has lead to high prices of all goods, even food (they are among top 10 food producers in the world ). It has sent half the population into poverty with high rates of starvation. We are talking about a country with the largest middle class in South America wiped out over a period of months.

The bottom line, is there is no way out of this without more pain. I disagree with the writer who thinks debt forgiveness is an option. This problem isnt just too much debt, its a problem with having the wrong system. We have built an economy over that last 20 years that only fucntions by borrowing against the next 50 years of production. This economy needs to be destroyed and rebuilt.

We are going to get our medicine as a nation, and the transformation will be multi-generational.

Posted by Luis | Report as abusive

I believe that the fundamental underlying causes must be addressed and rectified in order to correct this catastrophe. That should start with identification of misfeasance, malfeasance and nonfeasance in business and government. Next comes confiscation of all assets related to such criminal, fraudulent or even deceptive behavior. These confiscated funds can go into central bankruptcy receivership account to be distributed to the injured parties including mortgagees, taxpayers, pensioners, and yes, victimized investors. It is criminal mismanagement that has led to this disaster. Whatever happened to the rule of law?

Posted by Jonathan Cole | Report as abusive

I think some of us may be missing the author’s point. What he’s really saying is devaluation of the dollar. Your dollar will now buy half or one fourth what it used to. This has been performed successfully, albiet painfully in several countries. Its not a pretty picture. Ten dollar a carton milk anyone?

Posted by D Simmons | Report as abusive

Oh how you have vindicated me, thank you!! I was making the argument for “forced hyperinflation” to a friend who works as a government auditor and he felt that it was not a viable path to follow. Glad to hear that I’m not the only one…

Posted by Sean | Report as abusive

Bankrupty for failed businesses should have been the solution last year. When bad businesses fail, good ones quickly buy their assets and produce better returns. Capitalism should be a self healing system. By intervening and providing any kind of financial support, America has failed the ideal of free markets, and will have significantly lengthened the healing process. Chicken Little Ben Bernanke was also the worst possible choice; prophesies in the markets tend to become self fulfilling.

Posted by Steve Shimwell | Report as abusive

Oh, there’s only a couple of minor problems with inflation as panacea for all our ills: first of all: which global investor (in the right mind) would ever invest in ever-inflatable (actually: deflatable) US-denominated government paper under a 20% annual inflation rate scenario? I certainly would not.

Would China continue buying our Treasuries for the sole purpose of replenishing our ever-bailing-out Treasury under a 20% inflation scenario?!? Yeah, but only if one and a half billion Chinese people suddenly went completely irrational, masochistic and/or self-destructive. Alas, I see no signs of Chinese leadership going poco loco any time soon.

And, oh…another minor problem. Inflation would eviscerate, if not completely euthanize US Dollar as the global-dominating currency of choice. That would be the end of America’s consume-everything-now-pay-everything-la ter economy, as nobody would be accepting our currency, except – perhaps – as a butt of jokes. That Venezuelan oil from Hugo Chavez would have to be paid in (suddenly very expensive) Venezuelan Bolivars, not with the piles of of suddenly worthless Dollars. This would hurt real bad — and not only our national pride.

And don’t even get me started on the price of imports. All of a sudden, all those cheap made-in-China imports (which means: 100% of everything in our stores, from soy milk to toys to electronic gadgets to hand mirrors and plastic tchotchkes to disposable umbrellas to contaminated pet food) would become dramatically more expensive: Flat-screen TV’s? New Car? Home renovation — hell, no! Not even a hope! Now OR in the foreseeable future, if ever! In this scenario, we are starring at the frighteningly real possibility of USA becoming a new Cuba or Zimbabwe.

And than, there is minor, shall we say, psychological component here. Inflation breeds insecurity, fears, economic paranoia. Money is dumped as soon as it is earned, prices change on a weekly, if not daily, basis; producers hold on to their stock rather than sell it for worthless money, shortages abound; economy suffers critical supply disruptions etc, etc, etc.

The reality is that there is absolutely NO cure for our ills. Neither good, nor bad, nor ugly. None whatsoever. Except, perhaps, one small sliver of hope, which has not been tried in 230 years: to once and for give up any and all hope of solving our domestic economic problems with a major global military conflict, and to then sit down with our archenemies for a brain-storming global economic session. And – Lo! – you might find them at least as reasonable as we are. America’s economy is not America’s problem anymore: we have outsourced our mismanagement and incompetence to the rest of the planet. This is the problem that needs to be tackled on a global level, and our New President will have to do a little pride-swallowing if he wants to help this country (by the way, the odds of this happening are about zero).

So much for the inflation as a chemotherapy for the economy. A humble suggestion: let’s try reasonable approach and have a radical surgery instead. It will hurt less. And the patient might actually survive, along with the rest of the world.

Posted by Adam Smith | Report as abusive

[...] Hvis vi skal have en ny tr

This is more classical economics, free trade BS . This is what Alan Greenspan said he would do to solve this problem , you know the guy who created the whole mess in the first place. To solve the problem look at the trade defecit , the income gap , and deregulation and privatization. Thats where the jobs went, thats where the money went, and thats where the infrastructure went. You want to find hte crooks follow the money .

Posted by urban | Report as abusive

Glad to hear someone finally calling it a DEBT CRISIS.

Posted by Darren LeRoux | Report as abusive

I’ve experienced what inflation does to a country first hand. Next came a war that wiped out everything in the country. It was easy to stir people to turn on the minorities in the country – they were desperate. So, be careful what you wish for.

Posted by EB | Report as abusive

Urban you are so right! We are mired in this economic crisis because of greed, corruption, incompetence and “Free Trade” at the highest levels of business and government. There is no other cause whatsoever. When money is put on the table morality goes out the window.

What happened to our anti-trust laws?

Posted by RFL | Report as abusive

What Adam Smith said :) He should be writing these articles.

Posted by Darren LeRoux | Report as abusive

If inflation rises than the price of oil that was so recently so very destructive will rise also as will all imports and commodities. Hybrid-economies like China will also have the advantage that they can control their monetary values better than the completely free markets can. Can’t you just see the new waves of foreclosures and bankruoptcies? Didn’t Bush Sr once say that Reaganomics was all “smoke and Mirrors”. He hardly gets mentioned anymore. He was clairvoyant.

Isn’t inflation just what happens when a country goes into decline? Vietnam was followed by a stiff inflation as I vaguely recall. The Italian Lira – became a tiny denomination after that country was defeating in WWII. It used to be a pound of something maybe only a Medici could remember when. And we don’t have the discipline of the Germans who made their Mark a standard of value in spite of total defeat. We’re not able to be that European or class dominated.

What happens to the costs of the social services safety nets? Sound like they will develope a great many gaping holes. And all of this at a time when business would like to grow more competitive in a much cheaper world labor market and the last thing they want to pay is higher taxes. Even those on pension plans and 401k’s will be watching them vaporize even faster now.

Lets not kid ourselves, we will become a third world country in fact while the newer economies with a lot more eager and younger worker force will become the astronomically larger economic super powers. And they will do it almost overnight. They will become independent of the US dollar faster than we will become independent of their production. What happens when Japan and China get nervous about our shrinking currency and start cashing in their biilons in US government securities and put their surplus wealth into other countries?

In spite of Obama’s lovely words the reality is so much more ruthless. And no one is treated with more disrespect and contempt than the formerly mighty.

There will be no cheap or painless fix. Somehow that retribution one commenter wants so eagerly will be settled on us all and it is simply because we live here and use the funny money.

Posted by PVR | Report as abusive

Thanks you W. May you and the folks who you allowed to do this to our country find a warm spot in hell.

God I rember being a kid and thinking reaganomics was screwing my future. At least he was tanking the Soviets with all that economic destruction. These fools were just profitering off us.

Posted by Eron | Report as abusive

Everyone talks about inflation being a high probability. The problem is that it should have already happened. What has been happening is almost anti-intuitive…. enormous amounts of money being poured into the world’s largest debt entity – the U.S. governmment. It is indeed almost Alice In Wonderlandish….people feel safest with their money where the debt is the greatest. And is Bernard Madoff the REAL mad hatter? And has the Cheshire cat shown itself yet…up to now perhaps only partly.

Posted by JRaymond | Report as abusive

I am in essential agreement with Mr Kemp. As the construction of this catastrophe involved many parties over many years, and is essentially reflective of the culture itself, the allocation of blame is an exercise best left to historians – it is a luxury we can ill afford at present.
The debt burden is unsustainable, the present attempts at wishful thinking aside, and will, one way or another, in real if not in nominal terms, be written down. I would argue that Mr Kemp is essentially correct in that it must, realistically, involve a combination of explicit write-offs or bankruptcies as well as inflation or other form(s) of devaluation. Relying on either one or the other of these rather than a combination would likely prove catastrophic in very short order. I would argue that it is vitally important to move radically, and decisively, to mitigate the situation to the degree possible (which is slight).
I would argue for:
1) Expedited forms of bankruptcy, both corporate and personal, with broad latitude to trustees.
2) The explicit rather than the present implicit nationalization of the very large banks which are, at present, in fact, bankrupt.
3) The creation of one or more national banks, perhaps on the carcasses of the nationalized existing very large banks (after their toxic debts have first or in parallel been written down in bankruptcy.
4) Preparation of a move to a replacement currency or a parallel currency, backed by specie so that it may be possible amidst the carnage and destruction to begin to move forward.
5) These central moves to be accompanied by large government spending programs of the sort presently contemplated so as to some degree minimize the pain on those most vulnerable.

Posted by Big Al | Report as abusive

Re-inflation is the answer to save debtors. Note I didn’t say “hyperinflation.” It seems blog posts jump to the extreme. It’s obvious that the government is working towards re-inflation, just as obvious as the banking crisis was 5 years ago.

So, debtors will win and savers will lose. This is the opposite of the past decade. Since we can *expect* inflation, we can take advantage of that fact by: 1. buying hard assets like metals, 2. buying currencies not experiencing inflation, 3. taking out a boatload of low interest rate debt now so that you can pay it back later with inflated dollars, 4. earn money in foreign currencies. By the way, equities should rise with inflation, if the number of shares are held constant.

Inflation is devastating to people who don’t understand it, just like leverage was crushing to those who didn’t understand it. Be informed, and you can prosper.

Posted by Tony | Report as abusive

Who will gurantee all this debt? Derivatives in the credit default category is $62 trillion alone. Bankruptcy is not in the cards. it would set off a daisy chain of events unheralded in this world. Get ready for GLOBAL WEIMER monetary fiscal insanity. GOT GOLD?

Posted by brian | Report as abusive

Why has nobody asked the question: “What happened to all the money?”. Surely, money can’t just disappeared into think air! Well, the answer is: all the money has been flowing out of the country into China and other major exporting nations. The present strategy by the Government to ensure that Banks loan more money to businesses and individuals so that spending will increase and the GDP will grow again is short-sighted. This will be good only for nice statistcal readings. In fact, asking dept-laden businesses and individuals to take on more loans is to ensure the bubble grows bigger and postponing the problems that we are seeing now to a few years later and maybe if luck plays out, one or two generations later.

To boost infrastruture development and spend more tax payers’ money to create jobs is good. But ultimately, when the newly re-employed start getting their salary and start spending again, where does the money goes to? To the the countries where we import most of our goods from.

So, as much as I hate to say the dreaded word, it is necessary. A little less of free-trade would be good. The government may need to erect some barriers to foreign goods entering the country so that some of the money stays within the country. In short, to be protectionist. It is not such a dirty word after all considering the the US is the major consumer and goods-importing nation of the world.

Posted by Timothy | Report as abusive

Big Al is right on. A couple of additional points, however:

1. In 2007 the level of leverage in the economy as a percentage of GDP was almost double the level in 1929. As Mr Kemp and others note, this leverage has to be squeezed out, and Mr Kemp ably describes the unpalatable choices. As to how we got there in each case, that\’s a long discussion in itself, but suffice it to say the causes were essentially the same; excessive speculation facilitated by men lending other people\’s money and collecting commissions (aka incentive bonuses) for doing so.

2. In 1929, we made the choice (not necessarily intentional) to lower leverage by reducing spending, increasing taxes which caused deflation and led to a depression-
by comparison, Germany decided to print money to pay off debts and that led to hyperinflation and fall of govt. Either way, they reduced leverage in the economy.

3. More recently, in the latin american debt crisis of 1980s, Brazil, Argentina, et al had similar problem– lots of debt (public and private) made possible by easy lending by US and other intl banks, and not sufficient GDP to pay it off. They ran the printing presses, and sure enough, they had hyperinflation and stagnation for 10 years until the lenders finally realized they had no choice but to reorganize those countries by writing off debt. OUr situation is not exactly the same (yet anyway) in that we still have the unique ability to borrow and repay our debts in dollars — but as Adam Smith says below, that could change quickly if the dollar loses its reserve status.

4. Now, in 2007-08 – the Fed/Treasury is so concerned with avoiding a 1929 type depression (which is Bernanke\’s area of academic expertise) that it is risking long term disaster by causing hyperinflation and all the consequences spelled out by Adam Smith.

5. Adam Smith talks as if we have a choice to avoid hyperinflation — right now, as painful as it may get, unless we stop all the govt programs intended to save a few entities and individual homeowners and instead start accepting some recessionary pain in the way of bankruptcies, failed banks and unemployment — we have no choice, we will face a very ugly situation of hyperinflation that is infinitely worse.

6. I\’d be very interested in how we can achieve what Big Al calls a combination of inflation and bankruptcies to reduce the level of debt– therein lies our best hope. FEd /Treasury should be thinking about getting banks to write down debt and sell assets at their marked down prices; they can\’t ask our foreign creditors to give us a break and write down USTs like we did for latin america in the 80s, but 10-12% inflation might come close to doing the same thing. Still it would take years, but what else can we do?

Posted by doublea | Report as abusive

Great column!!! Many of us have expected this.

Have a care with commodities. In terms of real value, contraction may continue even with inflation (conflation!), so make sure you’ll have a buyer.

Posted by Pete Cann | Report as abusive

funy how things Ron Paul was talking about 5 years ago are starting to resonate everywhere. The problem is the whole prsperity the last 30 years was a debt based pyramid scheme; the bottom level now is too big to expand any longer and it is caving in on itself. The only jobs being created will be federal jobs at teh same time the tax base is dissapearing. The states are the next ones to line up for a bailout; the rest of the world will ditch the dollar and you can imagine how fast the printing presses are going to run. Watch ike the good doctor said gold will go through the roof as they have no choice but ot monetize the debt.

Posted by brian mcnamee | Report as abusive

Mr. Kemp -

I enjoyed your article, but you leave an important question unanswered– why has the stock of credit expanded so rapidly?

The simplistic textbook answer is “savings”. I would suggest that a better answer is imbalances in the real economy fueled credit expansion. If our (US) trading partners recycle surpluses of 6% of GDP, and if wealthy households are saving 9% or more of GDP (keep in mind that in 2005 the top 1% of households received 24% of income), then that’s a lot of money flowing through the financial system – a wall of liquidity or a global savings glut if you will.

Some of the money financed business expansion, but most financed deficit spending and/or leveraged investing on Wall Street. The stage was set for the subsequent collapse and rapid deleveraging.

Regards,
Brian Shriver

Posted by Brian Shriver | Report as abusive

The perspective of the current economic quagmire by one of Thatcher’s children Louis Szikora..not quite sure how I stumbled on your website and comments but certainly am enjoying the read!

Mrs Thatcher had probably about right in her housewifely handbagging ways. She was a tough cookie who didn’t use government money to bail out weak companies…she always looked to reduce government borrowing and in my time made me proud to be British for the first time in my life. Her sometimes brutal honesty and disciplined ways spawned a whole new vitality in the UK as well as inspiring nations around the world to follow suit. She certainly had a finger on the pulse of the monetary supply and it would be hard to envisage the same sweetly named’credit crunch’ occuring under her watchful eye.

Am sure Maggie would in no way be bailing out greedy banks etc…nor would the UK be in a situation with a chronically overfed public sector and bloated unproductive welfare state and its millions of dependents. Nor would Mrs Thatcher have permitted an open door immigration policy to all-and-sundry whilst allowing our own burgeoning underclass to fester and rot on growing state dependency and criminally high rates of disability benefits to those able to work but not sufficiently motivated to do so. Anyone left wondering where the money’s gone?

Woe betide the US if Obama’s fine rhetoric and intentions bring the US to an unmanageable mixed economy such has become the UK…the UK in a debt crisis….oh did you see how Tony Blair nipped off just a few weeks before the first bad news hit our screens??? Good timing Tony…..

Am often inspired by US wealth creators though today shocked to learn about inadequate health care for those who cannot afford health insurance in the US. watch this quickly while it’s on BBC ‘s video on demand iplayer http://www.bbc.co.uk/iplayer/episode/b00 gvflg/Panorama_What_Now_Mr_President/

Obama’s got some work to do there and I hope the US can indeed become fairer in its treatment of the genuinely poor and weakest of society without being over liberal and squandering zillions of taxpayers’ money as happens in the UK. The point is zillions of taxpayers’ money to prop up what is effectively a bankrupt system is just weakening the West and rendering us less able to compete economically with the East.

I guess some of you in the US cannot imagine the extreme state generosity to the undeserving here in the UK.

That said…you need to fine tune your economy so that it benefits the truly needy without crippling the creativity of the people. It doesn’t inspire confidence to see a young US mother of 4 dying for lack of health insurance for a liver transplant whilst US can finance schools, roads and all sorts for Afghanistan etc.

As for the debt burden of today’s society…well I only have to look into my own excesses to understand what the rest of us have been up to. Am not proud..i have lived on borrowed time and equity in absence of real economic activity for many years. That said I will manage it or suffer the consequences if I do not…we all must suffer for our actions. I don’t expect any government bailout for sure!

On a positive note: health is the most important thing. Wealth creation is a great thing but we should not lose sight of basic human needs.I watched a programme about US people applying for food aid today…good Lord… they certainly looked like they needed a diet before state food handouts. End of the era of excess?

You know…it’s time we in the West focused less on material consumption as what defines us and our status in the world. We’ve imported just about all we can from Asia on tick…the last and most important thing I now recommend we import is a good dose of Buddhism and acceptance of the here and now. From this point on we should be able to see ourselves and our personal needs more humbly and realistically.

I do believe it’s the dawning of new political and economic order with a swing to Asia that will be unstoppable in our lifetime. Boohoo to those who internationally financed our Last Supper! They were just as guilty of greed as the rest of us ;)

Now… keep calm..learn yoga…meditate…whatever it takes for lift your stress of the here and now..learn to breathe and hear your own heart beat. Prepare to lose your homes, plasma tvs or whatever..but take a good look at those around you whom you love and care about…and check your pulse and look forward to sharing the next sunny day with them. Just look at how Thailand handled the tsunami….pretty cool people and known as the Land of Smiles. There’s more than just gadgets on the cheap we can obtain from Asia. We need to take on board some of their thinking too – big time from now on!

It’s the kinda thing many do in parts of Asia when disaster strikes. Live for the moment….yeah!

Am giving up the UK…there’s nothing left for entrepreneurs…am off to live in Asia soon. If ya can’t beat ‘em….join ‘em :))))

Thanks for listening…back to my imported Austrailian Chenin Chardonnay as long as the £ Pound permits ;)

let’s just keep it simple: save more, spend less

for the government, firms, and individuals. There will be some pain to be endured for sure but there’s simply fast and painless way out of it. How did you think countries like China and Singapore become such mighty economic super power so fast?

Posted by idle crane | Report as abusive

[...] BANKRUPTCY OR INFLATION The solution must be some combination of policies to reduce the level of debt or raise nominal GDP. The simplest way to reduce debt is through bankruptcy, in which some or all of debts are deemed unrecoverable and are simply extinguished, ceasing to exist. Bankruptcy would ensure the cost of resolving the debt crisis falls where it belongs. Investor portfolios and pension funds would take a severe but one-time hit. Healthy businesses would survive, minus the encumbrance of debt. But widespread bankruptcies are probably socially and politically unacceptable. The alternative is some mechanism for refinancing debt on terms which are more favorable to borrowers (replacing short term debt at higher rates with longer-dated paper at lower ones). The final option is to raise nominal GDP so it becomes easier to finance debt payments from augmented cashflow. But counter-cyclical policies to sustain GDP will not be enough. Governments in both the United States and the United Kingdom need to raise nominal GDP and debt-service capacity, not simply sustain it. There is not much government can do to accelerate the real rate of growth. The remaining option is to tolerate, even encourage, a faster rate of inflation to improve debt-service capacity. Even more than debt nationalisation, inflation is the ultimate way to spread the costs of debt workout across the widest possible section of the population. The need to work down real debt and boost cash flow provides the motive, while the massive liquidity injections into the financial system provide the means. The stage is set for a long period of slow growth as debts are worked down and a rise in inflation in the medium term. http://blogs.reuters.com/great-debat…deb t-disaster/ [...]

Great analysis – and if the subprime crisis hadn’t been the trigger, the studen loan & credit card debt would have been the trigger – we’d be asking “why did they make all those loans to students who didn’t have a job future in the U.S. thanks to outsourcing to low-wage countries?”.

The outsourcing of manufacturing has been a major factor – manufactured goods represent Real wealth, not Leveraged wealth – and the entire country forgot that without real wealth, no amount of leverage does you much good. This is also a side effect of NAFTA and similar trade deals, which increased the financial wealth of the United States while at the same time reducing real wealth.

Similarly, infrastructure – roads, electric grids, bridges – are real wealth because they allow the rest of the economy to function. Corrupt manipulation of energy prices increases financial wealth (i.e. the manufactured California energy crisis, 2000-2001) but destroys real wealth (businesses had to stop manufacturing, etc.) – but Wall Street doesn’t understand the difference between the two:

Real wealth is not subject to inflation – a lobster or a car is still a lobster or a car at the end of trading. Financial wealth is subject to inflation, and typically a decrease in real wealth will lead to inflation – the lobsters are rarer and so cost more; the cars are fewer and so cost more, etc. Argentina, here we come.

Posted by cargo | Report as abusive

Ladies & Gentlemen,

I can’t tell you how depressed I was lately regarding this economic situation. Then I read the posts following this article. The majority of the posters get it. Hyper-inflation will benefit the government and hurt the people.

Our “leaders” remember OF the people and BY the people . . . they just forget the FOR the people.

If you want to really understand what the US would be like in a hyper-infaltionary enviroment, just google: “weimar republic” or “zimbawe”. We don’t want to go there … I don’t care who’s company it saves.

Sadly, this IS where we are going unless the people wake up.

Posted by Mike | Report as abusive

So how exactly does the author see the government will inflate the debt away? As soon as money printing induced CPI increases, so do the interest payments on the huge national debt and we are back in deflation.

American stock mkts. are phoney as hell.contrived and controlled by hedge funds,and a conglomerate of corporations buying & selling their own shares in unison at given intervals. At this point in time i’m convinced the stock mkts. are grossly over bought. A real crash my be just around the corner.

Posted by Bill Gordon | Report as abusive

Good question Mr Kemp, but answer not so simplistic.
Credit default swaps (CDS), collateralized debt obligations (CDO) and the like –synthetic instruments or derivatives that can increase leverage without any relation to textbook theories tied to savings rates, etc.
The notional amount of CDS last year was in the tens of trillions of dollars, mulitples of the actual amount of underlying debt. CDS are useful as hedges, but left unregulated they are also susceptible to naked or leveraged speculation. By putting up margin, a small percentage of the notional, counterparties could take and trade positions (gamble, speculate) on certain assets like bonds or mortgages. Similar to call options or buying stock on margin for small investment you buy the right to participate in the upside without burden of putting up whole purchase price.
These are near perfect instruments for speculation.

In 1954, J.K. Galbraith, writing in “The Great Crash 1929″ (reprinted in 1979) wrote:

” The machinery by which Wall Street separates the opportunity to speculate from the unwanted …burdens of ownership is ingenious, precise and almost beautiful. Banks supply funds to brokers, brokers to customers, and the collateral goes back to banks in a smooth and all but automatic flow. Margins –the cash which the speculator must supply …are effortlessly calculated and watched. … Wall Street, however, has never been able to express its pride in these arrangements. They are admirable and even wonderful only in relation to the purpose they serve. The purpose is to accommodate the speculator and facilitate speculation. But the purposes cannot be admitted. If Wall Street confessed this purpose, many thousands of moral men and women would have no choice but to condemn it for nurturing an evil thing and call for reform. Margin trading must be defended not on the grounds that it efficiently and ingeniously assists the speculator, but that it encourages the extra trading which changes a thin and anemic market into a thick and healthy one. … Wall Street in these matters, is like a lovely and accomplished woman who must wear black cotton stockings, heavy woolen underwear, and parade her knowledge as a cook because, unhappily, her supreme accomplishment is as a harlot.” p.20

I dont know I exactly agree with all Galbraith says, but in the 1990s, CDS took the place of margin trading in the debt markets and allowed participants to create a huge market that fostered the creation of unrestricted and unprecedented amounts of leverage — I believe Warren Buffett once remarked something to the effect that he couldn’t quite understand all the possible implications of the CDS market, and that fact alone made him suspicious.

Posted by doublea | Report as abusive

Go to Zimbabwe! Mugabe would LOVE you. They are now printing their first hundred trillion dollar note for people to use..”for convenience”. Of course the news article reporting this neglected to say that Zim banks would never issue such a note to customers as they are limited to ten thousand zeedollars a day to bank customers by law, an amount that is not worth the paper it is printed on, and is likely rare; most having been used as fire fuel long ago. You should go to Zimbabwe. And stay there!

Posted by Bad Economist | Report as abusive

I agree, the only way to resolve this is mass defaults.
SO…..The debts are unrecoverable, take your losses, and if u still have the resources to continue than fill the void left by those that dont.

Posted by steve | Report as abusive

Most of Mr.Kemp’s analyses are right on but the final play may not be a combination of bankruptcy and/or inflation. I agree that the current debt level is not servicable but simply declaring bankruptcy will not solve it because CDS market will ensure that we will not have a single medium or large size bank left standing the minute we force a couple of big ones into declaring bankruptcy. We can not start nationalizing them all because than government would end up doing 90% of banking and trading. We all know that’s not possible. On the other hand, creating inflation is hard too, because money put into banks are not coming into markets. Effectively, money multiplier is 0 instead of being 10. So real money is shrinking at an unprecedented level, and taking down the real economy. This will be the hardest task ever for whoever is going to be managing the economy in the next couple of years. The solutions are not easy, most are not doable. It requires a lot of luck, and needs someone who understands the markets,a real trader like George Soros,not an academician (i.e. Greenspan, Bernanke) or investment banker (Paulson) or an opportunist (Rubin). We all got into this because some bankers thought they can generate great revenues without taking market risk with government bond like instruments, because geeks told them they are AAA. Now we know extra return does not exist without taking risk. Same philosophy applies here; we have to take some risks to get out of this mess we get into because we thought we were not taking risk. And for that, we need very good risk takers at the top to get it done.

Extrapolating John Kemp’s analysis, this looks like an extension of the recent Icelandic model / experience to the mainstream economies…

During last one decade all major crises came from the USA and its major allies like UK. They consider themselves most civilized and master of things like finance and humanity.

But if we anylize things deeply, we would find that most cruel and dis-honest people live in these two countries, for example Bush and Madof.

Posted by Al Baloushi | Report as abusive

The meltdown of the financial services industry has already obliterated trillions of dollars of economic value.

Part of John’s ‘solution’ advocates a second wave of wealth destruction through hyper inflation. This means that whatever money you have managed to salvage from the credit crunch economic meltdown will be devalued as the prices of goods and services rise.

I agree with John’s point that companies that have allowed their management to plunder and squander their resources should be go bankrupt and in the process terminate piles of debt.

In the case of failing and failed banks the government should buy these entities from the liquidators after the debts have been extinguished. The next step would be for Government to terminate the independence of the central bank and for control monetary policy and printing money to be restored to the State.

Posted by Gregory | Report as abusive

Eventually the course that would be set by Andrew Mellon must prevail. The twist is that putting underwater residential mortgage holder bail outs are inevitable given the collapse in real estate asset values, but it must be funded and that is where death duties come in. Those that clipped the ticket on debt must pay, and the old world money that went along for the ride is equally complicit in the erosion of regulatory, political and academic institutions. Making them pay equally on an ad valorem basis will see impetus rather than rhetoric behind the moral hazard imperative.

Posted by Ross | Report as abusive

A solution to the herding greed of capitalism is not socialism, or state intervention, but more free market capitalism. Free market capitalism depends upon transparency, a free flow of information and taking responsibility for bad calls. Cartels, black pools and off balance sheet conduits and SPVs have encouraged the development of a self destructive culture, highlighted some years ago by Frank Partnoy in his torchlight book F.I.A.S.C.O The system needs transparency and competition as they are the only real regulators. For every loser there should be a winner. Did not only the regulators, but also all the competition fall asleap on their watch? No. There can not just be losers, who all need tax payers’ bailouts. Tax funds should be used to assist new start ups, new regional banks and new mutal banking and lending organisations, not to guarantee the mistakes of the fallen.

Posted by Huw | Report as abusive

For some reason I retained a copy of page 15 of the Monday January 14th, 2008 European edition of the WSJ (its not aways just for wrapping fish and chips)that contained the following worrying advice from the breakingview.com column.

The piece considered whether the US government could lose its triple-A credit rating and imagined that a martian viewing the scenario would focus on the possible withdrawel of the “exhorbitant privilege”, i.e. Giscard D’Estaing’s phrase for the US’ ability to sell unlimited dollar denominated debt to foreigners. The column notes that a falling dollar keeps the total debt from growing by pushing up the value of US assets denominated in foreign currencies, and then it adds:

“Better yet, the US can shrink the real value of the foreign debt on its own. It just has to let inflation rip”.

Please NO! It will be like the book of Job.

Posted by Huw | Report as abusive

An excellent analysis, missing just one thing. The current move to nationalise the private loans of which you speak should lower their cost, freeing up cash. I imagine that a sensible view for central bankers is that this should go to reducing the debt pile. I rather suspected that politicians may have other ideas for it. In any event, the some of the inflation and default foreseen in your article is inevitable. In my view it would be best to be open about it so that inflation expectations can be properly managed. Haven’t seen anyone else with this analysis before now, so well done.

Posted by Manus | Report as abusive

Great observations in this editorial but, never mentioned is the role of the trade deficit, now a cumulative $9.2 trillion since our last surplus in 1975, all of which has been financed by a sell-off of American assets. The trade deficit is the reason for the explosion in debt, so the first step in correcting it is to restore a balance of trade. This nation desperately needs to abandon the ill-advised experiment in free trade that began in 1947 with the signing of GATT, and return to the trade policies successfully employed by this nation for the first 171 years of our history to assure a balance of trade.

First, we must look at what GDP means. I can be sitting around a job which pays a salary but may be twiddling my thumbs or attending never ending and mostly useless meetings, but since I am earning a salary, my activity or more precisely, inactivity would also be a part of the GDP. Our economy has become what it is, is because we place an undue importance on the “service sector”.

If an economy has a greater contribution from the “service sector” than from activity which produces goods to meet necessary and luxury goods, then the effective cost of the goods produced has logically been less efficient. For example, most government and private bureaucracies not involved in the making of goods actually decrease the value of their “labor” as far as GDP is concerned.

Posted by ClementW | Report as abusive

The whole notion of insuring bad behavior is what has created this economic UNFIT: uncontrolled flight into terrain. Widespread bankruptcy will destroy the banks, while hyperinflation will destroy the taxpayers. The only solution is a gradual descent, as investors take their losses and debt holders shed their toxic assets over the next few years. Any government attempt to accelerate this process will only result in disaster. In two words: do nothing. In time, recovery will come.

Posted by Pilotincommand | Report as abusive

Replying to Mr. Kemp, I wrote a poem:

Ode to Obama’s Inauguration
(With apologies to Rudyard Kipling)
By: Cecil R. Williams

On the road to Zimbabwe
Where hubris rules o’er our day
and motors slow like dying men
as Robinhood strikes, today!

On the road to Zimbabwe
Obama arrives to say
‘Productiveness is not important
as need is op’word today’

Oh the road to Zimbabwe
as the Lemmings ‘lights out’ say
civilization dies in agony while
what might have been, Kipling say!

“Oh the road to Mandalay
Where the flyin’-fishes play
An’ the dawn comes up like thunder
…………………………………………”

Posted by Cecil R. Williams | Report as abusive

One of the comments hit on the real question, that is, “Where did all of the money go”. Most are all professing their solutions to a problem, but they have not really looked at and defined what created this problem. The proposals treat symptoms and not the disease. Mr. Urban came very close when he pointed out that most, if not all of the problem arises, not from the effects of capitalism, but from the effects of uncontrolled greed.

Much of the debt, aside from the stupidity of rampant over-appraisal of real estate and mortgage fraud, stems from corporations borrowing beyond reason and the ability to pay back their foolish and greed inspired borrowing. How many corporate buy-outs have you seen, read about or even provided participation, where one company would buy another to enter a new or expanded area of business. And worse yet are the buy-outs that were to purchase the competition to absorb or liquidate them. In many or most of these cases the purchasing company just borrowed the money to buy up the purchased company and assets. In most cases the purchasing company’s stock falls while the bought-out company stock is inflated because the sellers will be able to take the cash buy-out payments like money that vanishes and is replaced by new debt burdens upon the buyer. Eventually, in many cases, the buyer cannot support the increased debt burden and the company shrinks until bankruptcy looms as the only way out. Is this where our country is headed, as we make the same mistakes on a much grander scale?

Investment and the taking on of debt must be supported by the creation of income to retire the debt. One of the most foolish actions of our government was the taxpayer refunds of last year where money was handed out for no benefit other than to promote consumer spending. Unfortunately for the U.S., the consumers probably spent this little windfall upon items made in China or other Asian countries. Wouldn’t it have been wiser to have taken that same government money and used it to build needed infrastructure, creating jobs and promoting the purchasing of necessary items, more probably produced locally? Billions of dollars were handed out to the taxpayers, and now we have little or nothing to show for it, other than a blip on our balance of trade deficits.

I will admit to all that I am an engineer and not an economist, but then just look at how your ipod has gotten smaller and your computers keep getting more powerful and less expensive, and compare that to how well the economists are doing what they do right now. Perhaps we need some serious and careful economic engineering, and a little less calling for inflation and public debt without any design goals and test procedures to monitor progress and achieve a desired and measurable outcome. It could only be worse if the lawyers were trying to resolve this crisis, but just wait, soon they will be.

Posted by Ruttencutter | Report as abusive

One of the solutions proposed, and echoed by many commenters, is to reduce the overall debt as much as needed, by “letting inflation rip”. That was the solution employed by President Reagan in the ’80′s when the public debt burden was considered too high by his administration. The great injustice of this “solution”, in my view, is that those who created the problem are rescued and rewarded, while those who did not contribute to the problem, are severely penalized. Those who avoided excessive debt, met their financial obligations, lived within their means and saved some of their income and invested it, provided for their own support in their golden years instead of sponging off “the government”. It was their invested savings that provided the capital for businesses and individuals to borrow, so the economy could thrive. Due to the government-created raging inflation, people like me who retired in the early ’80′s had our savings cut in half in our first few years of retirement, reducing our “golden years” to poverty instead of the comfort we had legitimately earned. If this tactic is employed by the Federal Government again, we will sink from impoverished to destitute, all in order to keep irresponsible, unethical, and dishonest businesses and individuals from having to take any responsibility for their bad behavior. Could we please have a little fairness?

Posted by Chuck | Report as abusive

It is a wonderful article and sure to energise the neurons in our brain. What we are seeing currently is like nothing experienced by Economists ever. By the time we get to know how this pans out over the next few decades,we may need to rewrite the history of Economics. We can definitely understand that currently all Asset classes are Deflating. How long and how deep this Deflations runs its course, only God knows. Theoretically we have all learnt that cranking the Currency Printing presses means Inflation, sooner or later. Will this Deflation damage Asset values so badly as to drastically reduce the Wealth disparity between the filthy Rich and chronically Poor? I do not know.

The real nightmare of this Deflation for us folks will come about if after reducing our Assets to near about Zero, we get runaway Hyper Inflation. The young may be able to cope and rebuild but those of us on the wrong side of fifty could have their lives shattered. This can really test the Human Spirit.
May we find the strength to face and overcome the challenges.
God Bless !

Posted by F.Daruwala | Report as abusive

This all the fault of the Federal reserve. Printing money and increasing the money supply, thus forcing the rest of the world to maintain same levels of money supply.

When there is too much money in the system bubbles are created – ie housing adn shares

Banks/ Wall St are businesses that sell money (if there is no excess money to sell) they cant lend it.

If you leave lollies in a room with children then leave and come back to see teh mess, who do you blame the children or the irresponsible teacher

The Fed should have let the economy tank after the tech bubble, then we wouldn;t have been in this mess.

A recession is needed, its part of the system/economics, and must not tried to be stoppped.

Liek the junkie who has to go theough withdrawal to get clean, otherwise keeps getting more hits/drunk – just means the hangover is going to be worse
in the end.

Get out of debt

Posted by Lucas Marx | Report as abusive

I would argue that the debt doesn’t matter as much as the long term return on energy. When the price of energy starts climbing it limits our ability to deal with risk thus the credit markets start to come down. I think we could change our fate by bringing up Algae oil production to about 4 Million barrels a day as quickly as possible.

Posted by Robert | Report as abusive

I have spent more time than I’d like to admit to reading both the article and many of the comments. Everyone is a [self-styled and often erudite] expert. And Mr. Kemp makes a lot of sense because he pragmatically lays out reality. However…

For anyone who’s interested, here is the real bottom line (yes, I suppose this makes me an ‘expert’ too): Kemp states, inter alia “…the necessary condition for resolving the debt crisis is a reduction in the outstanding volume of debt, an increase in nominal GDP, or some combination of the two, to reduce the debt-to-GDP ratio to a more sustainable level.” As for increasing nominal GDP, we need to create REAL value. You either capture it from the ground/air/sea, grow it, or make it; or some combination. That’s it. Massaging fiat currency is only economic masturbation.

The true underlying cause of today’s economic malaise is the personal, and I do mean personal, philosophy that we can live on the never-never. If you subscribe to that thinking personally, that means you subscribe to it as a buyer and seller.

Be more efficient in manufacturing. Capture margins otherwise relinquished to others by embracing better technologies that eliminate the costs you pay others to absorb (e.g., cheap labor), gaining competitive advantage and growing your business, creating more employment because you’re in a position to sell your products/services at a lower price while maintaining good margins to a broader universe of customers. Doesn’t this seem obvious?

And limit use of credit and OPM (Other People’s Money). We see these two as a panacea for reducing risk. Yes, it does, narrowly, but one never then develops a sense of careful pragmatism.

As for losses, suck it up, knuckle down and grab a shovel, pay attention to the suggestion box, reject hubris, stop passing the buck, change your MO in the ways above suggested, and spend money as if you earned it by the hour and had no credit.

Posted by A Goodman | Report as abusive

This may have been said before, but its worth a mention.

It isnt only the U.S or U.K that are bankrupt, its actually the whole monetary system, that was built on fraud. Writing off worthless toxic junk which was known as junk by those that securitised anything and everything possible, is what should be done. Privately gains and abuse should not be publicised and the pain should be localised as the gains were. “City” of London created the monster, deal with it… and what a pleasant death to the Anglo/Dutch Financial Empire it is. We need to sever all its tenticles and start a new global financial system based on the US constitution as its the only true Sovereign nation in existence, in conjunction with China, Russia & India. The rest are economic colonies of the empire.

Posted by Alicat | Report as abusive

Excellent article John. It seems that the penny is finally starting to drop that this is no ordinary recession–on which point, Microsoft’s Steve Bullmer’s excellent summary of what’s happening in the economy is well worth reading:

“We’re certainly in the midst of a once-in-a-lifetime set of economic conditions. The perspective I would bring is not one of recession. Rather, the economy is resetting to lower level of business and consumer spending based largely on the reduced leverage in economy,” (see http://finance.yahoo.com/news/Microsoft- resorts-to-first-apf-14127574.html)

Modelling the dynamics of debt deflation is my academic research specialisation. A recent paper on this that supports your argument–that the debt mountain is simply too big to be overcome by adding government debt to private debt–is available at:

http://www.debtdeflation.com/blogs/wp-co ntent/uploads/papers/NotKeenOnBailoutsFi nal.pdf

Cheers, Steve Keen

Simply put money is debt. The more debt the more money to actually the more we sign on the line to pay back a sum the more money is created into the system. Currently the fractional reserve banking system allows about a 9:1 ratio. ! dollar in 9 dollars out. This equals collapse period. Of course if we live in 1s and 0s it does not but because living in a finite world actually demands a sustainable practice that reflects actual value not a shifting of numbers and complex formula.

Man made law economic law all lose hands down to natural law.

A solution well that is easy. Simply turn our backs on the bankster overlords. They do nothing but take value in the form of real asset and give a imaginary paper value in return. Right now we will witness the collateralizing of many of our own natural places, national parks etc etc just to pay principal and then banks such as the ones in other countries whom loan us money to service our debt will own these assets when we declare bankruptcy.

This is not strange and it is not unplanned since the global banking system works in harmony and those who are the backbone of the central banks in different countries are ultimately the same people or their affiliates.

The question now is will we allow this to occur or what can we actually do about it now we have signed away our lives and our children’s lives into debt servitude?

This is not going to be solved by magic decree of a messiah it is not going to solved by a single solution. There is going to be conflict and there is going to be hostility but we can choose in smaller communities to just simply turn away from these powerful bankster interests and regain a sustainable form of value exchange.
Its gonna take guts and its gonna take fire.
I wish us all the courage and blessing that we will need int he days to come.
PC

Posted by phoenixCrow | Report as abusive

Excellent article!

Man created the money system as a simple means to represent fair exchange for goods. Since numbers are based on math we can easily create real problems as the system becomes more and more complex.

If we accumulated money “exchange power” without borrowing we would not have the problem we face and have faced before. Then again, borrowing has its place. When people borrowed for homes to live in, within their means this made sense. When businesses borrowed to build enterprises that create jobs, provide money to people and governements in the form of taxes…within limits this too made sense.

Years of increasing deficits on all ends, government, personal and corporate have lead to where we are today. The problem can be fixed by allowing the chips to fall where they may. Government does need to keep the flow going but without the excessive bailouts. Why not fix the price of oil for 2 years! Cut taxes, and let businesses that have made poor decisions fail. They will be replaced by stronger and better companies as their slack is picked up.

I’ve been saying they should refinance debts all along. Probably all of them (student loans, home loans, equity loans, business loans.)

This allows people to breathe easier, feel like they can loosen their belts a little now that their mortgage is $XXX less per month, now that their student loan is $XXX less per month, now that their business loan is $XXXX less per month, which will lead to… SPENDING! You got it. Remember, jobs are only there when companies think they can pay for them.

People will also feel like it is not such a burden to repay their debts; they will not feel like they can not afford the services this country runs on just because they need to eat.

We also need to educate people on credit/money usage. Yes, you really have to repay that money, it’s not just a joke because it’s all plastic and checks. Splurging should not be a daily attitude, more like a once-a-year attitude. (OK It could be more often, but you get the point – people should only ‘splurge’ when they know they’ll be able to pay it off.)

I’m so sick of this purchasing of “toxic assets.” Why not just refinance these assets so they are no longer toxic? Go from ARM to fixed. Go from high risk to low risk. If they’ve only got a minimum wage job, then give them a minimum wage mortgage, even if it stretches out for 50 years. If you let those who can’t seem to get ahead in life feel like they have the chance to have something in their own name, they’re going to keep it. It’s something to be proud of.

Oh and what’s with these f’ing ridiculous car prices, anyway? Does it REALLY cost you 10k more to build X vehicle over Y vehicle? I really doubt it!

“Make life affordable.”

Posted by Scordias | Report as abusive

[...] The last great empire builders – the UK and the USA appear to be on the brink disaster due to the collapse of debt financing. [...]

The acceleration of debt without meaningful productivity is the problem. I agree, bankrupt the meaningless – complex contracts and derivatives like mulitply held insurance contracts on failure. Pumping blood into a bleeding body is not the right way to save a life. Stop the leaking.

It should be a great year for accountants.

If Obama utters the phrase “Return to Gold Standard” we are saved. It is perception: When your money is backed by gold it holds more value to you then when your money is backed by the full faith of the government to replace it.

You’d also have to do a 25:1 conversion like a reverse stock split.

But i believe the root cause to be loss of perceived personal value of the dollar. You are told in business that your employees should act like they own the company. Why not the same mentality with money; with government; with monetary policy? They are talking about the money in your wallet. Americans need to make their voice heard outside of proxy.

Maybe on a household level we already have the beginnings of inflation. Maybe economists have their baselines and basis for their reports all wrong? Maybe we are seeing a new economy rise which invalidates everything they learned in college?

Much like the victims of Bernie Madoff, so was the US Economy a victim of fraud.

In previous postings I compared the economy to an athlete on steroids and the impact of taking the steroids away. The de-leveraging of the US economy is just like taking an athlete off steroids, those stats were inflated and they are not coming back. It was and is fraud.

Much as the Madoff victims are dealing with a range of emotions and realizations, it is about time Congress and the Obama administration come to some of the same conclusions: It is gone, what do I do now with what I have left. Sorry, investors ~ it is gone and the US Government should not under any circumstance print new cash for you. Congress, do not give those that perpatrated the fraud anymore American taxpayer money, it is like giving Bernie taxpayer money in order to keep perpatrating his Ponzi scam.

President Obama, let us find what and where the real economy is and then live within the means of the real economy.

Let me put it straight. There is no way out of the current crisis for the US without going into a controlled collapse. All these stimulus packages fancied by Obama and his friends will only end by burying the US economy under a pile of huge debts and deficits. In two years from now America will wake up to discover that the economy is still doing badly while the state coffers gone empty. At this point, a collapse of trust in dollar as a reserve currency of the world is bound to send a tzunami of dollars returning from all over the world to the US shores sweeping away the hapless country together with this semi messianic figure now posturing as its president.

There is a small but growing group of scientists and economists who believe that economic growth as been, and continues to be, closely associated with, and dependant upon, our use of energy. While there are many who argue that we have become more efficient in using energy, at least until 1984 the growth of the US economy had been very closely correlated with energy use. Since then the economy has been growing more rapidly than energy use, leading many to believe that we are becoming more efficient. In fact much of that growth has not occurred because of rigged official inflation estimates (see shadowstatistics) or, as you note, has been financed by debt, the energy cost of which has not yet been paid. Our research shows that, for example, the inflation-corrected Dow Jones index has tracked (snaked about) the total national energy use since 1915. The recent “corrections” are just returning to the energy index. Since US domestic energy production peaked in 1995 and total use in about 2004 there may be little opportunity for real growth in the future, leaving, according to this post, only inflation to settle the books. Yes we need a new economics, one based on biophysical reality and not on the absurd economic theories of neoclassical economics which violates many physical laws. The UK is in a particularly dangerous situation because the North Sea petroleum windfall (which is now almost gone) gave the country several decades of real growth and the expectation that this is normal (and Margaret Thatcher an undeserved reputation as financial wizard). The adjustment to the new reality will not be pretty. Remember: Mother nature holds the high cards.

Posted by Charles Hall | Report as abusive

Although we can agree that we had internally in US a lot of debts, a lot bad and some good, we shoould not translate all our ‘debts’ to have been made locally in the U.S.
Let’s go back to the expansion period documented in the chart : the U.S. banks, and the international companies incurred a lot of debt in foreign land – for the benefit of growing the markets worldwide. Let’s not forget that we have facilitated the growth of many countries, therefore should not be taking on the burden to pay back ALL the debt. This must a mutual effort, while we recognize the excess on our part was only part of the picture.
Who can give us these breakdowns – rough figures are ok.

Posted by Eddy Lahens | Report as abusive

The foundation of cash flow is intellectual.
By 1990 it was apparent that an ahistorical
product gridlock had been reached,worldwide.
The situation is profound and the cumulative
result of policies of planting fatal land mines in every act.

Posted by Diane Graziano | Report as abusive

A simpler way to put what was said in this article is that too much credit, and too much reliance on credit is the root cause of the problem. Bailing out banks so they can extend even more credit, is not the solution. It would in fact, be contributing to the problem, at enormous public expense. Better to allow weak banks to fail and allow the economy to readjust to one less dependent on credit.

Here we have another example of the virtues with making world currencies, especially the Dollar or Euro, convertible in same way, direct or indirect, into gold.
The “barbaric relic” stands as the guardian to prevent massive debt buildup because it allows for endless credit and money creation–as long as the system accepts it. The barbaric relic forces players to discipline themselves. Who wants to do that in today’s Relativity World?

The “final solution” will have to be some kind of return to a “gold exchange standard”, or band control of the major currency. Band control of fluctuation, per se, is barbaric as gold because it would force the issuer of the reserve currency to take credible steps to restrain trading within the announced bands. Discipline
The era of believing in paper money, as the monetarists, University of Chicago neophytes, Milton friedman quack economists, seems to coming down in a deluge that may have only begun to reap its misery. Hope not.
The only solution deals with some form of buttressing to gold for the Euro or $.
Suppose Communist-KGB member Putin put the Ruble on a gold exchange standard and enforced it!!!

All these “experts” miss the real points made in text and teaching decades ago. The key is wages, period. With high wages, debt goes down, savings go up and the economy booms. After Reagan, wages stagnated for 30 years and are now dropping. Hey, I made $7.35 an hour in 1962 in an unskilled but uncomfortable job working a hot press! That’s 50 years ago and I made more than some do now! We have had a 600% increase in productivity and nothing in wages. That’s the problem. All the rest is contemorary crap from the same people who created his mess! Without wage increases, nothing can save us. The economy cannot survive without money to spend and that money ONLY comes from wages.

Posted by robert1234 | Report as abusive

Society has enjoyed and binged on excesses. Bankers have abused their positions and left the rest of us to pick up the tab.

The only way forward is for a percentage of all secured debt to be written off and a larger percentage of all unsecured debt to be written off.

Let people stay in their homes rather thand allow repossessions and help those in trouble to keep afloat.

Bring in emergency measures to help refinance loans on reasonable terms and help small businesses with less than 50 employees stay afloat by providing cheap finance and a holiday on the payment of National Insuarance and Pension contributions.

To avoid redundancies, encourage small cuts in salaries for everyone in the company.

All this will help to keep society intact and able to grow again together. We can get over thsi together, the greed and excess has to stop.

Encourage National pride, self-respect. On housing, if a mortgage was granted in the last five years, ther is a good chance it is going to be in default sooner or later. This is especially so if LTV is 75% orhigher.

Give the borrower the ability to elect for the bank to take on it saher of the burden. If they lent 75% of value, then permit the conversion of up to 37.5% to equity and the occupier can pay rent on that at Base rate plus 1%. after 5-10 years, the occupier/owner can buy back the share for the market price then prevailing or the bank can sell their sahre to the Government for the price the bank paid for it.

The government could thus end up owning substantial number of properties that could be used to provide homes for families in due course.

Long term thinking is essential if we are to get out of this mess created by greedy bankers who wer arrogant and who have been playing with the lives of real human beings.

Posted by K. Morey | Report as abusive

[...] With a very real fear of either hyperinflaction in China and either that or bankruptcy for the US and Great Britain – the latter of which by the way just recently dropped interest rates to the lowest point in its [...]

[...] de la solución. John Kemp, un columnista de la agencia Reuters, comentó recientemente en una columna que Estados Unidos y el Reino Unido están al borde de la mayor crisis financiera de la que [...]

[...] columnist John Kemp says the solution must be some combination of policies to reduce the level of debt or raise nominal GDP. “Reducing the level of debt” can be accomplished either by bankruptcy or inflation. [...]

A slightly different way of looking at the problem: There are too many people and businesses that are trying to make a living on someone else’s back.

The way that they do this is through credit and debt.

Gereral Motors does no make any money by manufacturing cars. The profits come from the GMAC loans to people who buy a car.

Almost any merchandise you can buy has layer after layer of finance taking a small bite at each level of production. And this is in the US where we think we do not have a value added tax.

We’ve reached the point where the financial vampires are draining enough blood that the economy can no longer work.

Posted by Gerard Pierce | Report as abusive

[...] in financial markets had them totalling $860 trillion. That’s about 15x gross global production. The Great Debate Debate Archive U.S. and UK on brink of debt disaster | The Great Debate | [...]

Thank you for helping spread awareness of the core problem: the cancer of debt. The only solution to this debt deflation is Jubilee, the cancellation of debt. Our financial and economic systems can be reset, giving all a fresh start, but we have to demand the correct action from our leaders. Help spread the good news of the Jubilee Year!

[...] why he uses that figure. To do so we must differentiate between public & private debt. As this article explains its the private sector debt that has shot up much more than public debt over the last cpl [...]

I am in full agreement with this article. Consumption will not return to previous levels until we de-leverage our economy (per capita consumption highs my never return since it was driven so much by debt). Either excess income will go toward debt reduction or (and most likely), defaults will increase putting more pressure on banks and bond holders. In my mind, short term, deflation is the risk in the economy. Inflation may be the only solution to get us out of this mess. Either way, not a bullish scenario for the stock market.

Posted by Kevin Gage | Report as abusive

The problem with America’s bloated GDP, is that it is the sum of domestic production, much of which is the low paying service industry and does not reflect what each individual takes home. It’s individual disposable income that 1) pays down debt 2) invests in durable goods, not the summation of GDP. America’s economy of importing Chinese goods at extrememly low prices, which reflect China’s small GDP number, then reselling these goods by 500% mark-up at Wal-Mart, is what constitutes America’s bloated GDP, which does little to resolve American’s immediate financial concerns.

Posted by Bull Run | Report as abusive

[...] is caused by a huge debt bubble that the private sector generated. Reuters columnist John Kemp wrote in his blog on Jan. 20 about the public sector and the private sector debt. I especially recommend [...]

The United States debt is manageable. Inflation will take off sometime in 2010. The biggest threat to the U.S. in the future is environmental degradation around the globe. Our debt is not that big of a problem all things considered.

[...] is caused by a huge debt bubble that the private sector generated. Reuters columnist John Kemp wrote in his blog on Jan. 20 about the public sector and the private sector debt. I especially recommend [...]

[...] early 80’s western countries have been fueling their growth with debt. The chart below from John Kemp at Reuters compares the growth of the United States’ economy with the growth of its [...]

[...] early 80′s western countries have been fueling their growth with debt. The chart below from John Kemp at Reuters compares the growth of the United States’ economy with the growth of its [...]