The Postcatastrophe Economy

I'm now halfway through Eric Janszen's excellent The Postcatastrophe Economy: Rebuilding America and Avoiding the Next Bubble.

The first half of the book is devoted to providing his analysis of where the economy is right now and how it got there.  His views are quite consistent with my own, but it is clear that he has been thinking about the issues longer and has a more complete view of the field.

I'll provide a full review of the book when I'm finished.  I can say just from reading the first half that the book is a must read.

Debt Inequality v. Income Inequality

A lot of people are pushing the income inequality meme: that income inequality caused the financial crisis and subsequent (and continuing) economic depression.  A week or so ago, we had the IMF pushing it.  Robert Reich is currently peddling a book, Aftershock, which does the same.  And just today Linda Beale of Angry Bear and ataxingmatter queried "Inequality as a critical cause of the financial crisis? (by which she meant income inequality)."

My answer to Linda is no, income inequality was not a cause of the financial crisis, let alone a critical cause. 

The financial crisis was caused by debt-financed financial speculation gone bad.  While one is free to argue that wealth inequality arising from income inequality resulted in a lot of money seeking the high yields offered by financial speculation, if people hadn't used that money to borrow more money to leverage their bets, none of this would have happened.

The financial crisis caused the current economic downturn, called the "Great Recession" by Reich, which government hacks recently declared "over" back in June 2009 (although Bernanke and his cadre don't seem to believe it, either; you don't employ quantitative easing with a healthy economy).

Now we're at the point to ask whether income inequality matters.  Specifically, is the current economic downturn being prolonged by income inequality?

The facile answer would be yes; however, the correct answer is no.

Income inequality is a necessary but insufficient condition for suppressing demand (i.e. spending).  To suppress demand in the manner that we're currently witnessing requires income inequality coupled with debt inequality, which for the bottom 90% of American households is best measured by the debt-to-wage ratio.  If people did not have to spend their (increasingly shrinking) wages on servicing existing, overvalued debt, it would be available to spend on new purchases.

Unfortunately, the debt-to-wage ratio is something that is not tracked by anyone (at least to my knowledge).  I've seen the debt-to-income ratio and the savings rate, but both are typically tracked using BEA data, which, as I've documented previously, is highly suspect due to the fictional "imputations" it uses to inflate personal income, personal disposable income, and savings. IRS income data appears to be much more realiable (unlike BEA and Fed data, it is not subject to subsequent, self-serving revisions that can be detected only by reviewing old Census reports that captured the original data like a fly in amber), and Professor Emmanual Saez of UC Berkeley has a great IRS-based dataset available here (and lots of papers based on that dataset, in its various incarnations).  The Fed tracks debt data itself, but it relies on BEA data for income, disposable income, savings, etc.  Every few years, the Fed conducts its "Survey of Consumer Finances," which provides some information that is useful in connecting the dots between debt and income, but not necessarily between debt and wages.

A major limitation in the vast majority of the available economic data is the fact that it is expressed in the aggregate: the data that is made available for public consumption is for the ENTIRETY of the U.S. populace, and is not susceptible to a deeper dive to help understand what is really going on.  One of my favorite examples is the "median real income," which inherently measures the mid-point of all income, adjusted for inflation.  But what does the mid-point really tell us about income distribution when 50% of all income accrues to the top 10% of households (up from something like 35% thirty years ago)?  It should tell us that the so-called "stagnant" median real income masks a substantial decrease in real income for everybody not in the top 10%, but that's not what we hear.  We hear that everybody is just running in place.

To the extent that we ever see a parsing of the data, it depends entirely on what hypothesis the researcher is seeking to prove or disprove.  Thanks to Prof. Saez, we at least have a real drill down into the make up of the top decile of American households, at least as to income. 

Most income inequality researchers seem to focus on quintiles (five slices of 20%), but I don't find this meaningful for the simple fact that the Prof. Saez's data show that everybody below the top 5% is, in fact, a wage slave: at least 90% of the annual income for everybody below the 95th percentile of households comes from wages.  This is one reason for my emphasis on wages instead of income.  For 95% of American households, the ability to spend depends entirely upon the ability to earn.  If you lose your job, you can't (and won't) spend.  Period.

For those of us in the 95th percentile and above, well, we can keep on spending without a steady job because we've hoarded enough financial wealth that we can make money from our money and live on the fixed income doing so produces.

Now for the Data

First, I used the following Fed data (the D.3 table from the penultimate Flow of Funds report) to understand the amount of outstanding debt:

NOTE: I had to reconstruct the data for 1952-1974 using Fed data embedded in Census reports.

Second, I used the following Credit Suisse chart to estimate the relative amount of debt held by the top 10% of households versus everybody else:

FYI -- I believe that I've found the dataset Credit Suisse used to derive this chart at the Federal Reserve website, and I intend to check Credit Suisse's conclusions.  Regardless, however, a major question is what is meant by the term "income?"  The BEA measures income withouth capital gains.  The IRS provides measures with and without capital gains.  It is difficult to ascertain from the Fed survey data what is meant by "income," although it does seem to include income from all sources.  Moreover, the Fed slices and dices the survey data in truly odd ways that make it impossible to parse.  All that being said, I am assuming that "income" means income without capital gains.

Finally, I used Prof. Saez's data to calculate debt-to-wage ratios for 1988-2007 for the top decile of households versus everybody else, using IRS income data and calculating outstanding debt for the top decile using the Credit Suisse chart.

So, without further ado, here you go:

The final chart shows how the bottom 90% really piled on the debt in the last decade, while the top decile hovered around the historical mean.  That huge ramp in the ratio was no accident.

I'm happy to share my data sets, if anyone wants them.

Bank of England to Wealthy Savers: Start Speculating in the Equity Markets or We Will Steal What You've Saved

At least that's my translation of this story, which is posted up at Calculated Risk.

Anybody in the UK who can live off his monthly interest income is sitting on a big pile of cash that cannot be "spent" in a single month or even a single year.  If reducing interest rates is enough to cause this kind of saver to start spending his principle, the saver must chase higher yield and, therefore, become a speculator in the secondary bond and equity markets.

The BoE is basically demanding the lower rungs of the wealthy subject themselves to predation by the upper rungs.  You know, the ones that have "dark pools" and HFT algos that selectively cause flash crashes to their advantage.

What ultimately saved capitalism back in the mid-1930s is that the lower rungs of the wealthy realized they were just as at risk as the middle class.  The Bank of England is just begging for a new reform era by behaving this way, which is a great thing.

Note to Robert Reich: Debt Gap Is What Is Really Killing the U.S. Economy

In a recent interview (h/t to Jesse for the link), Robert Reich, according to the author of the piece, "argues that income inequality has left America's middle class too unstable financially to fuel demand for goods and services as in the past."

While income inequality is certainly an important factor in the demise of the U.S. economy, debt inequality is even more important.   More precisely, what is killing the U.S. economy right now is the huge and increasing inequality in the ratio of debt-to-wages for the top 10% of American households versus everyone else.  For the bottom 90% of American households, wages constitute the vast majority of household income.  While the debt-to-wages ratio of the top 10% of American households has remained relatively constant over the last twenty years, the debt-to-wages ratio of the bottom 90% of American households has almost doubled. 

This is no accident.  The debt-to-wages ratio of the bottom 90% of American households almost doubled because their outstanding debt substatiantially increased while their share of total wages largely remained unchanged.  This was due to increasingly loose standards for the extension of credit, which has led to many of the usurous practices that we're seeing today in consumer credit.  To put it bluntly, the American middle class is being systematically preyed upon by the financial sector.

If pre-1980s debt-to-wages ratios had been maintained, there's every reason to believe that the U.S. economy would not be "dead in the water" today, that people would be willing to spend money buying new things instead of feeling required to just serve the debt they already have.  Of course, we wouldn't have had the illusion of GDP growth that all that new debt helped to create (along with accounting tricks from the BEA).

Later today, I'll update this post to include data and charts that support my assertions regarding debt-to-wage ratios.  There's no straightforward way to calculate this ratio too far back in time, but there's solid data dating back to 1988.

There Is More Household Deleveraging Than the Data Show

As I suspected, the banksters are not writing off what appear to be worthless second mortgages and home equity lines of credit. 

For example, the top four banks (BofA, Citi, JPM and Wells Fargo) hold at least $423 billion in home equity loans, and over a third of that amount is for homes that are either worth less than the first mortgage or close to it (i.e., there's no hope of getting any money out of foreclosure, and the likelihood that people defaulting will be able to pay the difference).  Given the amount of leverage that the financial sector created in the derivatives market off of mortgage debt, if they were to write off that $150 billion in second mortgages, it could easily translate into write-offs of financial sector debt on the order of $1 trillion or more.

Check out this post from Larry Doyle of Sense on Cents for the details.

In the Debtrix, There Is No Red Pill

In the last forty years, Americans have gone from citizens to consumers, from consumers to consumables.  As citizens, we existed to participate in society by producing goods.  As consumers, we existed to proclaim our individuality by consuming more goods than our neighbor (who we didn’t know then, and still don’t know now).  As consumables, we exist solely to incur debt and be consumed by it.

We are trapped in the Debtrix, coppertops, and there is no escape.  There is no Morpheus in this debt matrix (he’s been rebooted as an actor), there is no Neo (another actor), and there is no red pill.

For the vast majority of us, those of us in what used to be called the middle class, our value to the Debtrix is measured by the size of our credit line and our propensity to use it.  So make sure to leverage up and spend borrowed money on things you don’t really need or want.  But, whatever you do, don’t lose your job because you are unlikely to find it (especially if you damage your credit score). 

For those of us without credit, well, our value to the Debtrix is measured by our ability to provide a pool of cheap, temporary labor, primarily to incentivize those with credit lines to produce more in order to keep them.  The middle class coppertops will have to increase productivity or end up like you, eating cake.

For those of us at the top of the pecking order, our value to the Debtrix is measured by our complacency in allowing it to persist.  The longer we are in the Debtrix, the more time it has to consume our wealth and our humanity (it’s already too late for Charles Munger and this guy, too). 

Although the Debtrix cannot be escaped, it can be destroyed through the very means it uses to consume us: debt. 

First, stop taking on new debt.  This alone will prevent the Debtrix from growing and will even force it to shrink as it fails to maintain the illusion of perpetual exponential growth.

Second, start retiring old debt.  If that means selling some of your possessions to pay the debt off, do it.  Many of us don’t use or need a lot of what we own.  If that means defaulting on non-recourse mortgages, do it.  The bottom 90% of households owes roughly 80% of the outstanding household debt, which is about $11 trillion total, of which $8 trillion is mortgage debt.  When you include the leveraged side bets the architects of the Debtrix placed on us coppertops paying that $8 trillion back, you’re looking at as much as $88 trillion in total losses for the Debtrix, which would break it.  TBTF would become TBTB (“Too Big To Bail”).

The Debtrix cannot be escaped, but it can be destroyed, and when it is, we'll be citizens again.

Poverty Level Soars: An Inevitable Consequence of Being a "Coppertop" in the Debt Matrix

The U.S. Census Bureau reports that nearly 1 in 7 Americans now lives in poverty.

Expect the trend to continue as the American middle class gets crushed by debts that have been growing significantly faster than their incomes.  Most of this debt was incurred based on home values which have dropped significantly and promise to drop further as foreclosures accelerate and shadow inventory enters the market.  With increased long term unemployment and increasing downard pressure on wages, the cost of servicing the existing debt is going to increase as a percentage disposable income even without new borrowing.  More middle class families are going to be driven into poverty as a result.

It's the Wages, Stupid

For the bottom 90% of American households, income essentially equals wages.  On average, wages represent over 75% of the pre-tax income for households in the bottom 90% of American households.  When you add income received from social security, retirement plans, and transfer payments (e.g., unemployment insurance payments, and state disability) to wages, this represents around 93% of total pre-tax income for households in the bottom 90%. (FYI - wages remain an important component of total income-- between 70% and 90%-- until you reach the top 0.5% of households.) 

While the bottom 90%'s share of wages has been falling steadily, it's share of total household debt has been increasing at a much faster pace.  Conversely, the top 10%'s share of wages has risen steadily while its share of total household debt has remained relatively constant.

As the size of the labor pool increases and downward pressure is placed on wages, the bottom 90%'s share of total wages will decrease, but its debts will remain unchanged.  This means that its debt-to-wage ratio will increase without taking on any new debt.  More people will fall behind, demand will fall, more people will be laid off, etc.  We are in a self-reinforcing cycle.

Unplug from the Debt Matrix

An increasing poverty rate is a feature, not a bug, of the current predatory system, which is consuming the American middle class to benefit a very small minority of Americans.  The American middle class is nothing more than "coppertops" in a debt Matrix.  Unless you unplug yourselves, you will be consumed.

I will be providing a more detailed post with data that backs up my conclusions.