Why The Economy Could Take A Long Time to Recover and How Your Assets May Be Affected

I’ve argued for a long time that the economic climate we currently find ourselves in resulted from too much debt, making this ‘recession’ a credit driven recession rather than the more typical inventory driven recession. Incidentally, the last rather severe credit driven recession we experienced was in the 1930’s.

Here are the simple facts:

· The economic ‘expansion’ of the last decade wasn’t expansion at all. Instead, due to the creativity of Wall Street and major banks, we simply borrowed against future production by creating additional debt. In other words, we spent money we didn’t have to such an extent that much of the accumulated debt will likely never be paid. (See chart below)

· Consumers are now paying down their debt rather than spending, making the consumer-spending dependent US economy slow. The more the economy slows and the more prices drop (yes, we are in a deflationary environment); the more this cycle feeds itself. Consider this again from Business Week, July 29, 2009:

“How can that be? Because the inflationary effects of the new money are being fully offset, or more than offset, by the far-reaching and long-lasting impact of household debt repayments. While cleaning up debt is a good thing for the long-term health of the US economy, it’s hell on consumer spending, which accounts for about two-thirds of Gross Domestic Product. The economy is teetering on the edge of deflation – a general extended decline in prices – despite the Fed’s intervention. Excluding food and energy, consumer prices rose a modest 1.8% in the 12 months through May – and including food and energy, they fell 1.3%, the most since 1950.” (Emphasis mine)

· Our country’s attempts to solve this economic problem by creating additional debt are making the problem fundamentally worse. Any economic reprieve will likely be temporary and the eventual landing harder than it may have been otherwise. While consumers have quit accumulating debt, the government clearly has not. From a repayment standpoint, government debt is the ultimate responsibility of the taxpayer – regardless of whether or not the debt is public or private. Take a look at this chart from John Mauldin’s “Thoughts From the Frontline” newsletter:

The chart illustrates total US Debt to US Gross Domestic Product. As you can, the economic expansion we’ve experienced since the early to mid 80’s is largely a result of massive borrowing. Since March of 1981, the level of total debt compared to GDP has increased a whopping 235%! Today, as a country, our debt amounts to 375% of what we produce in a single year. Debt eventually has to be paid or defaulted upon. In my opinion, the few politicians that do understand this have made a conscious decision to let future generations deal with a debt burden so great it cannot possibly be repaid.

· If our debt laden economy continues to sputter, so too will corporate profits making traditional ‘buy and hold’ and ‘asset allocation’ investing difficult for many investors. In my opinion, the government’s injection of funds into the economy along with the relaxation of the “mark to market” accounting rules will not be enough to sustain the current market rally.

· The cash for clunkers program has ended, the $8,000 tax credit for homebuyers ends in November and the fed has stated it will stop quantitative easing in October. All of these programs borrowed against future production. Once the borrowing ceases, our government will eventually be forced to look at and hopefully deal with the massive amount of accumulated debt. Only then can a real, sustainable economic recovery begin.

I’ll say it again – wise folks are raising their cash positions on market rallies.

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