Debt Built Up to Levels Even Obama Says Are “Unsustainable”

Hey...the rally is on!

Yesterday, the Dow rose 235 points. And the public's mood is at an 8- month high.

"Look, things seem a lot better now than they did back in October," said a lawyer we spoke with yesterday. "I think we really hit bottom towards the end of last year."

Our friend's view is probably the dominant one. Things are looking up. Not that the news is good...but it just seems "less bad" than it was...or even less bad than was expected.

Foreclosure filings are at a record high. But "most homeowners think bottom reached," said a news item on the internet.

"Bank crisis in US could last to 2013," adds a headline from Reuters. Yet, most people think the banks are on the mend. They don't expect any further major bank failures. They think the financial sector will come back...maybe slowly, but more or less steadily and satisfactorily.

The average bear market bounce in the stock market lasts only 2 months. By that measure the current rebound should be at an end. It began on March 9th. Since then, stocks have recovered 30% to 40% - all over the world. But this rebound doesn't seem to be ending. Why?

Well, it might last longer than most because the crash that preceded it was stronger than most. Or, it might last longer than most because the feds are fighting this downturn far more than they usually do. We're trying to remember the figures...but the total response is at least 10 times greater than normal.

So, it wouldn't be totally surprising if the rebound were robust. But if it's what we think it is - a bear market bounce, not a genuine new bull market - the government's support is pernicious. It helps disguise what it really going on...and draws even more investors into the trap. And the longer it goes on, the more investors will come to believe that this is bull market is for real. As it continues, they'll commit more and more of their money to it...

When the market was still falling last autumn, we looked at other bear market rallies and guessed that there would be an "Obama Bounce" coming. We thought it would begin after the election...and then, when there was only a weak ricochet after the election, we thought the bounce would come after the inauguration. Instead, it didn't really get underway until March. Since then, it has been following the usual path.

How far could it go? Who knows? But it wouldn't be extraordinary if it took the Dow back to 10,000. And it would not be unusual at all if people stopped talking about the 'green shoots' and began noticing entire fields of clover.

So, let's take a minute to try to remember why we think this is only a bear market trap...

The problem is debt. It built up over a quarter of a century to levels that even President Obama says are "unsustainable." People have too much debt - student debt, credit card debt, private equity debt, mortgage debt, and every other kind of debt you can imagine. As long as the economy is expanding...and the credit markets are offering more debt...the problem is not critical. One debt is paid by taking on another, greater, debt. Houses are refinanced, for example, at higher prices...but lower interest rates.

Then, the cycle turns. Instead of continuing to expand, credit begins to contract. When people go to refinance, they discover that their collateral is worth less than it was before, real interest rates are higher, and the lenders don't want to lend any money anyway.

Bummer...

And then, all that debt that they built up over the last quarter century is a problem. It has to be paid down to the point where it isn't a problem. And that means the obvious thing - people have to cut back on their spending. As long as the amount of debt is contracting...as long as interest rates are rising...as long as asset prices are falling...and as long as people have more debt than they feel comfortable carrying - sales, profits, and stock prices are going to be depressed. No reason for a new bull market.

This process should last a long time. Why? Because it takes a lot longer to pay off debt than it does to run it up. People have to earn the money to pay down their debts. And it's harder to earn money in a declining economy than it is when the economy is booming. People have to make changes...they have a lot to figure out...and a lot to reorganize. It could take two years...4 years...10 years or more.

But wait a minute. What about all this government bailout money? What about the biggest government program since WWII - the fight against capitalism? What about the most expensive financial commitment every made? Bigger than the pyramids, more expensive than Alexandria and Babylon put together, more colossal than the Colossus itself...

About $15 trillion has been earmarked for the big bailout/stimulus program. Surely, it will short-circuit the correction and get the economy going faster...won't it?

No, it won't. You can't wait for it to happen either.

Because you can't correct financial mistakes by subsidizing them. You can't erase bad investments by putting more money in them. You can't turn bad businesses into good businesses by giving them money. And you can't cure the problem of too much debt by borrowing more money.

Instead of forcing people to correct the mistakes of the bubble era, the government is doing all it can to keep bad investments in the money, brain dead firms alive and keep zombie banks in business. The more money the feds put to the task, the less quickly the economy corrects errors and adjusts to the new realities.

Still, all that money has to go somewhere, doesn't it? Won't a lot of it go into stock prices?

The answer is 'maybe.'

But this money that might go into stocks, where does it come from? Ah, dear reader, there's the glitch...there's the fly in the ointment...there's the rub.

Every dollar that goes to prop up Wall Street, for example, must come from somewhere else. A headline we saw yesterday reported that the "Rich get richer on Wall Street." Of course they do. Instead of going broke and getting fired - as they should have - the government steps in with more money. Not only do the banks stay in business, they're able to pay their managers even bigger bonuses.

The government borrows from the private economy - money that might have been lent to a developer...or to a bakery...or to a homeowner - and puts it to work. Now, it's true that in a credit contraction, borrowing seems to go down. But it does so for a good reason. The economy is not working properly. People don't know what projects will work and what ones won't. Besides, asset prices - which tend to support lending - are falling. Who wants to take a chance on lending money when the collateral might be disappearing? So, new lending tends to freeze up...until the period of shock, adjustment and restructuring is over.

The feds' theory is that they are merely putting idle resources to work...and getting the economy going again. What they are really doing is taking resources out of safe idleness, and wasting them on active projects that don't pay off. That is not the basis for a genuine new bull market. It is the basis for a big disappointment.

And it's adding nearly $2 trillion of new debt to the federal balance sheet each year.

But wait again...the government is not just borrowing money, it's also creating money 'out of thin air.' Surely, THAT will light a fire under the economy, no?

Well, yes and no. But it's too big a subject for this morning...

We'll save it for another day.

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

Debt Built Up to Levels Even Obama Says Are "Unsustainable", 10.0 out of 10 based on 2 ratings

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