Public Debt Replaces Private Debt in the Name of Progress

The Dow fell 109 points yesterday. Gold was flat. Otherwise, all quiet on the financial front.

We’re keeping these reckonings short this week. Your editor is attending a financial conference in Vancouver. He doesn’t want to miss anything.

What have we learned so far?

Both Rob Parenteau and John Mauldin mentioned the danger of fiscal retrenchment. Tightening seems like the right thing to do. It IS the right thing to do. But it results in bigger deficits.

How could that be?

“It sets in motion a vicious cycle,” said Rob. The private sector is already correcting. If the public sector tries to correct its debt at the same time it puts even more pressure on households and companies. Their income goes down (less government spending). And their taxes go up. So they cut back. Jobs are lost. So tax revenues fall. So the government’s deficit increases and it must cut even more.

“That’s what is happening in Ireland. Ireland has done everything right. It cut spending just as it said it would. But the picture has deteriorated, not improved.”

What’s the solution? There is no solution. But both Rob and John implied that perhaps the government should wait for an upturn in the private sector before it begins cutting in earnest.

Here at The Daily Reckoning, we wouldn’t worry about it. First, we don’t think governments really are cutting in earnest. We think they’re just flirting with the idea. When the time comes to go upstairs, our guess is they’ll have to leave the party rather than get serious. Already, Hungary announced that it was fed up with austerity. When push comes to shove, will other nations stick it out? Probably not many.

Second, the real problem is still too much debt. It needs to be destroyed. The sooner, the better. Nobody ever said it would fun. But it’s better to get it over with.

That’s why a hands-off approach would have been much better in the beginning. After Lehman went down, the whole street was ready to fall. Households, businesses, banks – trillions in debt might have been wiped out overnight; we’ll never know.

Instead, we’re headed for Tokyo where they’ve had bailouts, boondoggles and counter-cyclical fiscal stimulus for 20 years. And for what?

“It would have been worse had the Japanese authorities not acted,” say the neo-Keynesians.

How they know that is a mystery to us. As it turned out, Japanese investors lost nominal wealth equal to three entire years’ GDP. And the economy today hasn’t grown in 17 years or created a single new job.

Nor has the debt been reduced. Instead of permitting the private sector to destroy and pay off its debt, the public sector fought against it…borrowing heavily to try to bring about a recovery. Result: no recovery…and almost exactly the same amount of debt. But while the private sector paid off its debt, the public sector picked up the borrowing. Now it’s the government that owes money all over town.

Is that progress, or what?

Meanwhile, ‘double dip’ sightings are becoming more frequent. Here, The New York Times brings joyless tidings from the housing industry:

Construction starts on residential buildings declined in June to the lowest level since October, the government reported on Tuesday, as the sector struggles with a tepid recovery and the end of a government tax credit.

The Commerce Department reported that housing starts in June were at a seasonally adjusted annual rate of 549,000, about 5 percent below the revised May estimate of 578,000. The June rate was at its lowest level since October 2009 and also fell below analysts’ estimates of 580,000, according to a Bloomberg survey.

The June figures were primarily the result of a 20 percent decline for condominiums and apartments.

Another indicator in the report showed that building permits for June were slightly higher at 586,000, up 2 percent compared with May, while those for single-family homes dropped to 421,000 in June, about 3 percent below the figure for May.

“It reflects what builders are thinking about the housing market,” said Patrick Newport, an economist with IHS Global Insight. Referring to the June figures, he said, “They just don’t think they are going to sell many homes, and for good reason.”

The median time to sell a home in the United States has crept up to about 14 months, he said. “We need to start creating more jobs,” Mr. Newport said. A better jobs market would generate demand and get construction back on track.

And this report from Charles Hugh Smith:

Financial analyst Meredith Whitney recently joined the ranks of those who foresee a serious decline in housing prices in the second half of 2010. Her reason: Banks are starting to unload higher-priced homes in their bulging “shadow inventory,” and with sales dropping sharply now that the federal tax credit for homebuyers has expired, there’s a massive mismatch between supply (rising) and demand (falling).

Evidence for falling demand is plentiful: Pending home sales have tumbled 30%, hitting two records. Mike Larson of Weiss Research recently said: “Demand has fallen off a cliff in the wake of the tax credit expiration, with pending sales falling by the biggest margin ever to the lowest level ever.”

The consensus is the sharp decline in home sales is the result of the federal tax credit ending, but few analysts have hazarded guessing where new demand will come from, absent the tax credit. Meanwhile, the supply of homes for sale or in default marches ever higher in all price segments.

To the surprise of those who reckoned that higher-end homes were holding up better than the rest of the market, the delinquency rate on investment homes with an original mortgage of more than $1 million is now 23%. And a staggering one in seven homes over $1 million is in default. Even the posh Beverly Hills zip codes have seen prices shrivel by 31%.

An Ever-Larger Shadow

Lenders are thus rightly worried that many of the 11 million homeowners who owe more than their house is worth – the 24% of homeowners who are “underwater” – will walk away from their mortgages, especially if the real estate market rolls over again. Such an increase in so-called strategic defaults would burden lenders with even more unsold homes – a category known as “shadow inventory” because lenders don’t always list a newly foreclosed home for sale immediately.

This shadow inventory could reach as high as 7 million homes by some estimates. Other analysts have calculated that it will take 103 months (about 8.5 years) to clear this gigantic inventory of foreclosed, distressed and defaulted homes.

To put these numbers in context: according to the US Census Bureau, 51 million households have a mortgage and 24 million own homes free and clear (no mortgage), and about 37 million households rent.

Even more sobering, the total number of vacant dwellings in the US increased to a record 19 million in the first quarter of the year, up from 18.9 million in the fourth quarter of 2009. As new homes continued to be constructed, inventory rose last year by 1.14 million to 130.9 million, while occupied homes increased by 1.07 million to 111.9 million.

Bill Bonner
for The Daily Reckoning

The Daily Reckoning