(2/1/10) U.S. stock prices have dropped like a stone over the past two weeks. Total market capitalization of U.S. stocks was $13.1 trillion at yesterday’s (1/31) close, down $885 billion from its $14.02 trillion peak on 1/19.

Some analysts think it was China’s monetary tightening that caused the drop in stock prices. Some think it was Obama’s announcements of new taxes and new regulations on banks. Some think that investors have simply lost their nerve.

It was Obama’s war on capital that caused the meltdown. The numbers below show total U.S. market capitalization–the total value of all stocks trading in all markets–at several key dates over the past 2 weeks.

On 1/11/10, before any of these things happened, the U.S. markets were worth $14.02 trillion, which we will use as a benchmark for our analysis.

On 1/12/10 Chinese officials announced they would tighten monetary policy. There were sharp changes in individual stock prices but on 1/13/10, two days later, U.S. market cap was essentially the same at $14.02 trillion. No big deal.

On 11/13/10, the evening before Obama announced the punitive tax on big banks–$117 billion collected over 12 years. On 1/19/10, six days later, U.S. market cap was essentially unchanged, at $14.02 trillion. This makes sense. An ostensibly one-time tax of $117 billion, collected over 12 years, is only worth $66 billion in today’s dollars at a 10% discount rate–a rounding error in market cap numbers.

Obama Bank Tax Estimates

On 1/21/10, Obama dropped the bomb. He essentially announced the breakup of the banking industry, imposing limits on the allowable size and business activities of a bank, measures that would force banks to divest many of their most profitable operations. U.S. market cap fell by $740 billion (6.3%) from $13.88 trillion to $13.14 at yesterday’s close. Altogether, market cap fell by $880 billion since Obama started meddling with the banking system. This $880 billion was sucked directly out of the value of U.S. pension assets and household net worth. An anti-stimulus plan if I ever saw one.

Way to go, “O”.

It is obvious why Obama is attacking the capital markets. Republican wins in Virginia, New Jersey and Massachusetts driven by public rejection of his health care plan have undermined public support and put the mid-term elections in jeopardy. The public is angry. Obama would like to redirect that anger on someone else. Hence the war on banks.

We can’t afford Obama’s war on capital. The cost of punitive policies, in lost net worth, slower growth and fewer jobs, will fall directly on the people he claims to want to defend–the middle class. Unfortunately, this may be just the beginning of the Obama Inquisition. Stay clear of the stock markets until it is over.

JR

The latest business loans numbers show that bank loans to businesses are still falling. As I have written in recent posts here and here, large banks have systematically shut down their lending to small businesses over the past 2 months, an unintended consequence of the hugely profitable government bailout programs. Basically, today if you can’t sell it to the government don’t bother making the loan.

The chart above, from the Federal Reserve Bank of St. Louis, shows commercial and industrial loans from all banks. Banks have loaned approximately -$100 billion to U.S. companies since last fall. Tough to make payroll when you have to pay more to the bank than you get from the bank.

The latest weekly figures, above, show that banks have reduced loans to businesses by $15.8 billion–roughly -$4,000,000,000 per week–in the past month alone. That does not mean there is less borrowing; it means there is negative borrowing. Banks have forced their business customers to actually pay down their loan balances by $4 billion per week. The only way to do that in a small business is to lay off a worker or sell some inventory or other assets at a deep discount.

Essentially all business loans are small business loans–big public companies get their working capital in the commercial paper market. This is a major reason why employment continues to fall.

This is not the end of the world. I wrote a few days ago, in a piece called Time to Think About the Next Story-Inflation, Rising Rates, Commodity Prices, Weak Dollar, that the tsunami of bank reserves released by the Fed over the past six months is hugely profitable for banks and will eventually force a reopening of the credit markets. This chart is just to remind you that it is going to take longer to show up in jobs numbers than it has in bank stock prices.

JR

One of the (many) problems with using big increases in federal government spending as an economic stimulus tool is timing. You can’t appropriate and spend it fast enough to matter much during the downturn. Spending it years later, after the economy has already begun to recover on it own, then becomes an inflation worry.

There is a new CBO study, Implementation Lags of Fiscal Policy, that details the path of the money this time around. In spite of all tyhe talk we have seen about shovel ready projects not much of the money has actually made its way into the economy yet. As you can see in the figure above, except for HHS and the Dept. of Labor, less than 2% of the money appropriated to all other departments (Education, Transportation, Energy, …) has been spent. The total spent so far is just $24.6 billion out of $379 billion.

This chart details how much of the $787 billion in stimulus money will hit the economy each year over the next three years. As you can see, only 11% of the $308 billion appropriated to discretionary spending like highways, mass transit, energy and education will be spent by the end of this year. Overall, less than a quarter of total funds will be spent in 2009.

Why is this s problem? Because there are early signs of recovery coming in now every day. By the end of this year the recovery will be undeniably underway. That means next year (2010) and the year after will be periods of rapid growth and rising inflationary worries. That’s why bond yields have increased by more than a full percentage point in recent weeks with more to come over the coming months. And that’s one of the reasons why commodity prices have been rising so fast.

Investors should be very careful to avoid long-term Treasury bonds today

JR

The Dept.of Commerce released the April Personal Income and Outlays report today. Could have been worse. Personal income was $12,091 billion, an increase of $58.2 billion, or +0.5% over March. Disposable personal income (DPI) increased $121.8 billion, or +1.1% in April. Personal consumption expenditures (PCE) decreased $5.4 billion, or 0.1%. Real disposable income increased +1.1% in April.

The April change in disposable personal income (DPI) – personal income less personal current taxes – was boosted as a result of government stimulus measures, which reduced personal taxes and increased social benefit payments. Even without these factors, however, disposable personal income increased $77.1 billion, or +0.7%, in April.

The increase in peronal income did not come from higher compensation. Private wage and salary disbursements decreased $1.3 billion in April. Goods-producing industries’ payrolls decreased $11.4 billion; manufacturing payrolls decreased $3.7 billion. Services-producing industries’ payrolls increased $10.1 billion. Government wage and salary disbursements increased $4.4 billion.

It was the temporary tax relief. Personal current taxes ($1182.4 billion) decreased $63.6 billion in April, compared with a decrease of $34.1 billion in March; down sharply from $1517.7 just six months ago. The Making Work Pay Credit provision of the stimulus plan reduced personal taxes $49.8 billion in April and $11.2 billion in March. The provision allows a refundable tax credit of up to $400 for working individuals and up to $800 for married taxpayers filing joint returns.

Sustainable increases in disposable income won’t happen until employment starts to rise again. And jobs can’t grow until small businesses have access to bank loans for working capital. As I wrote in a recent post, business loans are still falling. When loans turn  up, so will jobs and personal income.

JR

This morning I woke up in the dark to do a 7AM spot with Alexis on Fox Business Money for Breakfast. Our topic was Geithner’s first trip to Beijing to meet with the Chinese officials on U.S./China economic issues. What issues would be on the table?

That’s easy. They want to know what the U.S. is going to do to protect their $2 trillion in U.S. Treasuries and other dollar-denominated securities from inflation and a falling dollar. Doogie is going to try to convince them that we have it all under control—we will get that deficit down soon as the economy starts to grow again. They won’t buy it.

A few weeks ago I received a request for a private meeting with Vice Premier Zeng Peiyan to discuss economic issues between our countries. He was most eager to understand two things. First, why was the U.S. government spending so much money on the stimulus packages. (China’s stimulus package was not as big as advertized, mainly accelerated infrastructure projects that were already in the budget.) Second, why was the Federal Reserve flooding the market with dollars? Bank reserves in the U.S. have increased from $85 billion one year ago to roughly $1000 billion today.

I explained that the crisis first became visible in June 2007 when banks revealed they were holding some $300 billion of toxic (covenant-light) leveraged loans. From then until August, 2008 the Fed talked stimulus but walked tight money–bank reserves grew only 1% during this period–because the Fed acted to sterilize the impact of their newly-announced liquidity measures (Bear Stearns, AIG,…) by selling Treasury bills from their portfolio (idiots!). But in September, after the near run on money market funds, after depositors began to take money out of their banks in earnest, and after Lehmann died the Fed panicked and started shoveling reserves into the banking system, which is why reserves have increased 10x in 8 months.

Explaining the budget explosion was not so easy. Some economists in Washington actually believe that increasing government spending raises GDP growth like it says in the textbooks. (I am not one of those economists.) But most of the spending increase was the result of Hank Paulson’s ($700 billion) power grab last fall and the change in administrations that allowed the Obama team to come in and take advantage of the crisis by adding every program they have ever dreamed of to the Federal budget. As a consequence, Obama’s first (2010) budget will spend $1.8 trillion more than revenues and the CBO projects deficits of roughly $1 trillion per year, basically forever. (And the budget does not yet include national healthcare!)

To a holder of $2 trillion in U.S. securities all this isn’t the best news. He then asked a third question: what can china do to protect the value of its assets from U.S. inflation and a falling dollar? I told him that if I were in his shoes I would have a quiet conversation with Geithner and arrange a private transaction in which he would swap all his Treasury holdings for inflation-protected Treasuries, or TIPS.

I wonder what they are talking about at the meetings in Beijing today?

JR

Note: When I wrote this explanation of budget deficits and interest rates just a year ago as a chapter of my book, Lessons from a Road Warrior, we were in a different world where budgets mattered, at least a little. We argued about deficits of $100 billion or $200 billion, and never had to use trillion in polite conversation. Today, government spending is completely out of control. Since last fall, when Congress was railroaded into giving Treasury Secretary Paulson complete discretion over spending $700 billion for the TARP bailout plan all semblance of fiscal discipline has been destroyed. Obama’s team quickly used the financial crisis to add another $1.2 trillion of spending and has added or expanded countless spending programs in his first budget. As a result the deficit for Obama’s first full budget year is likely to approach an incredible $2 trillion–not including the cost of his proposed national healthcare program. Trillions more have been provided by the Federal Reserve, without congressional approval or oversight, by taking on the authority to add all sorts of assets to their once-pristine balance sheet.

I decided to leave the numbers and the charts unchanged from the original examples in part to highlight the difference between then and now. The analysis remains unchanged. Balance sheets are still huge compared with private saving and private and government borrowing. It still takes a huge amount of government borrowing to move the needle on interest rates. And the most important question for interest rates is still whether anything is going on to change people’s willingness to hold the securities that are already outstanding, not how many new ones the Treasury is selling. But today the numbers are big enough that people all around the world are taking notice and reevaluating whether they want to hold dollar assets. This is the most important economic question of our time.

—–

Textbooks have it all wrong when they teach students that interest rates are determined by the supply and demand for credit. For example, a leading finance textbook (Investments, by Bodie, Kane and Marcus) states:

Forecasting interest rates is one of the most notoriously difficult parts of applied macroeconomics Nonetheless, we do have a good understanding of the fundamental factors that determine the level of interest rates.

1. The supply of funds from savers, primarily households.
2. The demand for funds from businesses to be used to finance investments in plant, equipment, and inventories (real assets or capital formation).
3. The government’s net supply of or demand for funds as modified by the actions of the Fed.

These statements are wrong, wrong, wrong. Had you acted on them to structure your investments over the last 30 years you would have lost all your money. Interest rates are simply a calculation we make from asset prices, as I explained in a recent post. Asset prices are determined in asset markets by existing asset supplies and the demand to hold existing assets. In spite of what the textbooks tell you, throughout history, the correlation between interest rates and deficits is actually negative; i.e., higher deficits are associated with lower interest rates. The drawings below explain why.

Interest rates are not determined by savings rates and are not determined by the demand for credit. As a logical matter, it is debt, not deficits, along with people’s demand to hold different types of assets, that determine interest rates.

Budget deficits in the ranges we have historically seen them—a few hundred billion–don’t matter much for the economy. Not for interest rates. Not for growth. The multi-trillion dollar bond markets don’t care at all whether the government is a net seller or a net buyer of $100 billion in new Treasury securities in a given year. They care whether the people who own the old paper today are still going to want to own it tomorrow. And that will depend on whether something happens to change people’s minds about future after-tax returns on bonds relative to other assets–period. The rest is all rounding errors. Nothing else matters.

When the Treasury holds an auction to finance a deficit, they print and sell new T-bills or other Treasury IOUs (notes and bonds) to investors like Aunt Tilly. This isn’t the first time the government has borrowed money from private citizens. Aunt Tilly and other investors already own a huge stock of similar old T-bills—$5.1 trillion worth at the end of 2007—that we call the national debt. At the end of last year, there were $9.2 trillion of old T-bills outstanding—the government’s accumulated borrowing since the time of George Washington. Of those, $5.1 trillion, or 55%, was held by private investors like you, Aunt Tilly and me.

New treasury paper and old treasury paper are perfect substitutes to investors. Not almost perfect substitutes—perfect substitutes. In practice, they are indistinguishable in the market. T-bills, notes and bonds are also very good substitutes for many other securities owned by investors, including agency securities, corporate securities, municipal securities and securities issued by financial institutions. These, in turn, are substitutes to some degree for equities, foreign securities and tangible assets in the minds of investors. When you buy a bond, you shop for its issuer, its maturity date, its call provisions, its tax features, and its yield—not its model year. This means that new bonds and old bonds that are the same in every other way must sell at the same price. Arbitrageurs make sure they do.

It’s like the commercial where the dad asks his teenage son to drive to the local gas station to put gas in the family car. Hours later, the dad is still standing in the driveway when his son returns with the explanation, “But Dad, you didn’t want me to mix the new gas with the old gas, did you?”

Bond investors mix the new bonds with the old bonds all the time.

Flow-of-funds is a theory to explain the price of new bonds. Portfolio balance is a theory to explain the price of old bonds. But in the real world, there can only be one price for all bonds. Which theory wins? Portfolio balance, because almost all bonds are old bonds. The important question is not whether the government will borrow money this year. It is what price it will take to make Aunt Tilly—and all the other investors who owned T-bills yesterday—still want to own the stock of T-bills tomorrow.

But balance sheets do not sit still; they grow over time. The stock of tangible assets grows as a result of building houses, factories, shopping centers and new cars faster than they wear out. The stock of private financial assets grows as people issue mortgages to finance home purchases, and companies issue new stocks and bonds to finance capital spending, home construction and durable goods production—at a faster rate than the old ones mature. We create new government securities to finance the budget deficit, or we destroy them by using a budget surplus to buy back debt.

As our net worth grows, so does our appetite to hold all assets. This growth is represented by drawing a second pie chart showing the larger stock of stuff (tangible assets) and financial assets. Historically, U.S. balance sheets have grown at about 7% per year.

Higher net worth gives investors like Aunt Tilly an appetite to own more T-Bills too, as illustrated in the drawing. You can think of this appetite as thousands of Aunt Tillys standing in line in front of the Treasury building, waiting to place orders for the new T-bills that the government will sell next year (to add to the ones they already own).

That appetite is larger than most people think. If net worth grows 7% next year, as it has done historically, investors will want to increase their holdings of T-bills by $357 billion, from $5.1 trillion to just under $5.5 trillion.

If the Treasury issues just enough new T-bills to satisfy Aunt Tilly’s appetite, then everyone will go away happy. There will be just enough T-bills to go around. Prices will remain the same as they were last year. Interest rates will remain unchanged.

But what would happen if the treasury issued too few or too many T-bills to satisfy investors’ appetites? That’s easy. There would be a scuffle. If they were too few T-Bills for sale due to a smaller government deficit, then Aunt Tilly would wrestle with the other investors for the limited supply. This would drive T-Bill prices up and interest rates down.

If the government ran up the deficit and there were too many T-Bills for sale, then the Treasury would be forced to lower their asking price to sell their inventory. T-Bill prices would fall and interest rates would rise.

It is only to the extent that budget deficits exceed Aunt Tilly’s appetite for new securities that they can be said to push interest rates up at all. In our example, we can think of the $357 billion from the previous example as the interest rate neutral budget deficit—one that will put no pressure on interest rates. The balanced budget that we all wish for would actually exert downward pressure on interest rates every year. Over time, government debt would gradually become extinct like the dodo bird; it would be irrelevant for investors.

This does not mean that I love budget deficits. It does not mean that deficits are good or bad. And it does not blunt the fact that higher government spending uses tons of resources and creates all sorts of incentive and resource allocation problems. It just means that budget deficits are unlikely to be a factor in determining interest rates in the range in which we have historically seen them.

If deficits don’t determine interest rates, then what does? The answer is any factor that could drive a wedge between the relative returns on different assets. Higher inflation does that by increasing the return on tangible assets (i.e., the gain on owning a home raises its return) relative to returns on securities. That makes people sell securities to increase their holdings of real assets, like we saw during the 1970s, which drives interest rates higher. Lower income tax rates increase the after-tax returns on taxable securities relative to real assets, for example, because people are forced to report all income from securities on their tax forms but are not required to report the value of living in their home as taxable income. This will drive interest rates lower. Rising productivity growth can quicken net worth growth, which will increase Aunt Tilly’s appetite for all assets and drive interest rates lower. And the Fed can influence the rate of net worth growth by making it easier or more difficult to finance investments.

JR

The credit crisis is all you hear about from officials in Washington and from talking heads on TV. Indeed, the credit shortage is still alive and well. Employment is still falling and small business owners–the only real source of new jobs–have an even tougher time getting working capital loans from banks than they did 2 months ago before bankers fell in love with the new government bailout plans. But it’s time for investors to move on to the next story.

The credit crisis is ending. The wall of money created by the Federal Reserve to extinguish the credit crunch and deflation that they, themselves, had created has rigged the deck so banks will make money. The banking system today is being run as a de facto monopoly bank by the Fed. The Fed is paying them interest on reserves, which at $990 billion are roughly ten times the level they were just eight months ago. Over the same period, bank depositors withdrew roughly $90 billion from their bank accounts to keep at home just in case their bank failed. As I pointed out in a post yesterday, there are signs people are beginning to exhale–currency holdings are no longer rising. When they once again feel safe they will put that $90 billion bank into their accounts, which will swell bank reserves by the same amount from 10x to 11x times last August levels.

This tsunami of reserves since last September translates into bank profits at no risk. The Fed pays the same 0.25% interest on bank reserves whether the bank lends the money to customers or not. How much? One quarter percent of the $1 trillion reserve increase equals $2.75 billion per year in incremental bank earnings. The spread between deposit rates–effectively zero–and lending rates, including fees is huge. And the FASB accounting rule change at the end of the first quarter that allowed boards of directors the leeway to value assets based upon their expected cash flow rather than firm quotes from dealers was a huge boost to bank balance sheets. That’s why bank stocks have knocked the lights out since then. And those reasons are why bank stocks have been the biggest bet in my portfolio this quarter with returns 17% over the market so far this year.

Now it’s time to change the bet gain. I still have big bets on bank and financial stocks but have been increasing my exposure to two other bets, China and inflation. Both bets have been working nicely.

My visits with Chinese leaders and Asian CEOs at the BOAO Forum in April convinced me that we were going to see a long string of positive growth surprises from China and its main suppliers around the Pacific Rim–Singapore, Hong Kong, Australia and Indonesia.

The inflation bet is still early. But the recent run of commodity prices and weakness of the dollar suggest it is not too early. Once the credit crunch and recession are off the front page people are going to focus more and more on two factors. First, the Fed tsunami of bank reserves will sooner or later translate into rising price levels. If the Fed allowed the reserves it has already created to remain in the market after the crisis is over the U.S. price level would rise to about 9x its current level over a small number of years, i.e., the $3 vanilla latte you bought at Starbucks today is going to cost you $30–you better start saving your money. Of course, the U.S. political system will not allow a nine-fold increase in the price level so sooner or later the Fed is going to have to take steps to reduce bank reserves. Hint: the same guys who brought you the current disaster are going to be the ones who will be in charge of shrinking reserves. This is not going to be elegant.

The other reason, of course, is that government spending is completely out of control. Ever since last fall when Treas. Secretary Paulson convinced Congress to give him $700 billion to spend however the hell he wanted with no controls or oversight the barn door has been open. Obama’s team has pushed trillions of dollars of new spending through that door in the space of a few months. The result is the $3.5 trillion budget Obama proudly presented to Congress. That budget projects budget shortfalls of roughly $1 trillion per year for the next decade. And that does not even include the added cost of his new national healthcare system.

Those huge spending numbers, of course, mean that Congress will soon increase every tax rate in the book including taxes on ordinary income, dividend income and capital gains as well as higher corporate taxes. We can also expect increased excise taxes on tobacco, liquor, and energy of a forms. Last week the White House also floated the idea of adding a national sales tax–they call it a value added tax–that would be a huge increase on working families. The problem is these tax rate increases are not going to generate much revenue–they never do–because people can easily avoid them by either using tax shelters or by simply deferring or avoiding the realization of income. Over the past 6 decades tax rates have varied all over the map but tax revenues, the amount people actually pay, has been 19% of GDP +/= one percent.

If spending is out of control and the government can’t raise more tax revenue we are going to have massive budget , or budget deficits, shortfalls every year. The Treasury is going to have to sell truckloads of new Tbills and bonds into the market every year as well as roll over the ones already out there. That is the scenario that is now beginning to spook the bond and currency markets. Big bank reserve growth, big spending increases and big budget deficits mean the market is being floods with dollar assets, which has to drive down the value of all assets denominated in dollars. That’s why the long Treasury bond yield has increased by more than 100 basis points, or one full percentage point, in recent weeks. And the dollar is posting new lows against both the Euro and the pound. And that’s why the vice Premier of China asked me last month if there was a way China could protect its $2 trillion Tbill portfolio against inflation and a falling dollar.

Faster growth in China and higher inflation point you in the same direction–commodity stocks. I have been increasing my exposure to oil (STO), coal (BHP) and copper and metals (FCX). I expect to add more to these positions next week.

It has been a long time since we needed to worry about the impact of budget deficits on interest rates. But now we do. The best analysis I have done on the topic is Chapter 4 of my book Lessons from a Road Warrior. Over the next few days I will write a series of blogs to help readers think through the issue.

JR

The amount of currency people hold in their pockets and under their mattresses is the single best indicator of the level of fear on main street. Since last summer, when people first got the wind in their nostrils that banks might fail in big numbers, individual depositors have withdrawn roughly $90 billion from their bank accounts “just in case.”

To put that number in perspective, the total reserves of the U.S. banking system last summer before people got spooked was $85 billion.

In recent weeks, however, people have stopped taking $100 bills out of their bank accounts. Total currency held by the public was $849.4 billion on May 18, less that it was a month earlier ($850.1 billion on April 20.) I think it is a sign people are beginning to unclench their buttocks and become a little less afraid. That’s a great sign for spending. When people became frightened last August/September they slammed their wallets shut and stopped buying everything. That’s when the economy fell off the table, inventories spiked up and employers began laying off workers in a hurry.

When the public exhales and put their money back in the bank there will be a rebound in spending. There will also be a further $90 billion spike in bank reserves, which will eventually show up as lending. I don’t know about you, but I can’t wait to see this happen.

JR

The new U.S. Financial Data report out today from the St. Louis Fed shows that bank loans to business are still falling. This fits what we hear from entrepreneurs, that large banks have been systematically reducing availability of working capital loans for small companies—likely an unintended consequence of the Treasury bailout programs that make it bad business to make any loans that are not salable to the government.

The chart above shows that the lion’s share of the more than $100 billion (left scale) cut in total bank business loans since last fall is attributable to large banks (right scale). Small banks that do not have full access to the Treasury programs are still making loans.

Banks lend money to small companies, not big ones. Job gains (and losses) come from small companies, not big ones. That’s why this chart tells us we are going to see another lousy job report next week. I think we still have several months of job losses ahead of us before employment turns up again.

JR

As you know from my recent posts, I spend a lot more time thinking about balance sheets and a lot less thinking about GDP, than most economists. In this post I want to look at the balance sheet of the household sector. The most recent data from the Fed’s Flow of Funds report show that at the end of Q4/2008 (12/31/08) households (including nonprofit organizations) owned the following mix of assets.

Households hold 62% of their assets ($40.8 trillion) as financial assets like deposits, T-bills, bonds, stocks and mutual funds. They keep 31% ($20.5 trillion) in real estate assets, and they hold 7% ($4.4 trillion) in the form of consumer durable goods like used cars, old washing machines and computers (in all 38%, or $24.9 trillion in tangible assets). As I have written for years, these percentages represent portfolio choice decisions for people based on their perceptions of return and risk for each asset class. These portfolio decisions are exquisitely sensitive to changes in tax rates and monetary policy.

The table above shows the history of household balance sheet composition. The first thing to notice is the household balance sheet numbers are huge when compared with GDP (roughly $14 trillion per year) or its components like consumption, investment, net exports and government spending. At the end of 2008, people owned $65.7 trillion worth of total assets, made up of $24.9 trillion of tangible assets and $40.8 trillion in financial assets.

The tangible assets, in turn, can be divided into $20.5 trillion in real estate assets and $4.4 trillion in consumer durable goods. It makes sense that the assets on our balance sheet are so big. They represent all the economic activity that has ever happened–all the buildings we have built, all the cars and washing machines we have ever made–less the ones that are no longer in service. In the case of autos, for example, there are more than 15 used cars and trucks on the road and in the driveways for every one that will be produced (i.e., that will appear in the GDP accounts) in the U.S. this year.

In spite of what you read in the headlines, total household liabilities, including mortgages, installment credit and credit cards, add up to just $14.2 trillion. Net worth is a whopping $51.5 trillion–more than 3.6 times total debt and almost five times disposable personal income of $10.6 trillion.

So where is the financial crisis we read about? It is in the behavior of asset values over time. Our net worth of $51.5 trillion is $12.9 trillion (20%) lower than it was just 6 quarters earlier in Q2/2007. That puts our net worth roughly where it was at the end of 2004 ($51.9 trillion) but still much higher than it was a decade ago in 1997 when it was $33.3 trillion.

You can also see from the figures when the trouble started. Tangible asset values peaked in Q1/2007 at $28.4 trillion; since then they have declined by $3.5 trillion or 12.3%. Financial assets peaked 2 quarters later in Q3/2007 (when the leveraged loan and asset-backed securities markets froze up) at $50.5 trillion but have declined by $9.7 trillion or 19.2% since then. Essentially all the adjustment in both types of assets was due to price decline; the physical stocks of tangible and financial assets did not materially change during this period.

When asset values change abruptly, as they did over the past two years, it is always a demand story. That’s because over a short period asset supplies can’t change by much because new asset creation and retirement are small compared with the stock of outstanding assets. In this case it was the sudden drop in demand when investors pushed away from the asset-backed securities market a year and a half ago.

JR