Leverage

By Dave Cantey 2013 11-24-13

For years now, we have gone on and on about DEBT, and how the current world-wide debt bubble, the largest in human history, will eventually crush the economy. How? The answer is found in what debt does, i.e., how debt works. To understand, one must realize that debt provides leverage. If you are a consumer, then debt allows you to spend more than you would be able to spend without debt. If you are a capitalist, then debt allows you to invest more. Leverage is what debt provides. The word leverage comes from the word lever, as in to pry. The problem is not leverage per se; rather, the issue is how much leverage. In the picture below, we see an example of 20 to 1 leverage. In an economic example, 20 to 1 leverage would mean that each unit of asset is composed of 19 units of debt and 1 unit of equity. (Asset value divided by equity value equals leverage; or, asset value minus equity value equals debt.)

In 2008, the banking system was leveraged at between 30 and 40 to 1, depending upon which bank we examine. When Lehman Brothers and Bear Sterns failed, they took down the entire economy because the whole banking system was grossly over leveraged. Since the crash of 2008, the economy is said to be deleveraging, which means that the amount of debt per unit of equity is supposedly being reduced to safe levels. Under the new Dodd-Frank rules, bank leverage is limited to about 10 to 1, which is considered a safe level for banks. The very definition of deleveraging, therefore, means a reduction in the total amount of debt in the system. So, how are we doing at this point? In 2008, total US debt was $53.5 trillion; now, total US debt is $57.6 trillion. Total US debt has increased by 4.1 trillion! So, if the banks are deleveraging from 35 to 1 in 2008, down toward 10 to 1 under Dodd-Frank, how can this possibly occur without collapsing the economy? Answer: The Fed. The central bank has moved the debt out of the banks and onto the Feds balance sheet by means of $2.7 trillion in QE. Please see that QE is solving absolutely nothing. It is postponing the problem, and the problem is now bigger than ever because there is more debt in the system than ever. The Fed is just setting us up for an even bigger disaster down the road. If total debt is up $4.1T, and the Fed has contributed $2.7T, where has the rest come from? Well, government deficits continue, consumers are buying new cars like crazy, and capitalists now have more margin debt (stock market debt) than at the peak in 2007. By the way, the total of all risky derivatives (futures, options, credit default swaps, ABS, etc.) in 2008 was $175.8 trillion; now derivatives total $231.6 trillion. You tell me, are we moving in the right direction to resolve the debt bubble? P.S. The Fed itself is now leveraged 54 to 1. Who thinks this is a good idea?