On Thursday The Big Picture had some excerpts from the January newsletter of GMO, a global investment firm. The comments were written by Jeremy Grantham, the chairman of GMO’s board, and are absolutely fascinating, if not easily quoted on a blog like this.
The excerpts at The Big Picture were run under the title Grantham assigned the first section of his newsletter, “Greed + Incompetence + A Belief in Market Efﬁciency = Disaster,” and they are worth a moment of your time. If you want to worry about the people Obama has picked to pilot the boat during this storm, check it out.
But the the part that really stunned me was Grantham’s discussion about the scale of the economic disaster, especially when it comes to write-downs and private debt. Keep reading for more.
From GMO Quarterly Letter (PDF.)
But let us look for a minute at the extent of the loss in perceived wealth that is the main shock to our economic system. If in real terms we assume write-downs of 50% in U.S. equities, 35% in U.S. housing, and 35% to 40% in commercial real estate, we will have had a total loss of about $20 trillion of perceived wealth from a peak total of about $50 trillion. This relates to a GDP of about $13 trillion, the annual value of all U.S. produced goods and services. These write-downs not only mean that we perceive ourselves as shockingly poorer, they also dramatically increase our real debt ratios. Prudent debt issuance is based on two factors: income and collateral. Like a good old-fashioned mortgage issuer, we want the debt we issue to be no more than 80% of the conservative asset value, and lower would be better. We also want the income of the borrower to be sufﬁcient to pay the interest with a safety margin and, ideally, to be enough to amortize the principal slowly. On this basis, the National Private Asset Base (to coin a phrase) of $50 trillion supported about $25 trillion of private debt, corporate and individual. Given that almost half of us have small or no mortgages, this 50% ratio seems dangerously high. But now the asset values have fallen back to $30 trillion, whereas the debt remains at $25 trillion, give or take the miserly $1 trillion we have written down so far. If we would like the same asset coverage of 50% that we had a year ago, we could support only $15 trillion or so of total debt. The remaining $10 trillion of debt would have been stranded as the tide went out!
Grantham goes on to argue that “somewhere between $10 and $15 trillion of debt will have to disappear.”
While these are sobering, if astounding, numbers, Grantham does point out that a lot of this is related to the perception of wealth and the emotional confidence John Maynard Keynes termed “animal spirits.” In other words, he points out, your house is still your house, even if your mental concept of how much it is worth is drastically different. And dollars are worth more!
Still, I wonder if folks are getting a clear picture of how much wealth has vaporized. This article in The Oregonian yesterday gives an idea how reluctant some are to admit the severity of the economic situation:
Nobel Prize winner Paul Krugman gave a far more dire economic forecast in Portland last week than Oregon experts continue to present.
Krugman, a Princeton University economics professor and columnist for The New York Times, predicts — at a minimum — several years of a depressed economy. He calls the recession’s resemblance to the Great Depression “extremely frightening” and finds new signs of collapsing global trade shocking.
That vision starkly contradicts the opinions of Oregon economists, who generally predict the economy will bottom out this year and begin recovery in 2010. The discrepancy is partly philosophical, but could also reflect pressures on local economists to avoid presenting nightmare scenarios.
Frankly, I’ve been wondering if Krugman was being a little too gloomy at times, but perhaps not, given the new realities.
To bounce back to Grantham a moment, he offers four possibilities for reducing private debt, and I’ll simply paraphrase the hell out of it, with apologies to economists everywhere. We could have gigantic write-downs, we can do what Japan did and try to let the passage of time reduce private debt as we slowly work our way forward, or we can have massive inflation that will devalue the debt. The fourth, and worst possibility, would be to start another bubble in another market sector, ala Greenspan, if I understand Grantham’s thinking here. Grantham does not think there’s a sector to do it in anyhow, so it may be a moot point.
There appear to be no palatable options. But as I try to get my puny little non-economist brain around all of this, the best way to go might be to insist on massive write-downs combined with a nationalization of the banks. Right now we seem to have the worst of all worlds, with zombie banks continuing to paralyze the economy. This disaster is already going to cost the taxpayers a king’s ransom, so we might as well get on with it so we can start building back a sane financial system.