And I Lever

Bright are the stars that shine. Dark is the sky. I know this economy of mine will never die and I lever.

My apologies to Sir Paul McCartney. The U.S. had been carrying on a two decade love affair with ever-cheaper leverage and with easier access to potential borrowers (even those who should not have has access).

Once Paul Volcker broke the back of inflation Fed policy became relatively simple, when the economy stalled simply lower rates. Making monetary policy more accommodative enabled consumers to borrow more. It also enabled home owners to refinance homes at lower and lower rates and affordably tap home equity. Lowering rates put home ownership within the reach of an ever increasing number of people. This drove home prices higher (more pennies in the piggy) and encouraged home builders to construct McMansions on every available plot of land they could find. Not since the post-war days of William Levitt.

This all worked well as long as borrowing costs could be made cheaper when the economy stalled. However, lowering rates is a finite proposition. One cannot lower rates below zero and that is currently where the Fed Funds rate is, effectively. The second factor which led to two decades of economic growth was so-called financial innovation. Seeing mega dollar signs, banks and investment makes wanted to keep the gravy train rolling. To do this they had to find away to offer credit (leverage) to a wider ranger of potential borrowers. But how? Enter the Quants.

Wall Street began hiring quantitative mathematicians. They were literally rocket scientists. Financial institutions were led to believe quantitative formulas could account for any and every eventuality. However, formulas are only as good as the data which is inputted. Since prior data was from a time with more stringent lending standards there was no way the models could have been 100% reliable. They could not account for human nature, such as the reluctance to continue paying a mortgage on a home purchased with down payment. However, few bank executives questioned the models as the money was rolling in.

Although this all came to a head late in 2006, it had been building for two decades. Because this trend went on for so long, many market participants strategists, money managers and economists began to believe that short, shallow recessions and V-shaped recoveries were going to me the norm going forward. Many have been calling for a V-shaped recovery this time around only to be disappointed. For twenty years they have mistaken leverage-induced economic activity for real growth, in spite of falling real wages.

Where do we go from here? We will almost certainly live in a world with much reduced levels of leverage. Growth will be based on productivity. There is no re-levering this time around. Home prices will rise, but more gradually. Wages will rise, but not sharply. The stock market, following a small correction, will experience a small rally and will probably trade sideways for years, much like the 1970s as long-term borrowing costs gradually rise until they reach levels which inspire the next era of easing.

FYI: Don't be surprised if we see 12% unemployment