Deleveraging

There are several publications that I read weekly, The Economist, Bloomberg Businessweek, TIME Magazine, and the occasional Foreign Affairs when I have time.  However, there is one website that I value dearly: The Motley Fool.  The reason I like the The Fool is because it stresses investing, not trading.  It is a fantastic resource for anyone looking to dabble in the stock market and retire with more wealth than you have now.  In addition to stock advice, the Fool has some amazing articles every so often that go largely unnoticed by the public at large.  Don’t worry TMF, this Fool noticed.  On April 24th, Morgan Housel penned an article called “Why It’s So Much Better Than the Great Depression” that articulated just how bad the Great Depression was compared to the Great Recession.  While the whole article is a must read, I found the explanation put forth by Ray Dalio extremely helpful in understanding where we are and what lies ahead. 

“Imagine someone who makes $100,000 a year and has a net worth of $100,000 with no debt. That person can safely borrow about $10,000 a year for several years, meaning they can spend $110,000 a year even though they only make $100,000. The flip side to all that spending is that someone else is earning$110,000 a year. “For an economy as a whole,” Dalio writes, “this increased spending leads to higher earnings, that supports stock valuations and other asset values, giving people higher incomes and more collateral to borrow more against, and so on.” That describes our economy from 2000 to 2007.

But it can only last so long. Eventually, debt service payments take up too much of income, and everything breaks apart. “The person spending $110,000 per year and earning $100,000 per year has to cut his spending to $90,000 for as many years as he spent $110,000,” to pay down the borrowing spree, says Dalio. That means some one else can now only earn $90,000. And it means the economy grinds to a halt, as it has since 2007.”

Now that you get the idea behind deleveraging, you understand where we are and where we are headed.  We are by no means out of the woods yet, and there is still a bunch of uncertainty in the market regarding QE3, the spending cliff of Jan 2013, and the upcoming elections in November.  But thus far, this financial crisis has been handled pretty well and policy makers are just waiting to see how the economy reacts.  Take a look at the chart below to see where we are compared to what could have happened.

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