The great destruction of wealth is just getting started: Kohler

We learned today that the global recession, as defined by rising global unemployment, is only just getting underway.


It might feel like it has been going for more than 12 months and you might be getting very tired of it already, but the collapse in the real economy is just a few months old – following the global economic “cardiac arrest” last October – and is now building a head of steam.

In the past 24 hours companies in the United States and Europe announced job cuts totalling 62,000, headed by Caterpillar’s decision cut its workforce by 20,000.

In addition there was Sprint Nextel (8,000), Home Depot (7,000), Pfizer (8,000), General Motors (another 2,000), ING (7,000), Phillips (6,000) Corus (3,500). Last week Microsoft announced 5,000 lay-offs, while in Australia BHP Billiton said it was cutting 3,000 jobs.

So the rise in unemployment, especially in Australia, is still in its infancy, as is the impact of the slowdown on corporate earnings.

Although this began as a credit crisis and will only end when the world’s banks are repaired and can reopen for business, what is now unfolding is the “reverse wealth effect” – the opposite of the consumer spending and business investment boom that came out of the housing and sharemarket bubbles.

In his latest letter to clients, Jeremy Grantham of the Boston-based investment firm GMO, lays out graphically how the reverse wealth effect works for the United States.

Assuming declines in value of 50% for the stockmarket, 35% for housing and 35-40% for commercial real estate, there has been a total loss in perceived wealth (my emphasis) of about $US20 trillion from a peak of $US50 trillion.

US GDP – the annual value of goods and services produced – is $US13 trillion.

“These write-downs not only mean that we perceive ourselves as shockingly poorer, they also dramatically increase our real debt ratios.”

The national private asset base of $US50 trillion was supported by debt of $US25 trillion. Now the asset values have fallen back to $US30 trillion, while the debt remains at $US25 trillion, “give or take the miserly $US1 trillion we have written down so far”.

Maintaining the same gearing ratio means the debt has to be written down to $US15 trillion. However, as Grantham points out: “As always, now that it’s raining, bankers want back the umbrellas they lent us.” That is, they are demanding lower gearing ratios – no more than 40%, not 50%.

That means $US12 trillion in debt, not $US15 trillion – half the current level. So somewhere between $US10 trillion and $US15 trillion in US needs to disappear.

That’s just the United States. The story is being repeated around the world – in the UK, Europe, Japan, Australia, Russia, Iceland and now China.

The decline in real wealth, and the amount of debt that has to “disappear” is almost unimaginable.

Short of finding another bubble to reinflate asset values, there are only three ways to do it: write the debt off, inflate the money supply and reduce the real value of the debt, or do what Japan did and take years – decades – to gradually save more and pay down the debt (that hasn’t actually worked for Japan yet, by the way).

Each of these three measures is now underway. Each is extremely painful and takes a long time.

The sharemarket has already anticipated a big decline in earnings with its fall of 50%. Is it enough?

The problem is that price/earnings multiples can change for long periods at the same time as profits fall. A profit decline of a third accompanied by a halving of the P/E ratio produces a price fall of two-thirds.

Over the next few weeks we will get a clearer idea of the likely decline in corporate earnings, although it’s clear that companies are already seeing what’s coming and are cutting staff in readiness.

No one can really know what’s coming – it’s too early in the process.

But as Grantham reminds us, only “make-believe assets” are being destroyed – that is, the inflated values of shares and houses.

“It is worth remembering that real wealth lies not in debt but in educated people, laws, and work ethic, as well as in the quality and quantity of fixed assets and the effectiveness of corporate organisation.”

When we have dealt with this crisis all of those assets will be sitting around waiting to be put to full use again.

This article first appeared on Business Spectator.


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