On July 1st, the mysterious and pseudonymous columnist going by the name of Spengler wrote “How to stop the Great Crash of ‘08.” In a very sobering piece, he pretty well outlined what was coming, and offered some prescriptions for ameliorating the catastrophe. He ended:

With the above presentation I have discharged my civic duty. The likelihood that the present administration and Congress will do anything remotely like this, of course, is vanishingly small. My advice to individual investors? Invest in some popcorn, because the next six months will be something to watch.

In today’s column, he comments further on the situation at hand.

Leverage is the secret of American wealth. The average American family in 2004 had a net worth of US$448,000 on an income of $43,000, according to the Federal Reserve’s survey of consumer wealth. Wealth equaled 10.4 years worth of income. In 1989, the Fed survey shows, it was only 7.3 years of income, and just 3.8 years worth in 1962. Measured in years, why should the ratio of Americans’ net worth amount to annual income have tripled between the administrations of John F Kennedy and George W Bush?

That is an odd result. It cannot be due to productivity, because productivity should show up in higher income as well as higher wealth. I suppose one could argue that expectations for higher productivity growth in the future than in the past might jack up the ratio, but that is hard to believe that is true after the collapse of the Internet bubble. The answer is leverage.

If the wealth-to-income ratio falls back to its 1989 level, the net worth of Americans would fall by a third. That is a frightening prospect, but it is not necessarily the bottom.

[...]

The trouble is that no one knows where the process will end. American households cannot be worth 10 years of income, but should they be worth seven years of income as in 1989, or just three years of income as in 1962? Where should American home prices find a level? If they return to the prices of 1998, they will fall by half, which is where homes offered in foreclosure are clearing the market today in California and Las Vegas.

Banks that provided the leverage for American households and corporations will remain under siege until asset prices find a level, and that will take two years, give or take a lifetime.

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