Is The Consumer Really Deleveraging?
This morning my friend Cullen Roche at PragCap (a daily must read site as I have stated before) posted an excellent piece by Richard Koo discussing the "balance sheet recession." Cullen's accompanying points are critical to understanding where we are in the current credit cycle and the long term implications for organic economic growth to resume.
“If people who had been paying down debt to repair their balance sheets had actually resumed borrowing, it would mean that balance sheet problems were behind us. However, the fact that the latest colored bar in Figure 1 is above zero indicates that US households are still paying down debt.
Inasmuch as this act of reducing financial liabilities in spite of zero interest rates runs counter to the principle of maximizing profits, it suggests that US households continue to undertake balance sheet adjustments.”
"I think Koo’s view is confirmed by the NY Fed’s latest data on quarterly household debt trends. They showed another quarter of de-leveraging. But the balance sheet recession isn’t an event. It’s a process. And the process is very clearly moving in the right direction. For instance, see the improvement in consumer borrowing year over year:
We’re obviously digging out of a deep hole there, but we’re digging. Household debt is on the verge of turning positive. There’s still a lot of work to be done here and the recovery remains fragile, but we’re moving in the right direction. I’d previously estimated that the balance sheet recession could be over by 2013/2014. That could be a bit optimistic if you consider “the end” a return to historical trend debt accumulation of about 7%, but we’re moving in the right direction. Just one more reason why it’s so important for the government to remain supportive of very weak private sector trends here…."
However, I think the discussion needs to go further in order to fully understand the implications of the deleveraging process and the impact to future economic growth.
First, while there is a LOT of exuberance currently about a return to higher rates of economic growth in 2013 it is important to remember that we have yet to see and evironment of economic growth without artificial supports. Each time liquidity interventions by the Federal Reserve have waned, or ended, so has economic growth. As shown in the chart below you can see the lag effect as liquidity is drained, or added, to the system.
Secondly, the consumption by "Households" current makes up more than 70% of GDP. The chart below shows real (inflation adjusted) personal consumption expenditures as a percent of real GDP.
Therefore, in order to really understand the implications of the balance sheet deleveraging process we must first understand where the deleveraging is actually occurring and the impact on future consumption capability.
The next chart shows the consumer deleveraging process as most often shown by various media outlets. The chart shows the real growth of total consumer debt (credit and mortgages) since 1960. The green mountain of debt, and the deleveraging that has occurred, is what is generally used as evidence that the balance sheet recession is nearly concluded. However, I have added the red dashed line to provide context of where the deleveraging process will need to get to in order to return to the normalized trend of debt accumulation taking into account historical rates of income, population and economic growth.
However, while it is clear that the consumer has been deleveraging debt - the question of WHERE that debt reduction has occurred still remains unclear.
To answer that question the next chart strips out the household mortgage debt and looks solely at the bulk of the remaining credit. This is debt that is generally at higher interest rates than mortgage debt and has a much greater psychological impact on consumer behavior.
What is clear is that the only real deleveraging that has occurred has been in mortgage related debt. However, this has not been the function of consumers becoming more responsible and paying off their mortgage debt but rather through:
- mortgage forgiveness
- write downs
- charge offs
- short sells
These are hardly healthy processes of deleveraging that lead to stronger future consumption. More importantly, the majority of these activities have been through the support of some form of governmental intervention (HAMP, HARP, Settlements) that also are not part of the natural deleveraging process. Case in point, many of the home owners that went through a mortgage rework process wind up re-defaulting within six months.
Cullen is absolutely correct when he states that we are still digging our way out of a hole. However, that "hole" is likely much deeper than most understand. While we are seeing signs of economic growth, albeit weak, it has been primarily driven by artificial influences from suppressed interest rates to direct interventions through fiscal and monetary policies. Without these interventions it is likely that we would have very little, if any, real organic growth.
Consumers are trapped by a rising cost of living which exceeds their income growth. In order to maintain their standard of living they are forced to reduce their savings rate, access credit or become more dependent on government welfare programs as witnessed by the massive surge in food stamp usage and disability claims.
I agree with Cullen here that the private sector trends remain very weak and the balance sheet recession is a process. While much of the mainstream is extremely optimistic that the economy is set to come surging back in the coming year - I think it is much more likely that growth will remain in the "muddle through" process for some time to come. But that is just my "Pragmatic" view.