Understanding How “Debt Deleveraging” Works
FORECASTS & TRENDS E-LETTER
IN THIS ISSUE:
1. Gross Domestic Product Disappoints Again
2. Is Our Massive Debt Preventing Economic Growth?
3. Understanding How “Debt Deleveraging” Works
4. Conclusions – Deleveraging Will Continue
Gross Domestic Product Disappoints Again
Before we get into the issue of deleveraging, let’s take a quick look at the latest economic reports. Last Thursday the Commerce Department released its third and final estimate of 2Q GDP. The previous estimate had GDP rising at a tepid pace of 1.7% (annual rate). The pre-report consensus was that the final estimate would be unchanged. Unfortunately, the final estimate for the 2Q fell to only 1.3%.
The Commerce Dept. said the report was influenced by positive contributions from personal consumption expenditures, exports, nonresidential fixed investment and residential fixed investment that were partly offset by negative contributions from private inventory investment and state and local government spending.
Consumer spending and business spending actually decelerated in the 2Q as compared to the 1Q when GDP expanded by 2%. The government noted that this year’s drought and the resultant decline in agricultural production also influenced the lower than expected 2Q GDP number. Crop production declined $12 billion over the quarter and farm inventories — the crops and cattle that are stored on farms — dropped by $5.3 billion in the quarter.
Trade also contributed less to GDP than last reported, as exports were weaker than originally thought. The 1.3% increase in GDP was the weakest since the 3Q of last year and one of the weakest seen since the recovery began three years ago. Preliminary readings suggest that growth could be even lower for the 3Q.
Separately, the Business Roundtable’s CEO Economic Outlook Survey for the 3Q found that only 29% of CEOs surveyed expected employment at their companies to grow in the next six months. That is obviously another bad sign for the recovery.
In other economic news, durable goods orders plunged 13.2% in August, more than twice as bad as pre-report estimates. Durable goods are items that are expected to last at least three years, and orders for airplanes and autos were down more than expected last month.
The weaker level of orders since the end of spring reflects a global economic slowdown, and US exports to Europe and China have softened. Shipments of core capital goods, perhaps reflecting the anxiety of business, fell 0.9% in August to mark the second straight decline. Many believe that part of the reason is growing concerns about the “fiscal cliff.”
Next, a new Rasmussen poll found that only 23% of Americans believe their children will be better off than their parents, while 59% believe their children will be worse off, and 18% were undecided. In another new Rasmussen poll, only 41% believe the US economy will be better in five years; that is near the poll’s all-time low. So much for long-term optimism! It makes you wonder how the presidential race could remotely be this close.
On the bright side, the ISM manufacturing index released yesterday surprised on the upside. The index rose to 51.5 in September, up from 49.6 in August. This was well above the pre-report consensus of 49.5. Any reading below 50 in the ISM indicates that manufacturing is contracting, so the latest report was encouraging in that the index had been below 50 for the last two months.
Also, consumer confidence jumped sharply in August, for reasons that are still not entirely clear. The Consumer Confidence Index jumped from 61.3 in August to 70.3 in September, a seven-month high.
Yet while consumers may be more confident, they aren’t spending much as general worries about the economy remain. Fewer people are losing jobs, but not many are being hired. Home and stock prices are up, but workers’ pay is trailing inflation. Auto sales jumped earlier this year but have since declined. Manufacturing faltered this summer as noted above, but came in better than expected for September. This is what an economy stuck in a slow-growth rut can look like. For how long, we don’t know.
On Friday morning, we get the unemployment report for September. The pre-report consensus is that the headline unemployment rate was unchanged at 8.1% in September. As usual, the headline number will likely be less important than the number of people who gave up looking for work last month.
Is Our Massive Debt Preventing Economic Growth?
For many years, I have warned that our massive explosion in federal debt (up 50% just since Obama took office) would one day stifle economic growth. Obviously economic growth is currently stifled, what with the weakest post-recession recovery in decades. But the question remains as to whether our massive national debt and trillion-dollar budget deficits are the main reason for the disappointing reovery.
Consumers continue to deleverage – that is, paying down debt instead of spending more – because they fear for their jobs and the likelihood that we may be headed for another recession next year. This whole concept of deleveraging is foreign to many Americans – what is it?; how long will it continue?; and what does it mean for the economy, etc.?
U.S. News & World Report writer Chris Gay wrote a very good article last week that explains the deleveraging process and how our exploding debt is stifling the economic recovery. Rather than summarizing the report, you can read it for yourself below.
Is Debt Overhang What's Preventing a Strong Recovery?
Don’t expect stronger growth, some say, until deleveraging is complete
The Great Recession has revived interest in the late British economist John Maynard Keynes, but there's an American economist of Keynes's era that investors might want to read up on. Most people remember Irving Fisher, if at all, for his spectacularly mistimed declaration that stock prices had ‘reached a permanently high plateau.’ It was days before Black Tuesday [the stock market crash that ushered in the Great Depression].
Economists, however, know Fisher for his ‘debt-deflation theory’ of recessions, which holds that high debt levels help cause—and prolong—a downturn. If Fisher was right, America's still-high personal and corporate debt levels could explain today's sluggish recovery: Households and businesses are too busy paying down debt [deleveraging] to boost spending and investment, and until debt levels reach some moderate level, you shouldn't expect a strong recovery or a sustained rally in stock prices [QE3 might argue otherwise for stocks].
‘In simple terms, but accurate terms, [excessive debt] is the underlying problem now with the U.S. recovery,’ says Nariman Behravesh, chief economist for business-information provider IHS Global Insight.
So how far are we into the deleveraging process, and how far do we need to go? The short answer: partway, but moving in the right direction. McKinsey [Global Institute] reported in January that all levels of private-sector debt (borrowing by households, financial firms, and non-financial firms) had since the end of 2008 fallen from $8 trillion to $6.1 trillion, or 40 percent of GDP—the same ratio as in 2000. Some of that has been forced, as when homeowners enter foreclosure. Household debt had fallen from about 125 percent of GDP to around 110 percent.
The critical ratio of household debt-servicing costs to after-tax income fell from 14 percent five years ago to 11 percent in the first quarter, according to Federal Reserve data. Economists say that is a significant improvement, even if it does partly reflect refinancing at lower rates, reduced borrowing and write-offs of mortgage and credit-card debt.
Credit-tracking agency Equifax reports that outstanding consumer credit-card debt shrank a year-on-year 1 percent in August in the U.S. cities that are recovering most slowly, even as it rose slightly nationwide.
‘Historical precedent suggests that U.S. households could be as much as halfway through the deleveraging process,’ wrote McKinsey. ‘If we define household deleveraging to sustainable levels as a return to the pre-bubble trend for the ratio of household debt to disposable income, then at the current pace of debt reduction, U.S. households would complete their deleveraging by mid-2013.’
Then, of course, there are other shoes to fall, like deleveraging among our trading partners and by our own federal government, whose debt naturally rises in a downturn. But let's not get ahead of ourselves.
Why is private-sector debt so important to begin with? Two main reasons: One is that it amplifies the adverse effects of financial shocks and market extremes that are bound to occur in capitalist economies from time to time. As Fisher put it in the 1933 paper that introduced the debt-deflation idea: ‘… over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money.’
The second reason is the one that concerns us now: Heavy debt burdens hinder recovery, for reasons related to what economics knows as ‘the paradox of thrift’—saving more may be good for individual households in the long run but bad for the larger economy in the short run.
Fisher's theory has a modern-day incarnation in the ‘balance-sheet recession,’ a term popularized by economist Richard Koo of the Nomura Research Institute.
Here's how Koo says it works: Imagine a household that has income of $1,000 and a savings rate of 10 percent. It spends $900 and deposits $100 in a savings account. Normally, the bank would turn around and lend that $100 to a borrower who spends it, bringing aggregate spending to $1,000. In a private sector that is focused on reducing debt, however, there are no borrowers for the $100, even at negligible interest rates.
And the $900 that the household spent? It becomes someone else's income, of course. But if that someone also saves 10 percent that won't be borrowed, total spending is $810. That $810 in income for another 10-percent saver begets only $730 in spending, and so forth in an ever-decreasing cycle.
Koo is careful to note the difference between a balance-sheet recession, which is largely impervious to [Fed] monetary-policy fixes, and a financial crisis, which isn't. Alas, Koo notes, the Great Recession has involved both. What recovery there has been since 2008, he says, is the result of monetary authorities deploying an arsenal of weapons (capital injections, guarantees, asset purchases, and so forth) against the financial crisis sparked by what he calls the ‘policy mistake’ of letting Lehman Bros. collapse.
But the balance-sheet problem is not so easily remedied. Speaking at a conference in Berlin in April, Koo noted that the U.S. monetary base had more or less tripled since mid-2008, and yet M2 (‘money in circulation’) had barely risen and credit available to the private sector was actually down.
‘Why do we get these results?’ asked Koo. ‘Because the private sector is no longer maximizing profits; they are actually minimizing debt.’
Put more technically, the money multiplier—the process that turns a dollar deposit into more than a dollar of loans—‘is actually negative at the margin,’ Koo told his Berlin audience. Private-sector deleveraging is ‘the key difference between an ordinary recession and one that can produce a lost decade,’ Koo wrote in a 2011 paper.
What breaks the cycle? The private sector, left to its own devices, can deleverage to the point where borrowing becomes attractive again. But that process produces lots of economic carnage, as aggregate spending falls to some irreducible level. ‘In fact, [Fisher's] discussion of debt-deflation doesn't really have much of a mechanism for recovery at all, without intervention,’ notes Brock University economist Robert Dimand, a student of Fisher.
What government can do in the meantime is supplant the borrowing and spending that the private sector has relinquished—though here, of course, the constraints become as much political as economic.
Whatever the government does, it has become accepted wisdom that deleveraging after a financial crisis is a long, painful process. President Obama took up the refrain recently when he told a Cleveland audience that what we're experiencing today is ‘not your normal recession. Throughout history, it has typically taken countries up to 10 years to recover from financial crises of this magnitude.’
Obama's critics, like former Republican Sen. Phil Gramm—a champion of financial deregulation—say he's just trying to whitewash the results of failed policies.
But the weight of evidence seems to favor the president [in that this was no garden-variety recession]. Exhibit A for most economists is the work of Harvard's Kenneth Rogoff and Carmen Reinhart, who after surveying 20-Century financial crises around the world, 15 of them postwar, famously argued that the United States is following a familiar pattern: A huge build-up of leverage for a decade or so, an inevitable crash, then a decline in leverage comparable in size to the preceding expansions.
Elaborating, Reinhart and her economist husband, Vincent Reinhart, wrote in 2010 that post-financial-crisis unemployment in advanced countries rose by a median of five percentage points, and in 10 of the 15 postwar crises never fell back to pre-crisis levels.
Real, per-capita GDP fell by an average of 1 percentage point in the decade following a financial crisis. The typical postwar U.S. recession lasted less than a year, and within two years, GDP regained lost ground and returned to the long-term growth trend. After the typical postwar financial crisis, by contrast, the economy has required an average of four and a half years to reclaim pre-crisis output levels.
Of course, to say that deleveraging is the key factor governing the speed of recovery is not to say that it's the only factor. There's the euro crisis, electoral uncertainty, the fiscal cliff, and many other things.
What explains the slow recovery is ‘not just the balance-sheet issue,’ says Beth Ann Bovino, deputy chief economist for Standard & Poor's. ‘Partly it's a crisis of confidence. People are afraid to borrow and spend.’
Conclusions – Deleveraging Will Continue
The main takeaway from this article, I think, is the conclusion that in the wake of the financial crisis of late 2007 to early 2009, American consumers are just flat scared: scared that they will lose their jobs; scared that the economy will fall back into a potentially even worse recession; and scared that our massive $16 trillion national debt will sink the economy indefinitely.
As a result, they feel a serious need to cut back on spending and pay down their debts. Since consumer spending makes up apprx. 70% of GDP, it’s easy to see how the trend toward deleveraging has seriously and negatively affected the economy.
The article above vaguely addresses where we may be in this deleveraging cycle: “partway, but moving in the right direction.” Does partway mean halfway, one-third of the way, or two-thirds of the way? McKinsey Global Institute suggests that consumers may be about halfway through the deleveraging process, which they think could end sometime in 2013.
But the truth is, no one knows and no one can know. It’s all about perceptions on the part of consumers. And those perceptions are not just based on what happens with the US economy. American consumers are keenly aware of what’s happening in Europe and elsewhere.
As noted in the article above, consumers as a group have been deleveraging since 2008, but they still have several trillion dollars in outstanding debt. Will they continue to deleverage until it’s zero? Of course not. But will they continue to deleverage for several more years, thus assuring a continued lackluster economic recovery? No one knows.
It all boils down to consumer confidence, and not just for a couple of months. As discussed above, we saw a surprising bounce in the Consumer Confidence Index in September, but not a commensurate jump in spending. No, it will take a sustained rise in consumer confidence to spark a meaningful drop in deleveraging and increase in spending.
It will be very interesting to see how consumer sentiment changes after the presidential election. It could be significant, one way or the other. But that is a topic for another time.
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