It no doubt seems absurd to question the idea that deleveraging in underway. We've had three heroic central bank interventions, starting in August 2007, to reverse seize-ups in the money markets. The asset backed commercial paper market has been almost in run-off mode. Leveraged buyout loans have been scarce to non-existent. Banks have cut home equity credit lines and credit card borrowing limits. Commercial and industrial loans have fallen. The private mortgage securitization market is a shadow of its former self.
Yet the macro level data, at least as far as the US is concerned, tells a dramatically different, indeed troubling story (click to enlarge):
The chart is admittedly a bit hard to read, but it is prepared from Fed's Funds Flows through the latest reporting date, which is March 31, 2008. The chart comes courtesy Frank Veneroso's June 18 report, "Why a Second Wave is Inevitable." (no online version, but if you ask nicely, I can e-mail you a pdf). The line is Total Credit Market Debt/GDP. As you can clearly see, the steepness of the vertical ascent of the has not eased in the last year or two. If anything, it may have gotten worse.
We will return to discuss the implications of how big the debt level is, but the graph itself should serve to focus the mind. The March 31 level was 350% of GDP. The previous peak occurred in 1933, during the Great Depression, at just under 270% of GDP. Note that the peak was reached due to the start of the rapid fall in GDP taking hold faster than debts were written off, a dynamic not in operation now. So the comparable level to our situation is in fact lower than the 270% peak.
An additional bit of cheery news comes from reader Bjomar: Japan's total debt to GDP in 1990 was roughly 250% (it took some triangulating among this, this, and this source, his interpolation of corporate debt at 100-140% of GDP, household at 65%, and government at 60%). And unlike us, Japan had a very high saving rate, so its net debt would have been less alarming.
On my recent quick turnaround trip to the West Coast, I had the opportunity to read all sorts of interesting research various readers had sent me that I simply could not get to previously. All of it was useful, but the Veneroso discussion, and particularly his chart, seemed the most unrecognized, underappreciated element of the credit crunch.
Now the story in the first paragraph is not inaccurate. Private sector credit growth has slowed, in fact pretty dramatically in the first quarter. But "slowing growth" and "deleveraging" are two different conditions. Alejandro Neut at Banco Bilbao provides a good overview of the Fed's funds flow data for the first quarter of 2008:
Credit continued to decelerate in the first quarter of 2008. Total debt of the domestic nonfinancial sectors grew at a seasonally adjusted annual rate of 6.5% (1 pp lower than in the previous quarter and the lowest rate since 2001). Even when the reduction in debt growth was not as pronounced as the one in 2007Q4, when debt eased from 9.1% to 7.5%, the decelerating trend shows no signs of abating. This bleak assertion is based in the yet strong deceleration of households’ debt, segment which remains the main driver of the current downtrend (households’ debt grew a meager 3.5% compared with the previously seasonally annualized growth of 6.1% in the previous quarter). Debt in almost all sectors grew at a lower pace than anytime during 2007. The only exception was the federal government’s debt, which grew at an impressive annualized rate of 9.5%.
Business debt continued to expand at a healthy pace Business’s debt grew 10.8% yoy. With interest payments at historical lows (relative to profits) debt growth in corporate America was robust. This explains why businesses have been shifting the means to finance itself, from bond issuance to bank loans. But risks are growing: the financial gap remains at a high level, indicating the need for external financing in order to keep current operations.
Note that even though the tone of the report is downbeat, credit is still growing, but at a slowing pace. While certain individuals and institutions might be reducing their borrowings, on an overall level, private debt is still increasing.
And, of course, the other reason that we haven't seen deleveraging is that our friendly foreign funding sources have kept the credit spigots open and government debt has grown at a an accelerating pace, thanks in part to Iraq, but to a bigger degree due to various interventions. Tim Duy earlier focused on the role of foreign assistance in keeping a financial crisis from (yet) hitting the real economy to the same degree:
Perhaps most importantly, however, is the massive liquidity injections from the rest of the world, or what Brad Setser calls “the quiet bailout.” In the first half of this, global central banks accumulated $283.5 billion of Treasuries and Agencies, something around $1,000 per capita. This is real money – I outlined the likely implications in January. Foreign CBs are happily financing the first US stimulus package; will they be happy to finance a second? Do they have a choice? Their accumulation of Agency debt is also keeping the US mortgage market afloat. Do not underestimate the impact of these foreign capital inflows. If the rest of the world treated the US like we treated emerging Asia in 1997-1998, the US economy would experience a slowdown commensurate with the magnitude of the financial market crisis.
Duy suggested that it might be possible for the US to rebalance and increase exports enough to reduce the need for more foreign funding. However, China has announced its plans to slow the pace of yuan appreciation, a negative for US export competitiveness. But even worse, the housing recession is far from over. Plenty of measures (prices relative to income and rents, duration of the late 1980s-early 1990s housing recession, comparisons to serious housing recessions in other developed economies) suggests that we are at best only halfway through in terms of duration and average house price declines. More housing losses means more trouble for the financial system, which means more interventions that depend on foreign support.
Frank Veneroso argues we have to get off the debt E-ticket ride, now. Referring to the chart above, he writes:
This chart shows something that has gone vertical, something that is on a moon shot. If it were the GDP of Argentina in pesos I would agree that the moon shot could go on and on. But it is not the Argentine economy in domestic money terms. It is a macroeconomic ratio of total debt to GDP. Macroeconomic ratios cannot go on unending moon shots. They are basically mean reverting series. In many cases, such as an economy’s investment ratio or its profit ratio, these values tend to be more or less the same on average over long periods of time. There are some such ratios that exhibit an upward bias or a downward bias; the ratio of service output to GDP and the ratio of industrial production to GDP are examples. But even though there may be a secular “tilt” to the mean, the shift in that mean is always gradual. Over short periods of time like a decade or so mean reversion tends to bring you close to where you came from.
For the above ratio of credit market debt to GDP there is no gradual tilt to this ratio over the last two decades...How can that be, given that it is a macroeconomic ratio? ...If we look back in history, we see one prior vertical takeoff in this ratio – the period from 1930 to 1933. In that episode economic agents did not want to increase their aggregate debt to GDP..... A very bad recession from mid 1929 to mid 1930 started to take the denominator – nominal income – down rapidly....The resulting financial and economic carnage was so great that all economic agents wanted mean reversion. But debt is a stubborn thing to dislodge. It took a generation encompassing a wartime inflation to revert to the mean and eventually overshoot it to the downside.
Over the last year the U.S. has undergone the worst financial crisis in the three generations since that horrific episode of the 1930s. Even though we have had a severe financial crisis the ratio of total credit market debt to GDP keeps on rising. This could have occurred because government was socializing debt, but that has not happened yet.
Private debt to GDP rose as rapidly last year as it did before the onset of the financial crisis. It even rose in the first quarter of this year as the financial crisis intensified. But unlike the 1930s, when this ratio rose even though economic agents did not want it to rise because nominal income was falling, in this episode the private debt to GDP ratio has kept rising because fee hungry lenders continue to engage in expanding credit to profligate over-indebted borrowers. If one looks at this chart with a historic perspective it is clear that this ratio cannot keep on rising. But if you ask people in the market place whether we must go though a period in which credit falls sharply relative to income they will say that need not be. It is widely acknowledged that it has taken several units of debt to produce a unit of GDP in recent years. Most people strangely assume that will be the case in the next recovery. The same attitudes hold for our policy makers. They do not talk about an eventual reduction of credit relative to income. They talk about providing new channels of credit to offset constricting ones; for example, expanding the lending of the GSEs to offset the falloff in securitizations. Can the moon shot in the debt to GDP ratio keep going on, like so many assume? Or has something happened that makes at least a reversal, if not mean reversion, imperative now?
The answer is, reversal is imperative now. Why? It is widely understood that starting in the mid 1990s we entered into a historically novel path of serial bubblizations. Each asset bubble went hand-in-hand with an expansion of credit to the private sector....we can see why the reversal of the moon shot in the debt to GDP ratio is imperative. First, house prices now seem to be in an unstoppable downward spiral.....
It has been calculated from the flow of funds accounts that the ratio of aggregate mortgage debt to residential real estate value reached a peak of 50% when the home price and home finance bubbles reached their peak at the end of 2006. But the flow of funds accounts do not capture second and third mortgages. They do not capture the home equity loans that are in portfolios other than those of the commercial banks. There is a large “other” household debt item in the flow of funds accounts which includes various such claims against residential real estate collateral. I encountered one ratio calculated by the housing finance industry that suggested that, at the home price peak at the end of 2006, the aggregate loan to value ratio was 57%.....
If home prices fall nationwide by 35%, it follows that the average loan to value ratio will exceed 90%. About 30% of all residential real estate in value terms is without a mortgage. For all real estate with a mortgage, the distribution of mortgage indebtedness is very skewed. With the average loan to value ratio rising to almost 90%, a huge share of almost all mortgage debt will be deeply underwater. All studies show that when mortgages are well underwater there are defaults and foreclosures. This applies to the majority of mortgage debt classified as prime as well as the margin of mortgage debt classified as subprime. If home prices mean revert, the odds are high that in the shakeout that will follow the total credit market debt to GDP ratio will finally fall from its moon shot trajectory.....
There is another reason why. There are no more serial bubbles to be blown that are beneficial to income and output, even in the short run. The housing bubble was able to bailout the bursting of the tech bubble because it lifted household wealth and in turn employment, income, and output. Not so, the next new bubble now underway – the commodity bubble.....the effects on the economy from the commodity bubble are very different than those of the housing bubble. The public is not on board this bubble. They are not day trading tech stocks and feeling richer day by day. They are not buying second homes and investment homes, pyramiding their real estate wealth. The public’s involvement in the commodity bubble market is vestigial at most. Rather, the public is exposed to commodities primarily as goods which they must buy to use. This bubble – and in particular the oil bubble – is squeezing the bejesus out of everyman. Rather than being a new bubble that makes households feel richer, it is a bubble that is taxing them and thereby making them poorer.
The serial bubble solution to the problem of prior bubbles and the financial fragilities they spawn has come to a dead end with a third toxic oil bubble the financial authorities did not expect and do not want – the commodity bubble. Now the serial bubblization of the policy makers portends recession, not recovery.....The end of the moon shot in the debt to GDP would appear to be at hand.
Veneroso thinks the only way we might get a break is if the commodities bubble gets pricked and oil goes to $60. Since that is a wet dream for commodities bears, it looks likely that a grim scenario is not far from unfolding.
In case you view Veneroso as extreme, other analysts are leaning to a deflationary scenario, which presupposes deleveraging. Forbes cites the views of Merrill Lynch's North American economist, David Rosenberg:
Rosenberg expects commodity markets, which have recently begun retreating from record highs, to continue their fall, easing inflationary pressures amid the U.S. housing market's ongoing two-year decline.
"We do not see the prospective backdrop as inflationary," he wrote. "All one has to do is pick up the newspaper to see that autos, housing, or practically anything you want to buy in a department store is experiencing 'fire sale' conditions."
The next bubble that U.S. investors are likely to stoke will be in bonds, as commodities and stocks sell off during a painful economic period, comparable to the U.S. consumer recession of 1973-75, Rosenberg argues.
"Back then, collapsing earnings and price-earnings multiples triggered a 40 percent peak-to-trough decline in the S&P 500," he recalled....
As consumers continue to cut back and equities remain under pressure, "if there is another bubble around the corner, it is likely to be in bonds, and this will be particularly apparent once the commodity explosion reverses course," Rosenberg wrote.
U.S. households' bond exposure is not much more than 5 percent of their total assets, after the past two decades scrambles into stocks and then real estate.
But a shift back toward the late 1980s and early 1990s level of between 7 percent and 8 percent of total assets "would imply the potential for $1.75 trillion of incremental demand," Rosenberg expects, most of which would go to Treasuries and other higher-quality bonds as riskier corporate debt feels the pinch of a tough economy....
"The forces of deflation will outlast the cyclical inflation story," Rosenberg wrote, adding that Japan's experience in the 1990s of a lost decade of economic growth and deflationary pressures after equities and real estate bubbles there burst could mirror the unfolding situation in the United States more closely than many analysts reckon.
"Using the Japan post-bubble experience of the 1990s as a benchmark for comparison purposes may not be such a stretch as many people think it is because this is increasingly looking like a very similar secular bear market in equities," he wrote.
Another lesson the United States now can draw from Japan's earlier experience is that tax rebates may not free the economy up from the long lasting constraints of a credit crunch, he wrote.