Deleveraging with a twist

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The lat­est Flow of Funds release by the US Fed­er­al Reserve shows that the pri­vate sec­tor is con­tin­u­ing to delever. How­ev­er there are nuances in this process that to some extent explain why a recov­ery appeared fea­si­ble for a while.

The aggre­gate data is unam­bigu­ous: the US econ­o­my is delev­er­ing in a way that it has­n’t done since the Great Depres­sion, from debt lev­els that are the high­est in its his­to­ry. The aggre­gate pri­vate debt to GDP ratio is now 267%,  ver­sus the peak lev­el of 298% achieved back in Feb­ru­ary 2009–an absolute fall of 31 points and a per­cent­age fall of 10.3% from the peak.

This dwarfs any pre­vi­ous post-WWII experience–even the steep reces­sion of the mid-1970s.

The aggre­gate lev­el of pri­vate debt now tow­ers over the econ­o­my, putting into sharp relief the obses­sion that politi­cians of all per­sua­sions have had with the pub­lic debt. Rather like Nero fid­dling as Rome burnt, politi­cians have focused on the less­er prob­lem while the major one grew out of con­trol. Now they are obsess­ing about a rise in the pub­lic debt, when in a very large mea­sure that is occur­ring in response to the pri­vate sec­tor’s delever­ag­ing.

If they had paid atten­tion to the lev­el of pri­vate debt in the first place, then we would­n’t be fac­ing explod­ing pub­lic debt today.

How­ev­er, though the decline in pri­vate debt is steep and con­tin­u­ing, the rate of decline has slowed. Because debt inter­acts with demand through its rate of change, this has giv­en a stim­u­lus of sorts to the econ­o­my in the midst of its delever­ag­ing.

This is obvi­ous when one con­sid­ers aggre­gate demand as I define it: the sum of GDP plus the change in debt (where this demand is spread across both goods & ser­vices and the asset mar­kets). Though debt lev­els are still falling, because they are falling less rapid­ly there has actu­al­ly been a boost to aggre­gate demand from debt from the fact that debt is declin­ing less rapid­ly in 2010 than in 2009:

This is dou­bly so when the con­tri­bu­tion to demand from the pub­lic sec­tor is includ­ed, as this short­er term graph shows more clear­ly.

How­ev­er while recent data shows a pos­i­tive con­tri­bu­tion to demand from debt falling more slow­ly, on an annu­alised basis, the change in debt is still sub­tract­ing from aggre­gate demand–and more so than in the pre­vi­ous year. So total demand (across all markets–commodity and assets) had to fall, even though GDP itself grew. Obvi­ous­ly most of the fall in demand has been absorbed by the asset mar­kets, which have not recov­ered to the same lev­el of turnover as in the boom years–and nor should they.

The next table, which uses the aggre­gate debt fig­ure (pub­lic and pri­vate debt com­bined) from the Flow of Funds, shows that aggre­gate demand fell across July 2008 to June 2009, even though debt was still ris­ing, because the rate of growth of debt fell from $3.7 tril­lion to $1.4 tril­lion. Across July 2009 to June 2010, the decline in aggre­gate demand was less than the pre­vi­ous year (a 9.7% fall ver­sus a 15.2% fall), even though the change in debt had turned neg­a­tive.

The rise in aggre­gate demand sup­port­ed a recov­ery in employ­ment, but the prospects of this con­tin­u­ing to the point at which eco­nom­ic activ­i­ty booms once more are remote: with debt lev­els as high as they are, the poten­tial for fur­ther delever­ag­ing still exceeds the worst that the US expe­ri­enced dur­ing the Great Depres­sion.

I have recent­ly become aware of some oth­er econ­o­mists using a sim­i­lar con­cept to my mea­sure of the debt con­tri­bu­tion to aggre­gate demand, which they call the “cred­it impulse” (Big­gs, May­er et al., http://ssrn.com/paper=1595980). They define this as the change in the change in debt, divid­ed by GDP.

My def­i­n­i­tion empha­sis­es aggre­gate demand and cor­re­lates this with the lev­el of employ­ment (or unem­ploy­ment, as above), where­as theirs empha­sis­es the change in aggre­gate demand and cor­re­lates with changes in the lev­el of employ­ment. The log­ic is iden­ti­cal, but has the advan­tage of being able to cor­re­late the change in the change in debt with change in employ­ment. It high­lights an appar­ent para­dox: the econ­o­my can receive a boost from debt, even though it is falling, if the rate of that decline slows.

The next few charts apply this con­cept using the recent Flow of Funds data, and shows why it is so impor­tant to con­sid­er the dynam­ics of debt when try­ing to under­stand why this down­turn has been so severe—and why it also seems to have eased. First­ly, change in employ­ment and change in real GDP are obvi­ous­ly cor­re­lat­ed, and on this basis this down­turn is bad, though not sig­nif­i­cant­ly worse than pre­vi­ous down­turns in 1958, 1975 and 1983.

How­ev­er when you con­sid­er the cor­re­la­tion between the “cred­it impulse” and the change in employ­ment, this cri­sis has no prece­dent in the post-WWII peri­od:

Fur­ther­more, debt is the lead­ing fac­tor is this process. Though the cor­re­la­tion between changes in real GDP and changes in employ­ment are high­er than those for the accel­er­a­tion in debt and changes in employ­ment, the “cred­it impulse” leads changes in employ­ment while GDP slight­ly lags changes in employ­ment: cred­it, which is ignored by con­ven­tion­al “neo­clas­si­cal” eco­nom­ics, is in the dri­ving seat.

This is some­thing that Keynes real­ized after writ­ing the Gen­er­al The­o­ry (Keynes 1936), but which nev­er made its way into the text­book ver­sion of Keynes that con­ven­tion­al econ­o­mists like Stiglitz and Krug­man learnt as Key­ne­sian­ism.

Planned investment—i.e. invest­ment ex-ante—may have to secure its “finan­cial pro­vi­sion” before the invest­ment takes place; that is to say, before the cor­re­spond­ing sav­ing has tak­en place. This ser­vice may be pro­vid­ed either by the new issue mar­ket or by the banks ;—which it is, makes no dif­fer­ence… let us call this advance pro­vi­sion of cash the ‘finance’ required by the cur­rent deci­sions to invest. Invest­ment finance in this sense is, of course, only a spe­cial case of the finance required by any pro­duc­tive process; but since it is sub­ject to spe­cial fluc­tu­a­tions of its own, I should (I now think) have done well to have empha­sised it when I analysed the var­i­ous sources of the demand for mon­ey. (Keynes 1937, pp. 246–247)

The good news in the lat­est Flow of Funds data is there­fore that a slow­down in the rate of delever­ag­ing can impart a pos­i­tive impe­tus to employ­ment. How­ev­er the bad news is that the econ­o­my is now hostage to changes in the rate of delever­ag­ing, from lev­els of debt that far exceed any­thing it has ever expe­ri­enced before­hand. Since much of this debt was tak­en on to finance spec­u­la­tion on asset prices rather than gen­uine invest­ment, it is high­ly like­ly that delever­ag­ing will accel­er­ate in the future, as spec­u­la­tors tire—literally as well as metaphorically—of car­ry­ing large debt loads that finance stag­nant or declin­ing asset prices.

Drilling down into the debt data, it’s appar­ent that the sec­tor that caused the crisis—the finance sector—is the one that has delev­ered the most is also the one whose rate of delev­er­ing is slow­ing most rapid­ly.

This is not a good thing, nor is it like­ly to last. The finance sec­tor exists to cre­ate debt, and the only way it can do that is by encour­ag­ing the rest of the econ­o­my to take it on. If they were fund­ing pro­duc­tive invest­ments with this mon­ey, there would­n’t be a cri­sis in the first place—and debt lev­els would be much low­er, com­pared to GDP, than they are today. Instead they have enticed us into debt to spec­u­late on ris­ing asset prices, and the only way they can expand debt again is to re-ignite bub­bles in the share and prop­er­ty mar­kets once more.

Here’s where the lev­el of debt (when com­pared to income) mat­ters, as opposed to its rate of change: reignit­ing these bub­bles is easy when debt to GDP lev­els are low. But reignit­ing them when debt to income lev­els are astro­nom­i­cal is next to impos­si­ble. Spec­u­la­tors have to be encour­aged to take on a lev­el of debt whose ser­vic­ing con­sumes a dan­ger­ous­ly high pro­por­tion of their income, in the belief that ris­ing asset prices will let them repay that debt with a prof­it in the near future.

With the debt to GDP lev­els for all non-gov­ern­ment sec­tors of the Amer­i­can econ­o­my at unprece­dent­ed lev­els, the prospect that any sec­tor can be enticed to take on yet more debt is remote. Delever­ag­ing is Amer­i­ca’s future.

Big­gs, M., T. May­er, et al. “Cred­it and Eco­nom­ic Recov­ery: Demys­ti­fy­ing Phoenix Mir­a­cles.” SSRN eLi­brary.

Keynes, J. M. (1936). The gen­er­al the­o­ry of employ­ment, inter­est and mon­ey. Lon­don, Macmil­lan.

Keynes, J. M. (1937). “Alter­na­tive the­o­ries of the rate of inter­est.” Eco­nom­ic Jour­nal
47: 241–252.

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