Inflation versus deflation will be an infinitive ongoing academic debate. On several occasions we have pointed at the Federal Reserve’s balance sheet which has been expanded to unseen levels and simultaneously a US government which is creating a budget deficit which will soon go through the 100 % per GDP level.
When you are a classic monetarist you can only come to the conclusion this is going to ignite a serious inflation bubble in a couple of years from now. If you look at the logic that is used by the Australian Economic school there are arguments to be made this is a recipe for deflation seen in Japan, as foreign investors to flee both the dollar and Treasuries, driving up real interest rates, pole axing any revival in risk asset prices, themselves backed by the fruits of bubble-driven mal-investment.
Both schools have valid arguments, and that is why it is so difficult to choose a side in the debate and as a consequence tailor a policy on the back of the current issues. Certainly if the risk of a deflationary environment is being discussed, and Chairman Bernanke even repeated only this week in front of a Congress hearing Committee that deflationary risks are still present, the glooming picture of the Lost Decade in Japan shows up. However two highly reputed economists, Ben Bernanke himself and Paul Krugman, have developed a draft of a policy framework to solve the problem.
Paul Krugman’s paper in 1998 starts from the IS-LM curve in looking for an answer what Japan should have done to break through its deflationary cycle. He argues that when a central bank has brought its short term interest rates to zero, it will not be enough to start using the tool of quantitative easing to solve the liquidity trap. The reason for that is that from the moment, and this is very topical at this stage, that the markets believe that all this liquidity will be taken back somewhere in the future (for example central banks that are talking about exit strategies) the extra money that is printed right now will simply be parked on accounts and will not be spend. In this case the deflationary cycle remains intact.
In order to ignite spending behaviour a central bank should give a signal to the public that it will keep on printing money in the future rather than taking this money back. By doing this it will shift deflationary expectations to inflationary expectations. Or: “The way to make monetary policy effective is for the central bank to credibly promise to be irresponsible – to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs." (1)
The way to achieve this would be by putting upfront an inflation target which is higher than the real (negative) inflation number at that moment. To get out of this liquidity trap the central bank needs to radically change expectations to the notion that there is no exit strategy, at least until inflation is appreciably higher – not just inflation expectations, but inflation itself. Only then would the commitment to higher inflation be credible, with the central bank not just talking the reflationary talk, but walking the reflationary walk, turning deflationary swamp water into reflationary wine.
This was Krugman’s advice towards the Bank of Japan in the late 1990s. Unfortunately they were not followed up by the central bank until in 2001 they applied his policy advice to a certain extent. In stead of setting an explicit higher inflation target it committed itself to a policy where they would continue with QE until year-over-year core CPI moved above zero on a "stable" basis. This is a light version of what Krugman initially recommended and it would still take five more years before the deflationary cycle was broken.
Then there is Mr. Bernanke who did extensive academic research on the issue of deflationary pressures and reflected his findings in one of his most important speeches in November 2002 “Making sure it doesn’t happen here.”
His idea was that the BoJ should set itself a price level target (PLT) in stead of an inflation target (IT). The difference is that IT does not define the future path of the price level. This can result in a costly uncertainty for the economy. PLT reduces the future price level uncertainty. The question remains though whether this would come at the expense of increased macro economic instability.
The major problem with IT is that it does not require a credible commitment to long-run stability in the price level. In practical terms, shocks to the price level under IT are simply accommodated and as a consequence not reversed. And uncertainty around price stability is a major concern for consumers when they enter in mortgages for example.
PLT takes this uncertainty away as the central bank in question explicitly commits itself to a certain price level target number. (2)
Mr Bernanke argues: “to restore the price level (as measured by some standard index of prices, such as the consumer price index excluding fresh food) to the value it would have reached if, instead of the deflation of the past five years, a moderate inflation of, say, 1 percent per year had occurred. (I choose 1 percent to allow for the measurement bias issue noted above, and because a slightly positive average rate of inflation reduces the risk of future episodes of sustained deflation.) Note that the proposed price-level target is a moving target, equal in the year 2003 to a value approximately 5 percent above the actual price level in 1998 and rising 1 percent per year thereafter. Because deflation implies falling prices while the target price-level rises, the failure to end deflation in a given year has the effect of increasing what I have called the price-level gap. The price-level gap is the difference between the actual price level and the price level that would have obtained if deflation had been avoided and the price stability objective achieved in the first place.
A successful effort to eliminate the price-level gap would proceed, roughly, in two stages. During the first stage, the inflation rate would exceed the long-term desired inflation rate, as the price-level gap was eliminated and the effects of previous deflation undone. Call this the reflationary phase of policy. Second, once the price-level target was reached, or nearly so, the objective for policy would become a conventional inflation target or a price-level target that increases over time at the average desired rate of inflation." (3)
In this thesis Mr. Bernanke is counting on the communication skills from a/the central bank to create a clear difference between on the one hand a one-time re-flation to adjust a deflated price level back to levels in case there would not have been a deflationary cycle and on the other hand the central banks long term inflation target. Apart from the moral influence of a central bank to realise this perception change in the market he was also counting on a good interaction between the monetary and fiscal authorities to achieve this goal. Meaning one needs a government who is willing to apply a lose fiscal policy for a number of time together with a central bank who is willing to expand its balance sheet unlimited.
He continues: “My thesis here is that cooperation between the monetary and fiscal authorities in Japan could help solve the problems that each policymaker faces on its own. Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt – so that the tax cut is in effect financed by money creation. Moreover, assume that the Bank of Japan has made a commitment, by announcing a price-level target, to reflate the economy, so that much or all of the increase in the money stock is viewed as permanent.
Under this plan, the BOJ's balance sheet is protected by the bond conversion program, and the government's concerns about its outstanding stock of debt are mitigated because increases in its debt are purchased by the BOJ rather than sold to the private sector. Moreover, consumers and businesses should be willing to spend rather than save the bulk of their tax cut: They have extra cash on hand, but – because the BOJ purchased government debt in the amount of the tax cut – no current or future debt service burden has been created to imply increased future taxes.
Essentially, monetary and fiscal policies together have increased the nominal wealth of the household sector, which will increase nominal spending and hence prices. The health of the banking sector is irrelevant to this means of transmitting the expansionary effect of monetary policy, addressing the concern of BOJ officials about 'broken' channels of monetary transmission. This approach also responds to the reservation of BOJ officials that the Bank "lacks the tools" to reach a price-level or inflation target.
Isn't it irresponsible to recommend a tax cut, given the poor state of Japanese public finances? To the contrary, from a fiscal perspective, the policy would almost certainly be stabilizing, in the sense of reducing the debt-to-GDP ratio. The BOJ's purchases would leave the nominal quantity of debt in the hands of the public unchanged, while nominal GDP would rise owing to increased nominal spending. Indeed, nothing would help reduce Japan's fiscal woes more than healthy growth in nominal GDP and hence in tax revenues.
Potential roles for monetary-fiscal cooperation are not limited to BOJ support of tax cuts. BOJ purchases of government debt could also support spending programs, to facilitate industrial restructuring, for example. The BOJ's purchases would mitigate the effect of the new spending on the burden of debt and future interest payments perceived by households, which should reduce the offset from decreased consumption. More generally, by replacing interest-bearing debt with money, BOJ purchases of government debt lower current deficits and interest burdens and thus the public's expectations of future tax obligations.
Of course, one can never get something for nothing; from a public finance perspective, increased monetization of government debt simply amounts to replacing other forms of taxes with an inflation tax. But, in the context of deflation-ridden Japan, generating a little bit of positive inflation (and the associated increase in nominal spending) would help achieve the goals of promoting economic recovery and putting idle resources back to work, which in turn would boost tax revenue and improve the government's fiscal position." (4)
As far as the US concerns to a certain extend this is already happening. The Federal Reserve expanded its balance sheet considerable and the US Treasury is creating a mountain of debt (USD 1.8 trillion by the end of the year). The deflationary pressures at this moment are not yet that deep as was the case in Japan, but we are only the midst of the deleveraging process. As a result the US will stay in some sort of a liquidity trap for a while and will be the only party responsible for credit demand.
The question remains what will happen if the US consumer does not resume spending. In this case it is clear that Chairman Bernanke will be willing to go and use this extreme powerful tool. It will be like walking over thin ice and there is a possibility that the next generations will be paying a very high price for this (to the extent that we all are not already paying this), but the Fed Chairman made it clear in his title of his speech: "Making Sure 'It' Doesn't Happen Here" (5)
(1)"Japan's Trap," http://web.mit.edu/krugman/www/japtrap.html
(2) See also Donals Coletti and Rene Lalonde “Inflation targeting, Price level targeting and fluctuations in Canada’s terms of trade”, Central Bank of Canada, Winter 2007-2008
(3)http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm
(4) See also Ben Bernanke, Essay “Japanese Monetary Policy: A Case of Self-Induced Paralysis." Princeton University, December 1999.
(5) The article is also inspired on thoughts from Paul McCulley, MD at Pimco
Thursday 23 July 2009
Monday 13 July 2009
The Capitol Hill Baby sitting experiment
We have discussed the issues around deflation versus inflation already extensively in previous weekly reports. In this weekly we try to explain why recessions and the deflationary pressures that go hand in hand with them, take place. Then, we look at some data which can give some guidance whether deflation or inflation might win the debate in the foreseeable future.
Usually the best way to describe a certain system is to look at a model and see how it works on a micro level. One can compare it with model planes or cars being tested in a wind tunnel. In this case Nobel prize winner, Paul Krugman, explains the complex mechanics behind recessions and their deflationary pressures by referring to an example in history which is known as the Capitol Hill Baby-sitting Co-op.
This was a project, which started in the late 1950s, with the intention to give young families, who were living and working in Washington, a network of responsible, experienced adults to take on babysitting duties on a sit-for-sit basis. The experiment grew out to become a micro economy and would be highly representative in explaining how recessions take place and the pressure on prices it can have.
The project would work as follows:
Each member family is given a coupon – pieces of paper worth one half-hour of sitting time. That allowance is to be paid back within a year, in order to keep everyone sitting and everyone going out. A scheduling system is in place to organize sits each month, as well as a payment plan that includes time and a half for things like later hours.
In this system everything is based upon the belief that every couple goes out regularly and some others fit in to do baby-sitting. By doing so one part of the population could earn or save coupons which could be spent in turn when they decide to go out for an evening dinner.
However in the mid 1970s, the co-op experiment experienced something of a recession. There was a shortage of coupons, which led people to panic and hoard their shares. Because there was no regular circulation, the system was falling apart. When a rule requiring that couples go out at least once every six months ended up falling flat, the powers that be decided to create more coupons to alleviate the problem and encourage people to spend.
The shortage of coupons was created due to a lack of effective demand as households wanted to accumulate their cash (coupons). As is the case in a real economy the problem was located on the demand side and not on the supply side. Or in the words of the late Milton Friedman, too many people were chasing too few coupons.
In order to solve the problem the governing board of the co-op decided to put more coupons in circulation and the short term result was that couples were more willing to go out. This in turn created more opportunities to baby-sit, which in turn again stimulated young families to go out more regularly. In other words the vicious circle was broken by printing new coupons.
The latter is a text book recipe used by central banks to fight recessions; that is printing money.
In this respect one can wonder why for instance a nation like Japan could not get out of the deflationary spiral as the authorities used every tool available to break the vicious circle. They lowered short term rates to zero and kept them there for a considerable period of time. They did substantial amounts of quantitative easing. Last but not least there was public spending up to more than 170% of their GDP. None of the above was able to break the deflationary spiral.
Returning back to the micro economy of the baby-sitting co-op we can detect similarities. In order to get the system running again the governing board created the opportunity to borrow coupons and pay them back at a later stage with coupons earned from baby sitting. Of course to keep the system fair there was a penalty imposed where couples who borrowed coupons would have to pay an extra coupon back.
This gave the governing council a tool to boost demand, by changing the conditions of borrowing in times when demand was lagging. This is exactly what central banks are doing in general. However in the example of Japan interest rates were cut back to zero and nevertheless the economy did not kick back into gear.
The explanation for that: seasonal effects. Like in every economy, the baby-sitting co-op experiment experienced cyclical effects as well. Intuitively one can expect that couples were less motivated to go out during winter compared to the summer season. People would accumulate coupons for the summer when they would go out more frequently. When this seasonal phenomenon is not too strong the governing council could still make adjustments on the coupon borrowing in order that supply and demand returned to an equilibrium.
However it is perfectly possible when for example the winter would be very long and cold that even at no penalty to borrow coupons (zero interest rates) households would not be motivated to go out.
This is the situation where Japan has been in for the last 1.5 decades. Most probably due to demographic factors the Japanese population is not willing to spend anymore. An aging population is by definition more savings and less investing oriented. Furthermore an older society is more afraid for challenges of the future. This is why Japan’s economy will underperform significantly even with interest rates a zero.
This is what economists also call the liquidity trap.
The major reason Japan was/is stuck in a liquidity trap is due to the fact that the liquidity provided by the central bank was not passed on to the consumer or the industry. Banks used the extra liquidity to clean up their balance sheets. This is happening right now as well. One could argue, like Milton Friedman, that the solution to this problem would be that the central banks start lending directly to corporates and/or consumers. In theory this is possible, however central banks do not have the infrastructure to do this. Secondly this would not resolve the balance sheet problems of the banks either.
This is however the price one has to pay when a system built up excesses over many years and has to go through a deleveraging process. During this process the available credit is erased at a much faster pace than a central bank can print money. At this moment the amount of credit that is lost is approximately USD 14 tln versus USD 2 tln coming from the Fed and US government. This can be illustrated by looking at the gap between broad and narrow money (Figure 1). Broad money is reflected in M2. Narrow money is what the central bank is injecting into the system.
Figure 1 Broad versus narrow money
Source: John Mauldin OTB newsletter
Figure 1 describes the situation in the US however the picture is very similar in the Euro-zone and the UK.
As long as the gap remains very high it is unlikely that inflationary pressures will return. Even the argument that commodity prices sooner than later will automatically re-ignite inflationary pressures does not pass the test. This for the simple reason that commodity prices are inelastic. Elasticity is the degree to which a demand and supply curve reacts to a change in the underlying price of a product. In case a product is inelastic it means that it would be insensitive to price changes because the consumer has to buy it anyway even when the price would rise considerably.
Products such as oil and food are inelastic products. If prices would rise substantially people would look for alternatives to cut in their household budget. As a consequence demand for other products would fall and still create a deflationary environment.
Further taking into account that the industrial production apparatus is facing overcapacity (the aftermath of the excesses of cheap credit) and as a consequence a very weak labour market which keeps wages contained. This might be the ultimate reason why deflation is a much bigger threat than inflation right now, and for the next foreseeable future.
Usually the best way to describe a certain system is to look at a model and see how it works on a micro level. One can compare it with model planes or cars being tested in a wind tunnel. In this case Nobel prize winner, Paul Krugman, explains the complex mechanics behind recessions and their deflationary pressures by referring to an example in history which is known as the Capitol Hill Baby-sitting Co-op.
This was a project, which started in the late 1950s, with the intention to give young families, who were living and working in Washington, a network of responsible, experienced adults to take on babysitting duties on a sit-for-sit basis. The experiment grew out to become a micro economy and would be highly representative in explaining how recessions take place and the pressure on prices it can have.
The project would work as follows:
Each member family is given a coupon – pieces of paper worth one half-hour of sitting time. That allowance is to be paid back within a year, in order to keep everyone sitting and everyone going out. A scheduling system is in place to organize sits each month, as well as a payment plan that includes time and a half for things like later hours.
In this system everything is based upon the belief that every couple goes out regularly and some others fit in to do baby-sitting. By doing so one part of the population could earn or save coupons which could be spent in turn when they decide to go out for an evening dinner.
However in the mid 1970s, the co-op experiment experienced something of a recession. There was a shortage of coupons, which led people to panic and hoard their shares. Because there was no regular circulation, the system was falling apart. When a rule requiring that couples go out at least once every six months ended up falling flat, the powers that be decided to create more coupons to alleviate the problem and encourage people to spend.
The shortage of coupons was created due to a lack of effective demand as households wanted to accumulate their cash (coupons). As is the case in a real economy the problem was located on the demand side and not on the supply side. Or in the words of the late Milton Friedman, too many people were chasing too few coupons.
In order to solve the problem the governing board of the co-op decided to put more coupons in circulation and the short term result was that couples were more willing to go out. This in turn created more opportunities to baby-sit, which in turn again stimulated young families to go out more regularly. In other words the vicious circle was broken by printing new coupons.
The latter is a text book recipe used by central banks to fight recessions; that is printing money.
In this respect one can wonder why for instance a nation like Japan could not get out of the deflationary spiral as the authorities used every tool available to break the vicious circle. They lowered short term rates to zero and kept them there for a considerable period of time. They did substantial amounts of quantitative easing. Last but not least there was public spending up to more than 170% of their GDP. None of the above was able to break the deflationary spiral.
Returning back to the micro economy of the baby-sitting co-op we can detect similarities. In order to get the system running again the governing board created the opportunity to borrow coupons and pay them back at a later stage with coupons earned from baby sitting. Of course to keep the system fair there was a penalty imposed where couples who borrowed coupons would have to pay an extra coupon back.
This gave the governing council a tool to boost demand, by changing the conditions of borrowing in times when demand was lagging. This is exactly what central banks are doing in general. However in the example of Japan interest rates were cut back to zero and nevertheless the economy did not kick back into gear.
The explanation for that: seasonal effects. Like in every economy, the baby-sitting co-op experiment experienced cyclical effects as well. Intuitively one can expect that couples were less motivated to go out during winter compared to the summer season. People would accumulate coupons for the summer when they would go out more frequently. When this seasonal phenomenon is not too strong the governing council could still make adjustments on the coupon borrowing in order that supply and demand returned to an equilibrium.
However it is perfectly possible when for example the winter would be very long and cold that even at no penalty to borrow coupons (zero interest rates) households would not be motivated to go out.
This is the situation where Japan has been in for the last 1.5 decades. Most probably due to demographic factors the Japanese population is not willing to spend anymore. An aging population is by definition more savings and less investing oriented. Furthermore an older society is more afraid for challenges of the future. This is why Japan’s economy will underperform significantly even with interest rates a zero.
This is what economists also call the liquidity trap.
The major reason Japan was/is stuck in a liquidity trap is due to the fact that the liquidity provided by the central bank was not passed on to the consumer or the industry. Banks used the extra liquidity to clean up their balance sheets. This is happening right now as well. One could argue, like Milton Friedman, that the solution to this problem would be that the central banks start lending directly to corporates and/or consumers. In theory this is possible, however central banks do not have the infrastructure to do this. Secondly this would not resolve the balance sheet problems of the banks either.
This is however the price one has to pay when a system built up excesses over many years and has to go through a deleveraging process. During this process the available credit is erased at a much faster pace than a central bank can print money. At this moment the amount of credit that is lost is approximately USD 14 tln versus USD 2 tln coming from the Fed and US government. This can be illustrated by looking at the gap between broad and narrow money (Figure 1). Broad money is reflected in M2. Narrow money is what the central bank is injecting into the system.
Figure 1 Broad versus narrow money
Source: John Mauldin OTB newsletter
Figure 1 describes the situation in the US however the picture is very similar in the Euro-zone and the UK.
As long as the gap remains very high it is unlikely that inflationary pressures will return. Even the argument that commodity prices sooner than later will automatically re-ignite inflationary pressures does not pass the test. This for the simple reason that commodity prices are inelastic. Elasticity is the degree to which a demand and supply curve reacts to a change in the underlying price of a product. In case a product is inelastic it means that it would be insensitive to price changes because the consumer has to buy it anyway even when the price would rise considerably.
Products such as oil and food are inelastic products. If prices would rise substantially people would look for alternatives to cut in their household budget. As a consequence demand for other products would fall and still create a deflationary environment.
Further taking into account that the industrial production apparatus is facing overcapacity (the aftermath of the excesses of cheap credit) and as a consequence a very weak labour market which keeps wages contained. This might be the ultimate reason why deflation is a much bigger threat than inflation right now, and for the next foreseeable future.
Wednesday 1 July 2009
Average Joe is getting tired
Dear readers,
This week we will have a look at some data which shows how painful the deleveraging process is for US consumers.
We have talked about the deleveraging process of Average Joe already a few times. Like the Rolling Stones song “Between a rock and a hard place” the US consumer is getting squeezed between his employer and his banker. And the situation is getting more than worrisome.
The global economy is simply looking for a new equilibrium now that the Shadow Banking system has disappeared. Cheap credit was the fuel for US consumption which in turn gave the opportunity to Asian export-led economies to build up huge reserves. Simultaneously in order to meet this high demand, expansion was necessary and production capacity was increased to historically high levels. However, US companies (as a matter of fact this is a global phenomenon but let’s focus on the US situation for now) are now faced with overcapacity and they simply do not need such a large workforce anymore. As a consequence they are still laying off people on a daily basis.
The unemployment rate has been rising since the beginning of 2008. From around 5 % in Jan 2008 this rate has been rising to 9.6% last month. And there is no sign this trend will be reverted any time soon. But instead of showing you an unemployment rate number which might be a bit abstract, let’s translate this into a number for people who are sitting at home.
The total number of US unemployed workers is now at 14.5 million. Figure 1 shows the staggering spike unemployment is taking. This is the first way to visualise the de-leveraging process. In the late 80s we experienced a similar process when the US economy was dealing with the Latin America Banking crisis and later on with the Saving and Loan crisis. Earlier on in that decade we also had the period when former Fed Chairman P. Volcker was fighting an epic battle against inflation.
Figure 1 Total US unemployed workers
Source: © Bloomberg L.P. Used with permission. Visit www.bloomberg.com
However, one immediately notices that the spike we are seeing right now is much more severe. This is simply because of the avalanche of cheap credit created by the Shadow Baking system has been unseen in history. By the end of 2008, total credit outstanding in the US was 3.7 times the US GDP. In real numbers this is between $ 50 – 52 trillion. Figure 2 shows you the breakdown between US households, financials, Government and GSE (Fannie Mae and Freddie Mac).
Figure 2 US Total Credit Debt as a % of GDP
Source: Morgan Stanley
As far as financial institutions are concerned they are in the midst of their deleveraging process. Over the last couple of months we have already seen the pain they have to accept on their balance sheets going through this process. The government is actually more or less taking over this debt mountain. So this is more the law of communicating barrels that we are seeing.
But how is Average Joe doing? We saw the savings rate in the US is rising again. At this moment it is back around 5-6%. But we are not there yet. A lot of people simply do not have the luxury to save. There is an interesting data index which gives a good indication how hard people are feeling the pain on their monthly payments. It is called the exhaustion rate Index and represents the rate at which people who started collecting unemployment benefits have used up their allotted payments before finding a job. This number is showing that the water is above their eye balls. It is at 49.17 % or to put a real number on it, of the 6.96 million people who were receiving benefits aid last month there are 3.42 million people who have used up their payments and desperately need to find a job, otherwise they will have to fall back on family aid to make ends meet up or even worse a bench in the park is waiting for them. Bear in mind the total amount of people who are in a similar condition is much higher. These numbers do not reflect those who have been kicked out of benefit aid programmes or those who are still combining 2-3 jobs a day trying to keep up with their mortgage payments but are on the verge of foreclosure.
The latter is also a painful situation as the government programmes in place to give debt relief is for those who have hit rock bottom and have digged a whole in the ground. To qualify for government aid you don’t only have to fall behind of your payments. You must be delinquent. If you’re trying to cut on your food budget, or selling you’re wedding dresses and jewelry just in order to keep track with your mortgage payments, you will simply not qualify! We are talking about several millions of people here on top of these numbers.
The latest developments on the mortgage market is not helping these people either as the US 30-year average mortgage rate has surged from an April low of 4.85% to a high of 5.74% before falling back slightly. Current levels of US mortgages are still around levels last seen in 2001.
Figure 3 US Exhaustion rate
Source: © Bloomberg L.P. Used with permission. Visit www.bloomberg.com
As long as this keeps on deteriorating one cannot expect any improvement in sustainable growth on the consumer side. Neither can Asian economies, which are highly export dependent, expect that there will come a recovery in international commercial trade. The demand which has to come from Average Joe, who has funded their enormous reserves over the years, is simply not there anymore. With less supply for credit (due to the disappearance of the Shadow Banking system), these economies shift towards a new consumption equilibrium, which exporters are not prepared for.
Do not get us wrong. We probably see some slight recovery in growth, but this is only inventory driven. The so called green shoots that some people might have seen were based on this global inventory rebuild. This is not an abnormal phenomenon. One needs to bear in mind that the global economy around October last year came to a total stand still and inventories were build down very slowly. Around March the store shelves around the world got finally empty (depending on which products you are looking at as in the car industry the parking lots are still full with cars assembled in August-September of last year) and this needed to be restored to some extent.
For a full sustainable recovery we first need the housing market to restore and this goes hand in hand with the labour market as there is a high correlation between delinquencies on loan payments and losing one’s job.
This week we will have a look at some data which shows how painful the deleveraging process is for US consumers.
We have talked about the deleveraging process of Average Joe already a few times. Like the Rolling Stones song “Between a rock and a hard place” the US consumer is getting squeezed between his employer and his banker. And the situation is getting more than worrisome.
The global economy is simply looking for a new equilibrium now that the Shadow Banking system has disappeared. Cheap credit was the fuel for US consumption which in turn gave the opportunity to Asian export-led economies to build up huge reserves. Simultaneously in order to meet this high demand, expansion was necessary and production capacity was increased to historically high levels. However, US companies (as a matter of fact this is a global phenomenon but let’s focus on the US situation for now) are now faced with overcapacity and they simply do not need such a large workforce anymore. As a consequence they are still laying off people on a daily basis.
The unemployment rate has been rising since the beginning of 2008. From around 5 % in Jan 2008 this rate has been rising to 9.6% last month. And there is no sign this trend will be reverted any time soon. But instead of showing you an unemployment rate number which might be a bit abstract, let’s translate this into a number for people who are sitting at home.
The total number of US unemployed workers is now at 14.5 million. Figure 1 shows the staggering spike unemployment is taking. This is the first way to visualise the de-leveraging process. In the late 80s we experienced a similar process when the US economy was dealing with the Latin America Banking crisis and later on with the Saving and Loan crisis. Earlier on in that decade we also had the period when former Fed Chairman P. Volcker was fighting an epic battle against inflation.
Figure 1 Total US unemployed workers
Source: © Bloomberg L.P. Used with permission. Visit www.bloomberg.com
However, one immediately notices that the spike we are seeing right now is much more severe. This is simply because of the avalanche of cheap credit created by the Shadow Baking system has been unseen in history. By the end of 2008, total credit outstanding in the US was 3.7 times the US GDP. In real numbers this is between $ 50 – 52 trillion. Figure 2 shows you the breakdown between US households, financials, Government and GSE (Fannie Mae and Freddie Mac).
Figure 2 US Total Credit Debt as a % of GDP
Source: Morgan Stanley
As far as financial institutions are concerned they are in the midst of their deleveraging process. Over the last couple of months we have already seen the pain they have to accept on their balance sheets going through this process. The government is actually more or less taking over this debt mountain. So this is more the law of communicating barrels that we are seeing.
But how is Average Joe doing? We saw the savings rate in the US is rising again. At this moment it is back around 5-6%. But we are not there yet. A lot of people simply do not have the luxury to save. There is an interesting data index which gives a good indication how hard people are feeling the pain on their monthly payments. It is called the exhaustion rate Index and represents the rate at which people who started collecting unemployment benefits have used up their allotted payments before finding a job. This number is showing that the water is above their eye balls. It is at 49.17 % or to put a real number on it, of the 6.96 million people who were receiving benefits aid last month there are 3.42 million people who have used up their payments and desperately need to find a job, otherwise they will have to fall back on family aid to make ends meet up or even worse a bench in the park is waiting for them. Bear in mind the total amount of people who are in a similar condition is much higher. These numbers do not reflect those who have been kicked out of benefit aid programmes or those who are still combining 2-3 jobs a day trying to keep up with their mortgage payments but are on the verge of foreclosure.
The latter is also a painful situation as the government programmes in place to give debt relief is for those who have hit rock bottom and have digged a whole in the ground. To qualify for government aid you don’t only have to fall behind of your payments. You must be delinquent. If you’re trying to cut on your food budget, or selling you’re wedding dresses and jewelry just in order to keep track with your mortgage payments, you will simply not qualify! We are talking about several millions of people here on top of these numbers.
The latest developments on the mortgage market is not helping these people either as the US 30-year average mortgage rate has surged from an April low of 4.85% to a high of 5.74% before falling back slightly. Current levels of US mortgages are still around levels last seen in 2001.
Figure 3 US Exhaustion rate
Source: © Bloomberg L.P. Used with permission. Visit www.bloomberg.com
As long as this keeps on deteriorating one cannot expect any improvement in sustainable growth on the consumer side. Neither can Asian economies, which are highly export dependent, expect that there will come a recovery in international commercial trade. The demand which has to come from Average Joe, who has funded their enormous reserves over the years, is simply not there anymore. With less supply for credit (due to the disappearance of the Shadow Banking system), these economies shift towards a new consumption equilibrium, which exporters are not prepared for.
Do not get us wrong. We probably see some slight recovery in growth, but this is only inventory driven. The so called green shoots that some people might have seen were based on this global inventory rebuild. This is not an abnormal phenomenon. One needs to bear in mind that the global economy around October last year came to a total stand still and inventories were build down very slowly. Around March the store shelves around the world got finally empty (depending on which products you are looking at as in the car industry the parking lots are still full with cars assembled in August-September of last year) and this needed to be restored to some extent.
For a full sustainable recovery we first need the housing market to restore and this goes hand in hand with the labour market as there is a high correlation between delinquencies on loan payments and losing one’s job.
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