Reducing household financial leverage: the easy way and the hard way
In case you haven’t noticed, I have become slightly less “optimistic” about the prospects of a sustainable U.S. recovery. I used to think that the household deleveraging story was more of a decade-long project, and the economy would cycle throughout. But recent deficit hysteria has me worried; income growth might lapse.
What differentiates this recovery from every other cycle since 1929 is the lingering debt deflationary pressures. There is a very large overhang of U.S. household financial leverage that’s going down one of two ways: the easy way, through nominal income growth, or the hard way, by default. Unfortunately, the hard way is rearing its ugly head.
The chart above illustrates private-sector financial leverage (debt burden). Not a surprise; but, the real leverage problem is in the household sector, and to a much lesser degree, the non-financial business sector. Household debt burden is the ratio of the debt stock (generally mortgages outstanding plus consumer credit) to income flow (personal disposable income), while “de-leveraging” is reducing this debt burden.
Given that the burden has a numerator (debt stock) and a denominator (income), de-leveraging can occur through either variable. As such, I see three (general) de-leveraging scenarios (See an earlier McKinsey study on the consumer for a broader discussion):
1. If there is no income growth, then households must manually pay down debt at the cost of current consumption. The consumption decline drags the economy, and some default results.
2. If income growth is positive, then the degree to which households must pay down debt at the cost of current consumption will depend on the pace of income generation. This is the most macroeconomically-benign scenario.
3. If income growth is negative, i.e., deflation, then real debt burden rises. 30-yr mortgage payments, for example, are fixed in nominal terms and become more difficult to meet as income declines. In this case, widespread default is likely.
Of course, these are just three broad categories, but I believe that my point has been made. Clearly, choice 2. is optimal. However, evidence is pointing to a de-leveraging process that is more of the 1. and/or 3. type, especially as the federal stimulus effects run dry (although I have noted before that there is room for error in the measurement of the income data).
The chart illustrates annual growth of disposable personal income minus annual growth of disposable personal income less government transfer receipts (DPI – DPIexT). The variable DPIexT proxies the personal income growth currently generated by the private sector only. Note: this is a calculated number, based on the BEA’s monthly personal income report (Excel data here). The spread has never been wider, 2.1% Y/Y DPI growth over DPIexT growth in February, spanning every recession since 1980.
The government is propping up income (as it should be). Spanning February 2009 to February 2010, DPI averaged 1.2% Y/Y growth per month, while DPIexT averaged -1.1% Y/Y per month. Further, since the onset of the recession DPIexT fell an average 0.03% M/M (over the previous month), while DPI grew 0.18% M/M.
The economy has crossed the threshold and is expanding – phew! However, without a burst of export income, it’s going to take a lot more than 123,000 private payroll jobs per month to free the economy of its fiscal crutch. (I debated whether or not to use the term “crutch” when applying it to fiscal policy because fiscal policy is not a crutch; but the metaphor works.)
Households WILL drop leverage further; it’s just a matter of how smoothly.
Rebecca Wilder
Dear Rebecca — Can you pass me web links to access these two charts?
thx much
vr jsn
Hi J,
Just email me; I can send you the data directly. The charts are not copied from any source.
Rebecca
I suspect in terms of efficiency of increasing nominal income per unit of debt accumulation, to help bring incomes in line with asset prices, the best approach is simply to print money and distribute it as broadly as possible from the bottom up.
That is, we can perhaps get as much of a nominal increase of income by having the federal government issue a negative income tax financed not by selling bonds to China, but by printing the money; as compared with borrowing a comparable amount of money and spending it on general government operations.
At the rate we’re borrowing, it certainly seems worth contemplating the relative impact of say printing $25 Billion as compared with borrowing $250 Billion. It seems that what we WANT is some inflation, with it best as wage inflation relative to GDP or perhaps as steady wages relative to GDP with some consumer price inflation related to a negative income tax. Basically, we need to reallign asset prices with wages, in order to support existing asset prices sustainably.
Thoughts?
Rebecca,
I share your outlook concerns, though some government statistics do not appear to support your (and my) position regarding household debt.
Take a look at the household debt service ratio (DSR) and the financial obligations ratio (FOR), analysis of which is provided by the Federal Reserve. Here’s a comparison of 2009 4th quarter ratios and the last time such ratios were as low or lower. Household debt management appears to be in far better shape than could be the case.
Household Debt Service and Financial Obligations Ratios
DSR:
09q4 12.60
00q4 12.59
FOR – Total:
09q4 17.51
00q3 17.39
FOR – Renter:
09q4 24.39
93q4 23.92
FOR – Homeowner:
Total
09q4 16.08
03q3 16.06
Mortgage
09q4 10.55
05q4 10.54
Consumer
09q4 5.53
95q4 5.50
Notes:
“The household debt service ratio (DSR) is an estimate of the ratio of debt payments to disposable personal income. Debt payments consist of the estimated required payments on outstanding mortgage and consumer debt.”
“The financial obligations ratio (FOR) adds automobile lease payments, rental payments on tenant-occupied property, homeowners’ insurance, and property tax payments to the debt service ratio.”
“The homeowner mortgage FOR includes payments on mortgage debt, homeowners’ insurance, and property taxes, while the homeowner consumer FOR includes payments on consumer debt and automobile leases.”
Source:
Household Debt Service and Financial Obligations Ratios
Federal Reserve
http://www.federalreserve.gov/releases/housedebt/default.htm
These references also deserve a review:
Consumer Credit
http://www.federalreserve.gov/releases/g19/Current/
Z.1 Release
http://www.federalreserve.gov/releases/z1/
Statistics & Historical Data
http://www.federalreserve.gov/econresdata/releases/statisticsdata.htm
.
I looked at the BEA’s personal income/outlay and consumption expenditure tables. It’s clear that households will have a difficult time maintaining existing levels of disposable income and savings as local, county, state, and finally federal taxes and fees increase. I have no expectation during the next few years that average worker wage income growth will more than offset the growth in taxation and fees at all levels, and outpace price increases for certain goods and loanable funds interest rate increases. I don’t view consumer demand as the economic recovery savior for this cycle. That would be asking for a miracle.
NIPA Tables: Section 2 – Personal Income and Outlays
http://www.bea.gov/national/nipaweb/SelectTable.asp?Selected=N#S2
Underlying Tables: Section 2 – Personal consumption expenditures
http://www.bea.gov/national/nipaweb/nipa_underlying/SelectTable.asp#S0
.
Sigh. The powers that be are unaware (like many in Congress) or do not care.
Rebbecca,
Cent 21 is on the right track:
“Basically, we need to reallign asset prices with wages, in order to support existing asset prices sustainably. “
The problem is it is far easier to have asset prices (housing) drop than it is to raise wages to get back to sustainable price vs wage ratios. Traditionally the median house price should be 2.5 to 3 times the median wage in an area. Right now housing is still in bubble mode in many places, and still going down back to that sustainable ratio. Southern California has dropped 40-50% since the peak and probably has another 10-20% to go. There are other places just as bad. (Phoenix, Las Vegas, Florida, etc) There are plenty of housing bubble blogs for tons of data.
The asset prices need to come down to the historical mean so we can get back to a stable & sustainable real estate market. Anything that slows the process just prolongs the pain. We should be making foreclosure, short sales etc more efficient to get us out of the bubble and clear out the debt. In this case gov policy is exactly the wrong thing to do – unless your in the pocket of the real estate industry.
Islam will change