The Federal Reserve released its quarterly Flow of Funds Accounts, and the message is crystal clear: the private sector is dropping debt burden, while the public sector is growing it.
Quarterly private sector debt growth, households + nonfinancial business + finance, has been slowing or negative since the second half of 2007. In contrast, federal and state and local governments are selling debt like it’s going out of style, with 28.2% and 8.3% annualized debt growth in the second quarter of 2009.
It is no secret that the private sector is unwinding debt, but to what end? 100% of income? – 110%? – Or 65%?
According to Reuven Glick and Kevin J. Lansing at the San Francisco Fed, Japanese households dropped their debt burden to 95% of disposable income. If US households were to follow a similar path, then the debt cycle would be complete in 2018. An excerpt from the article:
After Japan’s bubbles burst, private nonfinancial firms undertook a massive deleveraging, reducing their collective debt-to-GDP ratio from 125% in 1991 to 95% in 2001. By reducing spending on investment, the firms changed from being net borrowers to net savers. If U.S. households were to undertake a similar deleveraging, their collective debt-to-income ratio would need to drop to around 100% by year-end 2018, returning to the level that prevailed in 2002.
There is deleveraging still left in the pipeline, but one cannot say that the Japanese experience foretells the path of US debt. The economic agents, their propensities to save, and underlying economic fundamentals are different: 100% debt to disposable income in Japan may not be the equilibrium level in the US. Unfortunately, though, nobody can tell you what the level is…just something less than 125%.
The path of saving (paying down debt)
The US economy has suffered a precipitous drop in consumer demand, as the marginal saving rate surged. Going forward, higher saving (the average saving rate) does not preclude income and economic growth per se, but increasing saving (the marginal saving effect) can.
As wealth effect ratios stabilize – the chart to the left features the wealth effect as household net worth/personal disposable income – I believe that household saving will stabilize and consumer spending will grow with income.
Admittedly, though, the lag structure of the recent anomalous wealth effect is not known, and the strong marginal effect on saving might continue (i.e., the saving rate grows, as in the San Francisco Fed paper). To be sure, the labor market has dropped wage growth to record lows (see Mark Thoma’s post here), and Q2 ’09 annual disposable income growth was negative (a first since 1951). Not good for contemporaneous saving and spending growth.
The next four quarters, or the early period of recovery, will be critical in setting the stage for income growth. The recovery is expected to be weak, with the consensus GDP growth forecast around 2.4% in Q4 2009. But given the precipitous decline in output, even a 5% annualized quarterly growth rate during the early recovery would be rather “weak”. There’s room for an upside surprise as financial and housing markets stabilize.
Rebecca Wilder (if you are interested, I listed additional Flow of Funds charts here)