Relevant and even prescient commentary on news, politics and the economy.

Financial Services Intermediation

Traditionally, non-commercial banking (i.e., everything except savings deposits and consumer loans) was about one of two things:

  1. Tax arbitrage or
  2. Regulatory arbitrage

    The rest is window dressing; that is, it was basic financial intermediation, usually for the purpose of helping Corporate and/or High Net Worth clients.*

    That was until the late 1990s and the Noughts, when the third level came to liquidity-prominence:

  3. Credit rating arbitrage

The third is the most chimerical of all, becausemdash;unless you’re selling to or buying from the company that is involved (which has correlation issues, as I noted long ago)—neither party (in theory) has control over the outcome of events. It’s asymmetric information on both sides: not so much gambling against the house as shooting craps in the alley, not certain whether there is a bobby down the block.

All of which is an indirect way of saying: Go Read Kash Mansori. Especially if you think US institutions are managing better than the EU is. (Hint: it may be true on the governance level, but the financial institutions’s exposure appears to tell another story.)

*Think corporate deposits, lines of credit, commercial loans, IPOs that are often used in part to pay off debt, and the like. Normal course of business options, with the selection influenced by tax or regulatory considerations.

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Who Committed Excess Borrowing?

With a hat tip to Rebecca’s post below, normalized borrowing growth in several sectors over the past 25 years. (Source: FRB Flow of Funds data)

Yes, there are three very similar (shades of blue) lines—but they are all household and non-profit data. (The growth in “credit market instruments” is, presumably, primarily driven by the non-profit sector.)

Note also—as Rusty would certainly tell you if I didn’t—that borrowing in the non-financial sector (the red line) has the flatest line of all (it’s at the top through the early 1990s and near the bottom as of last year.

Compare this with Mike Konczal’s graphic of corporate profit shares over the same period (h/t Brad DeLong) and there is a fairly clear case that accusations from bankers that consumers are suffering because of their foolish, excessive borrowing is a case of a very grimy pot talking to a copper kettle.

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Steve Randy Waldman Explains It All to You

Not certain this link will work, but at Interfluidity, SRW replies to Karl Smith, closing with a sentiment with which I am very much in sympathy:

It is not technocratic economists who will win the day and pull us out of our cul-de-sac, but angry Irishmen and Spaniards who challenge, on moral terms, the right of German bankers to impose vast deadweight costs on current activity because they lent greedily into what might easily have been recognized as a property and credit bubble.

Read the whole thing, even if this link doesn’t work.

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Evaluating the "excess" in the US corporate financial balance

In a NY Times op-ed, Rob Parenteau and Yves Smith reminded us that the private sector financial balance is a function of the household financial balance and the corporate financial balance. They concluded the following regarding excess corporate saving:

So instead of pursuing budget retrenchment, policymakers need to create incentives for corporations to reinvest their profits in business operations.

In my view, it’s not that simple (not that passing this type policy would be easy at all). As I illustrate below, firms, like households, are in a deleveraging cycle, where corporate excess saving is likely to persist for some time. (Note: US total corporate financial balance, excess saving if the balance is positive, is roughly undistributed profits minus gross corporate domestic investment)

In their NY Times article, Rob and Yves cite a 2005 JP Morgan study, “Corporates are driving the global saving glut”. In that study, JP Morgan argues that the global saving glut has been driven largely by G6 excess corporate saving, and to a lesser extent emerging economies. In the US, positive corporate excess saving persisted through the latest print, 2010 Q2.

The illustration above plots the total corporate financial balance as a percentage of GDP. I calculate the Total Corporate Financial Balance (TCFB) as in the JP Morgan study, which is the residual of the national accounting identity of the Current Account Balance minus the Household Financial Balance minus the Government Financial Balance. According to this measure, the TCFB was roughly +3% in 2010 Q2, or about +1% above the 2008-2010Q2 average (2.1%).

About the same time as JP Morgan published their research, the IMF and the OECD were wondering why global TCFBs were rising. Several factors are attributed the upward trend in the first half of the 2000’s, including (this is not a complete list of factors):

  • Repurchase of stock shares relative to dividend payouts
  • The falling relative price of capital goods dragging nominal investment spending as a share of GDP (see Table 3.2 of the OECD publication)
  • The overhang of leverage build in the 1990’s
  • Rising profits via falling taxes and low interest payments (especially in other OECD economies)

Although firms likely worked out much of the debt overhang from the 1990’s, the debt accumulation spanning the second half of the 2000’s was precipitous.

It’s very unlikely that the excess corporate saving will fall anytime soon, as non-financial business leverage is high just as household leverage is high. Total non-financial business debt peaked in 2009 Q1 at 79.5% of GDP and is now trending downward, hitting 74.9% in 2010 Q2.

If history is any guide, then the “excessive” borrowing spanning 2005-2008 will take some time to repair. Spanning 2002 to 2004, the non-financial business sector dropped leverage 2.5% to 64%. If this 2-year period of de-leveraging indicates an “equilibrium” level of leverage, then non-financial businesses are likely to run consecutive financial surpluses (excess saving) in order to reduce debt levels by another 11 percentage points of GDP for a decade more.

If firms run excess saving balances, then they’re not investing in future profitability via capital expenditures nor increasing marginal costs, like wages and hiring, relative to profit growth. So while it is true that some fiscal policy should be targeted directly at investment incentives (Rob Parenteau and Yves Smith article), these measures may prove less effective since the non-financial business sector’s desire to “save” and repair balance sheets is high.

I leave you with one final chart to inspire more discussion: a breakdown of the total corporate financial balance into its two parts, financial-business and non-financial business.

The financial balances in illustration 2 are computed directly from the Flow of Funds Accounts, Table F.8, rather than taking the residual as calculated in illustration 1. Thus, the total corporate financial balance will not match that in illustration 1.

The point is simple: the small drop in excess saving in total corporate financial balance in illustration 1 is stemming from the financial side. The non-financial corporate sector continues to raise excess saving by investing retained earnings into liquid financial assets relative to capital investment.

Fiscal policy should be targeted at the high desired saving by the corporate and household sectors alike. The idea is to pull forward the deleveraging process by “helping” households and firms lower debt burden via direct liquidity transfers (lower taxes or subsidies, for example). Only then will healthy private-sector growth resume.

Rebecca Wilder

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Private-sector leverage says that it’s not Bill Clinton

What’s your answer? “Thinking about the past few decades… to the best of your knowledge, which ONE of the following U.S. Presidents do you think did the best job of managing the economy?”

  • Bill Clinton
  • Ronald Reagan
  • Barack Obama
  • Lyndon B. Johnson
  • George W. Bush
  • Richard Nixon

That’s question #11 of the the Allstate-National Journal Heartland poll. 42% of the 1201 adults polled last month answered Bill Clinton.

I wonder why near half of those polled think that Clinton did the best job of “managing the economy”. Using one simple metric, private-sector financial leverage (accumulated dissaving), Clinton ranks among the top three worst economic managers, behind George Bush (Jr.) and Ronald Reagan.

The chart illustrates private-sector leverage as a stock of debt to GDP indexed to the start of each Presidential term. Therefore, the numbers are not the debt ratios, rather the appreciation of the debt ratios since the onset of each President’s term. The data are from the Fed’s Flow of Funds Accounts.

The sector financial balances model of aggregate demand posits that fiscal policy must shift in order to normalize GDP amid deviations of the private-sector surplus (desire to save) and the current account (see Scott Fullwiler’s article on the sector financial balances model of aggregate demand, which references similar work by Bill Mitchell and Rob Parenteau; or you can see last week’s answers and discussion to Bill Mitchell’s quiz for a simple outline).

When the private sector is levering up, the public sector is not doing its job. Since the 1990’s, the private sector loaded up on debt (ran private-sector deficits) in order to maintain GDP closer to full employment in the face of shrinking government deficits relative to those of the current account (since 1991 the current account trended down as a % of GDP). Deregulation, of course, contributed as well.

According to this metric, Barack Obama ranks highest to date, thanks to the automatic stabilizers and the ARRA. But we’ll see what happens when 2011 rolls around: the waning stimulus will drag economic growth; the Congressional tides may turn; and the immediacy of the crisis continues to fade. Unless firms start to “dissave” and pass on profits to households via hiring and wage growth, we may be in for a rocky ride, since the household desire to save will hover at very high levels for years to come (see David Beckworth’s post on the growing mismatch between mortgage debt load and real estate valuations).

Rebecca Wilder

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Open Question: What is the Optimal Level of U.S. Public Debt?

by Bruce Webb

Back in 2000 Alan Greenspan warned Congress about the potential disappearance of the long bond in the face of continuing surpluses. He probably knew at the time that he was just feeding the appetites of tax-cutters, and not say advocating for using those surpluses for something like Universal Single Payer, but he wasn’t crazy, because to some extent the world is dependent on the existence of SOME amount of U.S. Treasuries just to keep the gears of the world economy going. For the time being the U.S. dollar is the biggest component of most other countries foreign exchange reserves and is also used to buy and sell many commodities, particularly crude oil.

So the question is How Low Can We Go? Where is the sweet spot in terms of the ratio of U.S. Debt Held by the Public and world GDP?

Now we know the answer in relation to Social Security, at least the statutory answer. The Trustees are mandated to target a Trust Fund ratio of 100 or one year of future cost at any given time. And since the annual cost of Social Security goes up every year due to changes in population and inflation the result is that even a perfectly balanced system will contribute that much more to total Public Debt (Intragovernmental Holdings combined with Debt Held by the Public) each year. For example you can say all we ‘really’ owe to Social Security is the amount of principal above a TF ratio of 100 plus the costs of servicing the remaining reserve, or $1.8 tn out of $2.5 trillion plus interest on the total.

And it would seem that the same applies to the world economy. How much of that $8.5 trillion are we actually on the hook for? Certainly we owe interest on the whole amount, but realistically how much on net will EVER get redeemed even under ideal economic conditions?

This is not a rhetorical question to which I will spring some nifty answer under the fold, this post doesn’t have a ‘read more’. Anyone care to kick this one around?

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"Run Government Like a Business" = Deficit Spending

We’re used to that line by now. Ross Perot—one of the more prominent people who got rich due to government contracts—used it, Carly Fiorina and Meg Whitman are using it (while desperately hoping you don’t pay attention to how they ran Lucent/HP or eBay), and Aaron Sorkin even had Charles Grodin say it in Dave, if only to establish his Sensible Centrist cred.

So how are businesses running their debt-laden firms? Ask the WSJ and ye shall receive:

U.S. corporations have taken full advantage of low interest rates, going on a bond-issuing binge that has left them with tons of cash, which they appear to be holding largely as insurance against a new bout of financial turmoil, rather than spending on new hires. Nonfinancial companies were sitting on about $8.4 trillion in cash as of the end of March, or about 7% of all company assets, the highest level since 1963. Even before its [$1.5 billion at the bargain-basement interest rate of only 1%] bond issue, IBM had $12.3 billion in cash and short-term investments, which accounted for about 12% of all its assets.

The WSJ is, of course, worried about The Savers:

Meanwhile, though, savers are seeing some of the worst nominal returns in decades. As of June, the weighted average interest rate on deposits, money-market funds and other highly liquid investments stood at only 0.29%. Returns on riskier investments aren’t great, either: The average yield on near-junk bonds with maturities close to 30 years stood at about 5.9% this week.

As Brad DeLong said recently, in a slightly different context, “I share [the] belief that these numbers ought to be higher. But I also think that I don’t have very good reasons to claim that I am right that they should be higher.”

Neither does the market.

And it’s not as if those companies were all saving during the Good Times. Indeed, they were arguably more poorly managed than the government. As Floyd Norris noted almost two years ago:

Over the last four years, since the buyback boom began, from the fourth quarter of 2004 through the third quarter of 2008, companies in the S&P500 showed:

Reported earnings: $2.42 trillion
Stock buybacks: $1.73 trillion
Dividends: $0.91 trillion

The net flows there is -$220B, give or take a billion. It’s spending roughly $1.10 for every dollar you earn. And, to make matters worse, nearly twice as much was spent to make people go away (buybacks) than to reward loyalty (dividends).

If the government really were to be run like a successful business—the way the S&P500 are run, the way IBM is run—they would be borrowing long-term right now at that 2.82% 10-year or even than 4.00% 30-year rate.

If it’s good enough for IBM, it should be good enough for the U.S. Government. The Mitt Romneys and Ross Perots have been telling us that for years; many we should listen?

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Debt, Deficits, and Defense

Debt, Deficits, and Defense…The Sustainable Defense Task Force set in motion by Rep. Barney Frank has comprehensive suggestions. It is more specific than other suggestions I have read.

David Ignatius of the Washington Post sees deficits concern as a possible unifying process among right/left thinking. I don’t see it.

Bruce Bartlett comments on deficits and defense spending here and here.

Concerns about budget deficits and rising debt levels are leading to fractures in the heretofore unified conservative support for ever-higher defense spending. At least a few Republicans are now openly suggesting significant cuts in the defense budget, raising concerns among conservatives primarily concerned about national security. I believe that ultimately national security conservatives will be forced to choose between cuts in the defense budget and tax increases to reduce deficits.

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Is this the return to older values?

Savvy consumer of the St. Louis Today on line edition points us in the direction Pete Peterson might be suggesting from this post:

Debtors prisons might have gone the way of medical leeching and boneshaker bikes, but that doesn’t mean consumers in some states can’t end up in the clink if they fall behind on their bills.

Today, the Minneapolis Star Tribune reports on what appears to be the rising number of arrests of debtors who have been thrown behind bars for missing court-ordered debt payments or for not appearing in court after being sued by debt collectors.

The startling story reveals how debt-related arrest warrants in Minnesota have jumped 60 percent in the last four years, with 845 cases last year. That’s not a large segment of the state’s total arrests, but that doesn’t offer much comfort to those consumers who have been hauled into jail for court offenses stemming from debts as small as $250.

Some responsible, on-time bill payers might not be overly sympathetic to the jailed debtors’ plights, but they should keep this in mind: Often, the expense of arresting and jailing the consumers exceeds the amount owed. And that price tag, of course, is picked up by the taxpayers.

The laws allowing for the arrest of someone for an unpaid debt are not new.

What is new is the rise of well-funded, aggressive and centralized collection firms, in many cases run by attorneys, that buy up unpaid debt and use the courts to collect.

Update: Rdan here…Yves Smith takes the high road on ‘ruthless’ in PR push against strategic defaulters underway…is there a debtor’s prison in your future?. This is Peterson’s choice of words.

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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

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