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US Flow of Funds: wealth recovery fully underway, China?

by Rebecca Wilder
(crossposted with Newsneconomics)

This week the Federal Reserve reported the Q3 2009 Flow of Funds accounts. The headline indicators show household net worth improving and private debt burden falling.

The private sector – households and firms – is dropping leverage.

Update: This chart has been modified slightly – the leverage level data (highlighted in blue, red, and green) has been updated.
Either by default or by growing saving, the private sector is de-leveraging. According to the D.1 table, households and nonfinancial businesses dropped debt a further 2.6% q/q annualized, while financial sector debt fell another 9.3%. However, total debt (of the domestic nonfinancial sector) grew 2.8%, as the federal and state and local governments grew debt 20.1% and 5.1%, respectively.

Household wealth grew $2.7 billion trillion for a cumulative gain of $4.9 billion trillion since wealth hit a cyclical low in Q1 2009. To put this gain in perspective, household net-worth dropped $17.5 billion trillion from Q3 2007 to Q1 2009, 3.5 x the recent gain. Wealth to disposable income, a statistically significant factor of the personal saving rate, rests right around it long-term (1952-1007) average, 4.9.

The chart illustrates the wealth-effect as the ratio of net-worth to disposable income. The direct and adverse impact of the wealth loss on consumption probably peaked last quarter; however, the lagged effects are ongoing.

Notice that the ratio shifted discretely in the 1990’s, not coincidentally when China’s current account surplus took off.

Most likely, the wealth to personal income ratio has mean-reverted, and will not rise back to its 5.7 1997-2007 average. A necessary condition is that global portfolio flows rebalance – i.e., China saves less and the US saves more. However, this will not happen tomorrow – de-leveraging is a process that takes years. The increase in international saving (i.e., falling current account deficits) will take some time, and by definition includes the general government eventually dropping its debt burden. Not to mention the political rhetoric and growing trade barriers suggest that a long-term economic shift is a ways off.

Rebecca Wilder

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Household leverage: US vs. UK

Households in the US and the UK are members of the “most levered club”. But put their balance sheets side-by-side, and the outlook for the US economy looks a little brighter than that for the UK. Why? Both are dropping debt burden, but a qualitative analysis suggests that the UK household leverage (probably) should be falling at a more accelerated pace.

The chart illustrates leverage in the US and UK, or household debt (loans) as a percentage of disposable income (DPI) through Q3 2009 and Q2 2009, respectively (the UK releases Q3 Economic Accounts at the end of December). By Q2 2009, UK and US households dropped leverage rather coincidentally, -4.8% and -4.4%, respectively. However, the debt bubble was bigger in the UK than in the US, peaking at 160% of DPI compared to 131% in the US. Why isn’t leverage falling more quickly? Spending.

To be fair, UK Q3 statistics may paint a very different picture. However, that is unlikely, given that real retail sales continue to grow, 3.2% at an annualized rate in the three months ending in October.

Oh, it all makes sense now: UK retail sales remained firm in 2009, and real home values hit a (probably local rather than global) cyclical low much earlier than in the US.

This is an ominous sign for the UK economy. Households are kicking the can down the road: de-leveraging – paying down debt by dropping consumption and saving a relatively higher share of income – is inevitable.


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Flow of Funds Accounts: some are deleveraging, while others are not

by Rebecca

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)

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Debt fueled consumption


Rebecca Wilder will begin writing as a Bear soon. Meanwhile, she maintains her own blog NEWSNECONOMICS. Here is an example of an Aug. 19,2009 post, which I am cross posting today, and a follow up post here. There were several questions raised, but I think it an interesting notion. I own an old Malibu and not a Porsche, and have watched my premiums and out of pocket health expenses skyrocket this decade. I knew the money went somewhere! Here is the cross post:

Today I plan to rant just a bit about consumption because I was reading Yves Smith’s article today, and she referred to “debt-fueled consumption” – the now pejorative phrase that just rolls off the tongue. She says:

“no where does the article [referenced WSJ article in her post on the consumption share] acknowledge that the consumption level was unsustainable and debt fueled.”
And this is where I get just slightly irked, because it seems to me that the phrase “debt-fueled consumption” strikes the following chord: every American household was loading up on home equity debt just to buy big ticket items like Hummers and large sofa sets with cup-holders galore from Jordan’s Furniture (a discount furniture shop in the Boston area – generically, every city has one).”

I am sure that Yves Smith knows this, but the debt-fueled consumption was more likely paying surging health care bills than buying cute kitchenettes.
(charts are fixed…update rdan)

Myth 1: The years of debt-fueled consumption went into goods spending, jumping the consumption share of GDP to an excess of 70%.

Update: large edition of graph here.
Reality: The goods share of total consumption has been falling quite dramatically, while the service component surged. Therefore, it is more likely that the debt fueled consumption was going predominantly into the service component (paying service bills).

In Q2 2009, 25% of service spending went to health care – outpatient services (physician, drugs, dentist) or hospital and nursing home services – and 29% of service spending went to housing and utilities – rent, water, electricity, and trash. As such, over 50% of service consumption is more likely to remain stable, even rise faster, with the Boomers out there.

And as for the speculation that workers are postponing retirement due the drop-off in wealth, and consumption will be meager into the medium term, I simply don’t buy it. If anything, the aging population is going to fuel recovery – no matter when they choose to retire. Service sector consumption growth – much of it based on health care consumption – will simply become a larger share of GDP growth (cutting out autos, perhaps), and pick up some of the slack.

And here’s another thing. Myth 2: durables consumption – i.e., autos and furniture – are important contributors to the initial stages of the recovery. It helps, but service consumption is the biggie.

Update: enlarged chart is here

The chart lists the average contribution each GDP component during the initial year of recovery spanning the 1950-2007 (nine recoveries in total).

Reality: The average growth accumulated during the initial stages of recovery (1-yr following the recession’s end) following the last nine recessions is a remarkable 6.43% (consensus forecast for growth in 2010 is currently 2.3%). Only 0.47% of that came from durable goods. A huge 1.67% of that stemmed from the service component of consumption (again, health care and housing).

And as long as service spending rebounds, so too will the economy – even without a big pickup in autos. Inventories are almost a foregone conclusion, the residential construction sector is bound to pick up – 500-600k units is simply unsustainable for a US population that is growing at roughly 1% a year, and growth rates on such a small base can be large.

And here’s another link to jobs that has not been incorporated to many forecasts – growth in jobs means new health care insurance, means added spending on health care.

I could go on, but I won’t.

Rebecca Wilder

Chart from follow up here.

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