THE LONG TREK BACK TO SUSTAINABLE DEBT LEVELS

The private sector debt problem is no secret although the mainstream media is still blinded by the supposed public sector debt problem.  Of course, there is no public sector debt problem in the USA so it’s not surprising that the economy remains in a funk while policymakers fail to focus their efforts on the right problems.

On Friday I posted an update on the status of the long running balance sheet recession.  Over the weekend, the Wall Street Journal ran an excellent piece putting the problem of household debt into perspective:

$26,172: Amount of debt the average U.S. household would need to cut to bring balance sheets back to 1990s levels.

“…In the first quarter, households owed $13.3 trillion, an amount equal to 18.4% of total household assets, including stock portfolios, savings and homes, according to the Federal Reserve‘s flow of funds report. That was down from 21.7% two years earlier but still well above the 14.4% level that prevailed in the 1990s. That suggests household balance sheets don’t have nearly enough cushioning against financial shocks, like job loss and illness, as they should.

To get back to 14.4%, households would have to shed a combined $2.9 trillion of debt. In other words, either people cut their credit cards up like crazy, or they keep putting their keys in the mailbox and walking away.

Another way: Increase household assets by $20.4 trillion — a 30% gain that would all but wipe out real estate losses and take the stock market to a new all-time high. History suggests that day will eventually come, but given the current state of the financial and housing markets, it seems unlikely to come quickly.”

That’s an excellent summary of the issue.  Earlier this year, I provided an analysis showing how and when the balance sheet recession might end.  I said:

“At the current trajectory it’s not unreasonable to assume that the balance sheet recession will last well into 2012 and potentially  longer.  While a 1:1 ratio is “sustainable” by my estimates, it would be comforting to see levels closer to the historical levels in the 80% range.  If that is the case we could see the impact of the balance sheet recession persist far longer than anyone believes. The obvious upside risk is a dramatic improvement in the labor market.  On the other hand, our government is now explicitly encouraging fiscal imprudence in an attempt to “keep asset prices higher than they otherwise would be”.  This sort of policy has the very real potential to increase instability and turnrecovery into bubble.  Other exogenous risks (Europe, China, housing prices, etc) also pose substantial risks to the downside.  For now, I think it’s safe to assume that the recovery will remain fairly fragile well into 2012, but given the size of the deficit and potential for labor market improvement we could see continued economic strength.”

This still very much applies today.  I don’t necessarily think we have to get back to the 1990 debt levels as the WSJ piece implies, but we must see incomes come back in-line with total debt levels in order to allow for proper servicing of these debts.   The Fed is convinced they can fix this issue via their wealth effect, however, as I’ve repeatedly noted, this economy requires real wealth expansion and not just nominal wealth increases based on speculation.  Unfortunately, there are no quick fixes here.  And as the WSJ notes, there’s really only one thing that can heal the balance sheet recession – time.  In the meantime, we should remain cognizant of our issues and ensure that we don’t repeat the mistakes of Japan and Europe.

Update – Some readers have noted that this analysis does not break down the issues by class and income.  This is true and I am painting the picture a brush that is a bit too broad.  Readers might be interested in the following paper which succinctly summarizes the growing issue of debt and its effect on income disparity and unevenness in the US economy.

http://www.levyinstitute.org/pubs/wp_589.pdf

Update 2 – I’ve also updated this with a new post here.

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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • Jwilliams

    No. This is a terrible and misleading summary of the situation. It addresses averages across the entire population. It fails to take into consideration changes to wealth concentration. With the massive income tax cuts benefiting the very top, much more so than middle income America, and with income growth concentrated at the very top, we’re in a situation where all the assets are held by a couple million Americans, and all the household debt held by a couple hundred million other Americans. As a result, the situation of household indebtedness is far worse than portrayed in this article.

  • For Sure

    This article is so far off the mark it is beyond what the crew over at CNBS would cosider believable

  • boatman

    private debt continues to strangle us ….and the zombie-bailed-out-banks borrow at ZERO %,clip treasury coupons and speculate on commodities with it……many of my nieghbors used their bubbled house equity for collateral for all sorts of things they couldn’t afford.

    it wasn’t caused by “massive tax cuts for the rich”….what would you do? wealth redistribution?…….next there will be talk of ‘slave reparations’ in the comment section here.

    i guess cullen got on the socialist party hit list for his dissagreement w/krugman……..or maybe it was that he didn’t refer to him as “Professor” or bow to him as obozo is fond of.

  • boatman

    pawlenty’s plan’s effective tax rate for people with <50,000$/year income…….ZERO.

    i guess thats letting the rich off the hook,huh.

  • Anonymous

    @ boatman: pawlenty’s plan’s effective tax rate for people with <50,000$/year income…….ZERO.

    We already have millions of taxpayers with incomes <$50,000/yr who not only pay no income tax, but Clinton's "end of welfare as we know it" has morphed into tax law administered welfare, with many of those taxpayers now receiving so-called "refunds" generated by credits well in excess of their income tax withholdings.

    Alexis de Tocqueville was right – when he said way back in mid-19th Century times: "The achilles heel of the America form of democracy is the electorate's ability to vote itself money".

  • llisa2u2

    The majority of US citizens don’t realize they have been voting for quite a while to redistribute real wealth to a few elitists,especially since the 1980’s. Those elitists are only coincidentally Republican or Democrat. Much of the basic problem today is based in the fact that members of Congress are paid from public funds, and that members of Congress can determine their own benefits from these public funds. Corporate collusion and escalating political spending just escalates from that original little problem. Wasn’t that little problem mentioned along time ago by one of the US political leaders from way back when? The electorate really isn’t the public, the electorate body is really the electoral congress and buddies, and buddettes. The rest are a passive audience reacting to focused media hype focused by a few, possibly the same buddies and buddettes on the extended select and limited payroll of the spinoff of immediate profits to the few elitists.

  • quark

    I wouldn’t argue that the 1990’s was an example of the prosperity levels we need to achieve.

    We were feeding off of credit to expand our growth in the 1990’s just as we did in the 1980’s. You would need to go to the years following WWII to find real economic growth that did not sacrifice the future for current economic growth.

  • quark

    “future for current economic growth” should have read “future for current consumption.”

  • First

    Cullen.

    You are absolutely on target when you say “this economy requires real wealth expansion and not just nominal wealth increases” Unfortunately modern money tends to favor expedient nominal wealth creation.

    Anonymous.

    You say “Alexis de Tocqueville was right – when he said way back in mid-19th Century times: “The Achilles heel of the America form of democracy is the electorate’s ability to vote itself money”

    Even he could not have envision such madness when he said “The American Republic will endure until the day Congress discovers that it can bribe the public with the public’s money”. He did not know at the time that it would eventually print the bribes and grow it self to power.

  • jeffc

    Demographics for the US support the deleveraging thesis – many folks need to save to not only pay off debt but also for their retirement. Japan is an example still deleveraging for the past 20 years (unlike americans they are/have been net savers) and their difficulty is compounded by aging population that tend to spend even less.

    I also agree the income distribution gap in the US compounds this problem in america as the more wealthy (net positive equity) and extreme wealthy can trickle their wealth by excess spending but tend to invest/speculate to increase/maintain their wealth. The middle and lower class which drive the economy are largely living pay check to pay check and need to manage mortgage/retirement instead of any excess spending.

    I think anyone who believes the that things will get back to the way they were pre 2008 need to consider the demographic implications as a empty nest older population tends to spend less.

  • http://www.pragcap.com Cullen Roche

    Regular readers have seen me discuss this a million times in the past. Welcome to the site.

  • N

    We know why there is a huge increase in the debt to assets ratio: the housing bust. The suppressed level of the housing market is a temporary phenomenon that now some people accept as a permanent shift. This is not reasonable. Housing will recover sooner than later and it will bring the debt-to-asset ratio down.
    What are my reasons to believe this? First, the population growth is steady and household formation is on the rise again. These are the main drivers of demand for housing. Second, we have underbuilt dramatically in the last 3 years. Brad DeLong has estimated that while before the bust the construction was running at cumulative #300B above the multiyear trend, after the bust it has been running at cumulative $2T below. This means that the cumulative construction shortage is about $1.7T. The market has overreacted six times more on the downside compared to the overreaction on the upside. This is simply not sustainable.

  • VRB II

    There is not enough space to go into every specific about the wealth distribution gap widening. This is one part of the many inferences you could let your self incorrectly assume CR isn’t aware of or hasn’t thought of. The point is well made by Cullen here and weekly. I think you’ll find your issues with this piece are not with CR but letting your beleifs about what should or shouldn’t be affect how your processing what CR has written. There is obviously much more to this story and I hope some readers will assume CR- is thoughtfull enough to understand your concerns while not writing a 17 page white paper. So that he covers all basis. As much as I appreciate CRs hard work even I don’t know if I would read TPC if he tried to pre-emptively cover all the angles. He does it over time. Those of us who read him regularly don’t have to tell him what he’s missing. I’m certain over time you’ll see this.

  • dean

    the public sector helped create the private sector debt problem.

  • http://owncar.eu Tate

    The majority of US citizens don’t realize they have been voting for quite a while to redistribute real wealth to a few elitists,especially since the 1980′s. Those elitists are only coincidentally Republican or Democrat. Much of the basic problem today is based in the fact that members of Congress are paid from public funds, and that members of Congress can determine their own benefits from these public funds. Corporate collusion and escalating political spending just escalates from that original little problem. Wasn’t that little problem mentioned along time ago by one of the US political leaders from way back when? The electorate really isn’t the public, the electorate body is really the electoral congress and buddies, and buddettes. The rest are a passive audience reacting to focused media hype focused by a few, possibly the same buddies and buddettes on the extended select and limited payroll of the spinoff of immediate profits to the few elitists.
    +1

  • JWG

    I am looking at a chart that shows total US debt as a percentage of GDP as 369.7% as of Q3 2009. In 1932 it hit the previous peak of 299.8% of GDP, kept falling after that, bounced due to WW2, leveled out in the 1950s at a low level and then grew slowly until 1982, at which point it started a blowoff parabolic rise that continues to this day, with only a temporary blip down due to the 2008 crash.

    I know that correlation does not prove causation, but the parabolic rise of debt to GDP from 1920-32 and the ensuing disaster makes me think that TPC is, if anything, much more optimistic in 2011 than history would justify. The median wage earner is choking on debt; the averages look better due to distortions caused by the relatively few high end winners in the US economy. Without income stabilizers, transfer payments, delayed foreclosures, squatter’s rent and the Fed’s unlimited liquidity, we would now be reliving 1932, complete with Hoovervilles, bread lines and bank holidays.

    The 2008 GFC might have been only the first shoe to drop. QE is the magic amulet (in the eyes of Wall Street) that wards off the dropping of the second shoe. I think that S&P 1040 or thereabouts is the number for the Fed that will trigger the magic once again. We’ll take another step down the road to Japanification.

  • rhp

    @N,

    “First, the population growth is steady and household formation is on the rise again. These are the main drivers of demand for housing.”

    Populations of India, Nepal, and China have far outstripped housing for years, so these are only the “main drivers” when there are adequate jobs and money circulation to pay the builders. Until the balance sheet recession is addressed, the chances of housing rebounding remain low.

  • Wulfram

    It’s important to remember that desire is not demand. I may desire a Maserati — I would gladly settle for a Porche 911 — but that does not mean I create demand for the manufactures of those seductive, opulent vehicles.

    Those forming households now and into the next decade face an era of high unemployment, restricted wage growth, and job instability, as well as inflation of core items. They may desire houses, but the only way I see demand created is by households falling into the dangerous two income trap or through unhealthy levels of leverage.

    In addition, we’ll see boomers cause demand destruction as they liquidate or downsize in order to make up for shortfalls in retirement income.

  • Willy2

    “”No Public sector debt problem”” ? I have visited this blog for over a year now and learned a lot but this is something still don’t buy into. Yes, the FED could monetize the entire “”kit caboodle”” but then they’re preparing the stage for (Hyper-)inflation.

    Yes, I know what our TPC means: “”Public debt equals private savings”” but if there’s no problem with the public debt then this would effectively mean that the government on every level together has to nationalize the entire USA. Including every grain of sand. But then we’re back to socialism soviet style.

    The NY Times overlooks one important factor: Those who have debt simply need to have an income to pay interest on those debts. When there’s not enough income folks can’t pay interest on the debt and/or pay down that debt. But with unemployment still rising the total income to service debt simply decreases.

    And of course, the US is dependent on the kindness of strangers with its chronic Current Account Deficit since the mid 1960s.

  • Willy2

    Ooops, it should have been Wall Street Journal, not NY Times.

  • Adam

    Willy2,

    I’d recommend you keep reading up on MMT because you still haven’t mastered it.

    A couple points…
    You say, “Those who have debt simply need to have an income to pay interest on those debts.” When you really mean to say, “Those who have debt DENOMINATED IN US DOLLARS simply need to have an income IN US DOLLARS to pay interest on those debts.”

    For a USER of the US currency they must have an income in dollars (or some other source of dollars) to pay back debts in US dollars. The US government is its own source of dollars – it can never not have enough of them.

    “…but if there’s no problem with the public debt then this would effectively mean that the government on every level together has to nationalize the entire USA.” I assume you mean to pay back that debt and to that I would say why? Since when does the government have to pay back the debt? To pay back the debt would not be to nationalize everything, it would be to destroy all of the savings accumulated and held in treasuries. Since when is the destruction of private sector savings good policy? The debt should be continually rolled over into forever (that is a tad overly simplistic as there would be scenarios where paying it back would be approprate, but that requires an extreme level of sustained export surpluses).

    “And of course, the US is dependent on the kindness of strangers with its chronic Current Account Deficit…” When you finally understand MMT you will begin to question who’s dependent on who in this scenario.

  • Willy2

    I have read a lot about MMT and I still continue to think it’s bolderdash.

    I know Current Account Deficits are a double edged sword. But those who hold USD DO have a choice: Buy e.g. a 10 year note yielding say 2,5% (today) or Agency paper or holding cash. When the note goes down in value then any investor (including foreign central banks) WILL sell that note, pushing interest rates even more higher. And therefore the debtor (in this case the US) is dependent on the kindness of the creditor. The creditor is in control not the debtor. And since the early 1980s the US is a net debtor. And only because those creditors were willing to plough those USD back into US equities the US was able to survive.

  • http://www.pragcap.com Cullen Roche

    Not true. China is a large owner of UST’s by virtue of their trade surplus with the USA. There is no such thing as China dumping their UST’s. Besides, even if they did, they’d still have to find a buyer. Someone holds the assets. It’s not like China can crash the biggest market on the planet….You’re just not understanding the relationship between foreign ownership of debt and solvency of the issuer.

  • Adam

    You’re missing 2 key points. As Cullen just said the dollars are in a closed loop. They can’t escape, if China or whoever sells them then there must be a buy to put them somewhere. They get recycled back into the system and eventually back into the bond market.

    Secondly and most importantly and most often forgotten… the US is a MONOPOLY issuer of its currency. The US government (and the FED) has compelete control over price (or interest rates). As with any monopoly supplier all it has to do is set the price and supply to that level of demand at that price. One of the failures of QE2 was that the FED set the supply and not the price. Had the FED said it wanted 10 year treasuries at 2% and then just supplied the dollars (bought up all offers not at that price) to acheive it then 10 years treasuries would have been at 2%.

  • Willy2

    @TPC: You’re contradicting yourself.

    You’re mistakenly conflating a number of things.
    Yes, as a result of the US Current Account Deficit the amount of USDs outside the US increases.
    Yes, as a result of the chinese current account surplus the chinese central bank is accumulating USD, Euro’s etc. But this does not automatically mean that they will continue to buy or won’t sell USD and Euro denominated debt. They can also keep their USDs, Euró’s in cash. (Like TPC has said before). Foreigners have agressively sold their Agency paper in the 2nd half of 2008 and that pushed the teetering Lehman Bros., Fannie Mae and Freddy Mac over the edge.
    So, if foreigners are losing confidence in the US (i.e. rising interest rates) then foreigners are going to sell their Treasuries or reduce the average maturity of their USD denominated debt. But surprisingly, selling T-bonds or any other USD denominated debt, and that will surprise a lot of inflationistas, that will be a force pushing the USD(X) up.
    The chinese want to diversify out of the USD, so they issued debt denominated in Yuan to facilitate their trade with other asian countries.

    “find a buyer”” ? what about the FED in an attempt to keep the system from blowing apart.

    No, the FED does not have complete control over interest rates. If that would be the case then why went rates up in the timeframe august 2010-january 2011 ? In the 1950s, 1960s and 1970s the FED bought a lot of debt out of the market but interest rates went up anyway from about 2.5% in 1950 up to 15% in 1981.
    The FED (or for that matter any other central bank) can supply the money/increase reserves/print money (whatever you want to call it) but it’s the market that decides where that money will go. E.g. flee the US and then the US is in deep, deep trouble.
    And DO NOT conflate a rising USD with an inflow of USD into the US. It’s simply that demand for USDs increases more than for e.g. EURs, CADs, AUDs, NZDs or BRLs. Hence the falling e.g. Eur/USD. But those USD (a.k.a. cash) can be held outside the US.

    In every recession interest rates go down and the yield curve steepens. But with the 3-month T-bill rate at about 5 basispoints a steepening yield curve would mean that the long end (10 year, 30 year) of the curve could(/will) dramatically rise. And with rising long rates EVERY country is in deep, deep trouble. Including the USA.

  • Willy2

    Perhaps even short term rates could go through the roof.

  • http://www.pragcap.com Cullen Roche

    So China stops buying UST’s. Big deal. They’ve been cutting back for a year now and the US Treasury market has been just fine. All the fears about China were misguided. I don’t see the big deal here.

  • Adam

    You’re making a fundamental mistake; you are assuming cash is different than a treasury bill. The only difference to the US governments balance sheet between a dollar bill and a treasury bill is that one pays interest and the other does not.

    If I follow you’re train of thought you feel that if everyone just moves to cash currency that the US Treasury bond market would be in trouble. But you misunderstand a couple things.

    1) The US government always spends first. Operationally the Treasury does not say we have a project to fund and need to issue bonds. What happens is the FED calls the treasury and says we need you to sell X dollars of bonds to remove X dollars of reserves from the banking system. Where did those X dollars in reserves come from? It came from prior net spending. Bond sales only convert zero interest earning reserves (cash) into an interest earning bond. Both are financial assets which are interchangeable on the government’s balance sheet and between the FED and the Treasury they have an infinite capability of creating either.

    2) Why would someone (like China) want to hold all of their US Dollar assets in cash? Holding that much cash would be extremely expensive (of course it would generate a lot of employment). And where are they getting this cash from? The excess cash would have to come from either reserves spent into existence by the government or created by the FED as the banking system SWAPPED them for their treasuries.

    3) You also confuse actions with ability. Yes it is true that the FED does not actively manage every point on the yield curve; BUT if it wanted to it is within its power to do so. All it has to do is name a price and guarantee to buy as much as the market throws at it at that price.

    4) If foreigners were really losing confidence in the US why would they hold any US dollar assets, whether they are cash or treasuries? Again, there is only an interest rate difference between the two. If you think foreigners are afraid of defaulting on treasuries it is only because political default is a possibility; though it would be a very stupid one (and I’m not saying it’s not possible).

    “The chinese want to diversify out of the USD, so they issued debt denominated in Yuan to facilitate their trade with other asian countries.” So what? It would actually be a good thing over time for the US to not be the reserve currency. Yes we wouldn’t have a pricing advantage in the import markets but it would allow the dollar to float to a level where it should be balancing trade over time which would help bring that worrying budget deficit into line (if you’re worrying about it).