Yesterday I said that, given the housing rebound, it seemed ever more likely that the US economy would be able to power through the budget cuts from the sequester and the fiscal cliff. This is the asset-based economy at work. There is nothing sustainable about it over the long-term.
The asset-based economy is the term I use to describe the low savings, increasing household debt nexus that had been the central hallmark of the bull market leveraging cycle. After an initial rapid deleveraging during the crisis, the stabilization in house prices has given households balance sheet support. So households are back at it again, building up debt and reducing personal savings, courtesy of the Fed and the rebound in house prices. It won’t last forever. Either wage growth has to go up or spending growth has to go down.
Part of this is due to the income effect of lower rates and part of it is due to the increase in house prices that has allowed households to refinance. In that context, take a look at the following chart which I first posted in October.
When I posted it, I wrote the following:
I have made [balance sheet leverage] the central theme of this blog since its name, Credit Writedowns, is supposed to evoke a sense that bank and household balance sheets are the determining factor in this crisis. But my sense here is that policy makers are still steeped in denial, in large part because of the efficacy of their efforts in creating a cyclical rebound, as the economy has responded to low interest rates. This is illustrated in the chart by the steep decline in debt service ratios. And note, I called this rebound fairly early and received a lot of flak for it, so I do recognise the policy successes here. What mainstream economists and policy makers see when they look at the Goldman chart is that cyclical falloff in debt service ratios. This focus uniquely on debt service costs with no regard to debt to income or debt to GDP levels – what I call “The debt servicing cost mentality” – is extremely dangerous. What I see – and what Roach seems to be pointing to – is the less steep falloff in debt to income ratios. And this makes sense because policy rates are at or near zero percent, meaning that the next recession will not witness such a large divergence in debt service cost and debt-to-income ratios. For debt service ratios to recede in the next downturn, debt to income ratios must be reduced at the same rate, whether through lower debt from default and debt forgiveness or increased income. Likely, default will play the overwhelming role, at least initially.
This is what I was getting at in the last post. The cyclical path looks promising because of the Fed’s reflationary efforts. They have not only reduced the debt service costs to 30-year lows, they have also engineered a housing rebound that allows ever more homeowners to benefit from the reduction in mortgage rates. This is central to the cyclical recovery.
Unfortunately, these effects are cyclical – and dangerous – because it makes it seem like the outcome is sustainable. Certainly household debt to GDP level are lower than they were when the financial crisis began. Nonetheless, they are still elevated on a historical basis. Moreover, the data suggest an untoward level of releveraging is now emerging. Household debt for Q4 2012 came in at $11.34 trillion, up from $11.31 trillion in Q3. Moreover, data released by the US Bureau of Economic Analysis today show the worst dip in personal income in twenty years due to the fiscal cliff. This was not matched by a decline in spending but rather a decline in the personal savings rate from 6.4% to a paltry 2.4%, the lowest savings rate since the financial crisis began five years ago.
We should assume that income and spending will move in tandem over the longer term, though releveraging can allow income to grow less than spending for a considerable time. The key here is house prices, since housing is the principal asset for most households. Going forward, there are a limited number of ways for income and spending to come into line. Incomes could rise as the jobs recovery solidifies. In conjunction with the floor in house prices, this would underpin continued cyclical recovery. Households could dip into savings as house prices rise irrespective of wages. While this is clearly unsustainable, this is certainly the kind of behaviour that some engaged in during the housing bubble – and nothing precludes this from reoccurring. Finally, spending growth could drop to move down to a level consistent with wage growth.
These are the principal reasons I still believe the potential for recession is dangerously high, though no longer a base case. By no means have the full effects of the fiscal cliff, sequestration and higher gasoline prices coursed through the system yet. The lower savings rate will mean revert,. The question is how long the reversion to the mean takes – and under what circumstances do we mean revert i.e via lower spending or higher income.