Why The Real, Not Nominal, Consumer Debt Burden Will Push The US Economy Lower And Force The Fed To Accelerate Its Monetary Intervention
It is no secret that both the household debt/income ratio, as well as the debt service ratio (interest expense as a % of disposable income) continue to be near all time high levels, albeit slightly lower than recent all time records. In fact, the debt service ratio has declined more in real terms than in nominal terms, making the argument that the consumer deleveraging process might not be as dramatic as some expect. Yet it is precisely when looking at the real, and not nominal, value of a projected debt service burden, that explains why consumers will continue to be faced with a crippling debt regime, why deleveraging will continue, and why the economy will be far weaker than the Fed expects for years to come. Goldman's Jan Hatzius, who continues to be more bearish on the future prospects for the economy than ever before, explains.
One important reason why we expect the economy to remain weak is that the household sector is likely to deleverage its balance sheet further. This will require households ?and the private sector more broadly? to run a large financial surplus, which will keep demand weak unless offset by substantial fiscal (and monetary) stimulus.
Once again, the Fed is caught with its pants down as it is faced with no options of how to extract an economy continuing to plunge into a deflationary abyss. And it is not so much the overleveraged mega-corporations that are hurting as a result of massive debt load, as at least they can refinance into lower interest rates: it is mostly consumers - that driving force behing the US economy - who are unable to take advantage of refinanci g opportunities on their underwater assets, that will further retrench, causing further economic stress and increasing declines in GDP.
Tangentially, and a topic that needs to be investigated in depth here and elsewhere as it has gotten virtually no coverage in the media, is what will happen to the tax shield that interest payments provide. Assume a scenario where a company with $X in debt manages to refiance all of it at near-zero interest rates. This will simply make pretax net income jump substantially, and provide for a much greater tax provision owed to the government. As everyone is aware, the number one prerogative before CFOs and corporate strategists, is how to minimize tax payments, which, in our opinion, means that soon companies, even Investment Grade, will lever over and above the level of debt suitable for their business model, with dividend recap deals coming down the line, all in the pursuit of recapturing an debt interest-based tax shield. After all, a company (and most definitely its Board of Directors) would certainly prefer to pay a dividend to its shareholders, than to give away 40% of its profits to the government, even if this means a sudden and abrupt deterioration of debt ratios across levered corporate America. And once interest rates do pick up, and the next refi/maturity wave hits in 5-7 years, then it will be really game over. But that is a topic for another day. (We are also confident that the tax code's Section 382 NOL Limitations will also soon have to be adjusted to facilitate the M&A boom which everyone expects yet never happen, as there are thousands of companies with huge NOL "assets" that could be acquired if Sec. 382 were to be changed... and it will be).
But back to the consumer, and why the expectation (and reality) of deflation will keep US buyers subdued, and continue to make the US economy ever more reliant on the government's transfer payment, aka welfare, program.
A very simple illustration of the challenge is provided in Exhibit 1, which shows that the ratio of household debt to disposable income remains far above levels prevailing prior to the asset price and credit boom that started in the late 1990s. This suggests that the deleveraging of household balance sheets still has much further to go.
But while the ratio of household debt remains exceptionally high, the ratio of household debt service?interest and scheduled principal repayments?to disposable income looks less out of line with longer-term norms. This is shown in Exhibit 2, which plots the household debt service ratio as calculated by the Federal Reserve Board.1 Although it is still above its long-term average, the gap was never as big as in the case of the debt ratio and has declined substantially since 2007. What should we make of this?
And here is the kicker, explaining why once again the Fed has misunderestimated American consumers:
While the debt/income ratio shown in Exhibit 1 is hardly the end of the story, we believe that Exhibit 2 leaves out an important factor, namely that debt service is defined in nominal rather than real terms. The calculation does not take into account the rate at which inflation erodes the real value of household debt over time. This erosion will confer a bigger benefit on indebted households in a high-inflation environment such as the early 1980s than in a low inflation environment such as now.
Hatzius is kind enough to provide a simplistic example of the impossible task facing the US consumer of deleveraging into a deflationary environment, especially when the primary debt burden is in a 100%+ LTV position, and therefore unrefinanceable.
It is easiest to explain this point by means of a simple example. Suppose a consumer with a $50,000 annual income holds debt of $100,000 on which he pays a 10% interest rate. Ignoring any principal repayment, this implies a debt service ratio of 20%, i.e. 10% of $100,000 divided by $50,000.
Now imagine two separate cases. In the first case, inflation is 8% per year. This means that the real value of the consumer?s debt is reduced by $8,000. So the inflation-adjusted debt service burden is only equal to $2,000. In the second case, inflation is 1% per year. This means that the real value of the consumer?s debt is reduced by $1,000 and the inflation-adjusted debt service burden is equal to $9,000.
It is therefore useful to adjust the debt service ratio for inflation. We calculate the ?inflation gain? of households as the level of debt a year earlier multiplied by the year-on-year core PCE inflation rate, and then subtract this number from nominal debt service to obtain an inflation-adjusted figure. This inflation adjustment shows the real debt service ratio to be much more clearly above the long-term average than the nominal ratio. In fact, it has trended down only very slightly over the past few years. This suggests that the deleveraging of household balance sheets?and private-sector balance sheets more broadly? still has a fairly long ways to go.
Further inflation declines would increase the challenge. We expect core inflation to decline to ½% by the end of 2011, which would reduce the inflation benefit that indebted households receive yet further. In theory, lower inflation should be matched by lower nominal interest rates. But many households are unable to refiance their mortgages to take advantage of the declines in primary mortgage rates because they are in or near negative equity. Therefore, it is unclear to what extent the household sector will be able to reduce its average effective nominal interest rate much further from here, even in a declining inflation environment.
And this is precisely the issue: while companies would in theory refinance all the way to a cost of capital just about the Fed Funds rate, US consumers don't have that luxury. Which means that the government will be forced to extract increasingly more "capital" out of the US corporate system, whether via tax code changes or some other yet unthought of way. Yet the far greater implication is that the Fed continues to be stuck with no recourse of how to fix the system in the long-run, once the toxic spiral of deflationary deleveraging accelerates. And yes, the only option will soon be the nuclear one, which is QE on top of QE on top of QE, all with the hope of spurring inflation, yet leading to the unfortunate outcome of loss in the US reserve currency.
Hatzius' conclusion, which pretty much the same, is somewhat more diplomatic:
The still-high ratios of debt and debt service to disposable income suggest that the household sector? and the private sector more broadly?will need to continue running financial surpluses in coming years. Unless fiscal and monetary policy provide a strong counterweight, this is likely to imply only sluggish growth, with risks tilted to the downside.
As more and more pundits realize that looking at debt burdens in nominal terms is erroneous, and that one has to apply deflation expectations to projections of real debt burdens, look for the feedback loop of lack of confidence in the economy to become ever more acute, as consumers further retrench in the saving mode so very abhorred by the Fed. And as more and more money finds its way to the mattress and precious metals, look for some incendiary decisions out of the government that seek nothing less than to devalue the dollar directly.