Deleveraging, Releveraging And Finding The New Saturation Point
Submitted by F.F.Wiley of Cyniconomics blog,
Do you need a break from public policy buzzwords? Are you happy to go back to the days when cliffs were discussed occasionally on the National Geographic channel but not analyzed ad nauseum on CNBC? Are you tired of reading about austerity, austerians, anti-austerians and austeresis?
Okay, I may have made up the last one, but you’ve come to the right place.
Well, sort of.
I won’t do away with buzzwords altogether, but I’ll recycle an old one that’s faded from public discussion. Before cliff took its new meaning and austerity spawned a new branch of etymology, we had deleveraging.
It wasn’t that far back that everyone wanted to know: How much longer will deleveraging constrain growth? And the presumption seemed to be that deleveraging was a good thing. Most people agreed on these two points:
- With debt having reached a saturation point during the housing boom, deleveraging needs to occur.
- The economy will be on a stronger footing once it’s behind us.
Today, it still seems reasonable to ask how much longer deleveraging will play out. But after four years of painfully slow expansion, we should start by asking how much progress has been made. Is deleveraging well on its way, just getting started, or somewhere in between?
Or, as stated in the Length Fallacy Challenge that I introduced in March (see diagram): How long have we been deleveraging?
As in the other articles in the Challenge, I’ll share data that helps to answer the question, and then I’ll choose from the options on the right-hand-side. In later articles, I’ll explain how the answers tie together and offer my interpretation on what they mean for our economy.
Tracking economy-wide debt from the Great Recession to today
To keep it simple, my charts consider only three points in time:
- December 2007 (the beginning of the Great Recession)
- June 2009 (the end of the Great Recession)
- December 2012 (the most recent data)
Chart 1 shows that households and nonfinancial businesses reduced their aggregate debt from 175% of GDP in December 2007 to 163% in December 2012. But this fall in private sector borrowing was more than offset by increased government borrowing. Total debt for households, nonfinancial businesses and government is now significantly higher than it was at the start of the Great Recession. It jumped by 19% of GDP while the recession was underway and then edged up another 6% through December 2012, for a total gain of 25%.
(This is a slightly bigger increase than you would find if you worked with only the Federal Reserve’s oft-cited Flow of Funds Accounts, with the difference explained by the government category. The Fed’s total excludes IOUs awarded to government trust funds – following the precedent set by the Office of Management and Budget – even though these IOUs fit every reasonable definition of debt, as I discussed here. I’ve added the IOUs back into the totals.)
If we relied on these figures alone, we would say the economy has more debt than it did five years ago.
But what about the financial sector, which isn’t included in the first chart?
Financial institutions have clearly reduced leverage since the end of the housing boom, primarily by cutting back shadow banking. As shown in Chart 2, their debt fell from 116% of GDP in December 2007 to 88% in December 2012.
Once again, though, the drop in private debt is at least partially offset by the public sector. And the public sector is comprised of the one bank that the Fed doesn’t include in its financial sector totals: Itself. In other words, the most powerful bank of all.
Now, you may question my aggregation of the Fed’s liabilities with private bank debt, on the basis that the Fed doesn’t issue traditional debt when expanding its balance sheet. But the Fed’s increasing leverage is every bit as powerful as traditional debt issuance, and more, since it allows private banks to increase their leverage. The excess bank reserves that the Fed creates out of thin air are economically similar to callable loans. They even pay interest these days.
The Fed’s balance sheet expansion has lessened but hasn’t prevented a drop in financial sector leverage, which is now lower than it was at any time in the Great Recession. But from the first chart, we saw that debt for the rest of the economy is now higher than it was during the Great Recession. This leaves us one more step: adding up the figures from the two charts.
Here are the totals across all sectors:
I can see two possible interpretations for Chart 3. The first is that debt fell after the end of the Great Recession, and therefore, the economy has slowly deleveraged. The deleveraging began in the fourth quarter of 2009, and since then, debt fell at an average annual rate of 6% of GDP. This interpretation is mildly encouraging, but I don’t agree with it.
Consider that the leverage added during the Great Recession is almost entirely explained by public policies, including unprecedented amounts of peacetime deficit spending and central bank balance sheet expansion. And that these public policies were intended as emergency and temporary measures. At least, that was the story at the time and it remains so today, even though both the government’s deficit and the Fed’s balance sheet are still abnormally large.
What I’m saying is that the economy hasn’t fundamentally deleveraged by simply reversing the jump in debt during the Great Recession. That increase in debt was reactive and intended to be short-lived. A better test is whether debt is lower today than it was when we hit the wall at the start of the recession. The last chart shows that it’s not.
Finding the new saturation point
According to this second interpretation, the discussion about deleveraging is far from over. Debt reached its saturation point in 2007, and we resolved that predicament by pushing the saturation point higher, which is what happens when you replace private with public borrowing.
Today, we’re relying more than ever on the “full faith and credit” of the U.S. government – the last line of defense when it comes to preserving our hugely levered economy. We’ve made room to take on more debt, but we don’t know how much room.
I’ll put it in Hollywood terms by taking you back to the 1979 classic, Alien (but don’t click on the links if you’re squeamish):
You’re standing with Warrant Officer Ripley (Sigourney Weaver) and the rest of the Nostromo’s crew and you’ve just had your first encounter with the “facehugger” alien. That was the global financial crisis. You’re now recovering and planning your next move. The alien’s still out there, you just don’t know exactly where it is and in what form. In other words, the next crisis could be worse. (But you’re hoping the alien doesn’t reappear in the same way as the facehugger’s spawn.)
I know, overdramatic, but it seems to fit. And you have to admit: If there were an alien version of the financial sector, or at least our too-big-to-fail banks, the facehugger might be it.
In other articles in this series, I’m taking a shot at locating the alien, by estimating the point where public debt reaches saturation. (See here, for example.)
But getting back to the question, “How long have we been deleveraging?” – I’ll answer “zero years.” As in, what deleveraging? We haven’t even gotten started yet.
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