From Part 1's post-2009 faux prosperity to Part 2's detailed analysis of the "wholy unnatural" recovery to the discussion of the "recovery living on borrowed time" in Part 3 (of this 5-part series), David Stockman's new book 'The Great Deformation" then takes on the holiest of holies - The Fed's Potemkin village. The long-standing Wall Street mantra held that the American consumer is endlessly resilient and always able to bounce back into the malls. In truth, however, that was just another way of saying that consumers were willing to spend all they could borrow. That was the essence of Keynesian policy, and to accept the current situation as benign is also to deny that interest rates will ever normalize. The implication is that Bernanke has invented the free lunch after all - zero rates forever. Implicitly, then, Wall Street economists are financial repression deniers.
Five years into the Bernanke bubble the Main Street economy was still languishing. In all of the previous postwar cycles the prior top had been substantially exceeded sixty months later, but this time there had been no gains in breadwinner jobs, business investment, or the core components of national income. Even the consumption accounts were stagnant. They appeared to have gained new ground only because they had been puffed up with borrowings from future taxpayers that had been intermediated through transfer payments and expansion of the HES complex.
To be sure, the latter had been enough to trigger a spurt of inventory replenishment, especially in sectors like autos where a drastic liquidation had occurred in late 2008 and early 2009. In turn, that fueled an associated boost to rehiring and capital stock replacement. Yet the vicar himself was at a loss to explain the tepid multiplier effects from the initial rounds of restocking goods and variable labor, lamenting that a newly invented condition called “escape velocity” seemingly remained just out of grasp.
The reason the Main Street economy refused to follow the Keynesian script, however, could not be found in the texts of the master or any of the vicar’s uncles. The Keynesian catechism has no conception that balance sheets matter, yet Main Street America is flat broke, and that is the primary thing which matters. In fact, half of the nation’s households have virtually no cash savings and live paycheck to paycheck (or government check), and most of the remainder are still too indebted to revert to borrowing and spending beyond their current stagnant and often precarious paychecks.
The simple reality is that the household balance sheet is still way overleveraged, and for the first time in the postwar Keynesian era this leverage ratio is being forced down on a secular basis, thereby permanently restricting the rate of consumer spending. It goes without saying that this dynamic is the inverse of all previous postwar cycles.
The long-standing Wall Street mantra held that the American consumer is endlessly resilient and always able to bounce back into the malls. In truth, however, that was just another way of saying that consumers were willing to spend all they could borrow. That was the essence of Keynesian policy, including the Reagan tax cuts.
At the 1981 peak, for example, the household leverage ratio (household credit market debt divided by wage and salary income) was 105 percent, but this had risen to 117 percent five years later as the economy rebounded and interest rates fell. Likewise, households cranked up their leverage still further during the 1990–1995 cycle, causing the ratio to rise from 130 percent to 147 percent. Then during the five years after the 2000 peak, households took on mortgage and credit card debt with reckless abandon, pushing the leverage ratio from 165 percent to 190 percent, and finally topping
out at 205 percent in 2007.
So the fundamental history of post-1970 business cycles is that household leverage was being stair-stepped radically upward. Indeed, that was the true foundation of the endlessly resilient American consumer. Yet according to Stein’s law, any trend which is unsustainable tends to stop, and that is exactly what has finally happened.
When the second Greenspan bubble burst, household mortgages, credit cards, car loans, and the like amounted to more than two years’ worth of wages. That lamentable condition would have shocked any prudent banker in 1970, and it finally shocked most American debtors when both Wall Street and Main Street buckled violently in the final months of 2008. This trauma brought the reversal of a thirty-five-year trend of steadily increasing household leverage—a turnabout which fundamentally slackened the expansion capacity of the nation’s consumption-driven economy.
In an exercise that is just plain perverse, however, the Fed’s zero interest rate policies have given households exactly the wrong signal. The effect of radical interest rate repression has been to eliminate the sting of excessive debt by reducing the interest carry on current obligations. The natural impulse of households to sharply curtail consumption and materially reduce debt under current circumstances has thus been vitiated.
By contrast, had the free market been allowed to work its will, interest rates would have likely soared, causing a dramatic escalation of defaults as well as prudentially driven voluntary pay downs of debt. In that manner excess debt would have been dramatically liquidated, and the economy would have been given a chance to “reset” on a healthy basis.
Not surprisingly, since Fed policy has had the opposite aim only modest deleveraging has occurred, and even that has been concentrated in foreclosures on the worst of the subprime home and auto loans. Thus, by mid-2012 the household sector still had just under $13 trillion of credit market debt outstanding, amounting to nearly 190 percent of wage and salary income.
It is perhaps a tribute to our debt-besotted age that most Keynesian economists, whether in the hire of Wall Street or simply enthralled by doctrine, have interpreted this modest rollback as evidence that the household sector has substantially repaired its balance sheet. Under this happy scenario households were said to be on the verge of a new spree of borrowing and spending, meaning that the deleveraging crisis was over and that the American economy would soon regain its former gait.
But why is that plausible when the household leverage ratio is still nearly double its pre-1980 norm? Surely that earlier marker has some validity, given the overwhelming evidence that the US economy performed far better during the golden era after 1954 than it has during the last two decades of explosive debt growth. In fact, Keynesians are drastically misinterpreting the situation with respect to household leverage because they have been lulled into the financial repression trap.
As a result of the Fed’s yield pegging, the interest carry on household debt is artificially low, thereby generating far less liquidation and financial distress than would an equivalent burden of debt financed at much higher free market interest rates. Yet to accept the current situation as benign is also to deny that interest rates will ever normalize. The implication is that Bernanke has invented the free lunch after all—zero rates forever.
Implicitly, then, Wall Street economists are financial repression deniers.
Their favorite statistical chestnut, in fact, dramatically underscores this delusion. The so-called debt service to DPI (disposable personal income) ratio has fallen sharply, from a peak of 14 percent to about 11 percent by September 2012. This is held to be a signal that “escape velocity” will be achieved any day now because the American consumer will soon become his or her former free-spending self.
The two things profoundly wrong with that ratio, however, are the numerator and the denominator! In a normalized financial environment, the interest carry cost of current household debt would be 50 percent to 100 percent higher than at present. At the same time, the disposable income denominator is not nearly what it’s cracked up to be. It doesn’t measure ability to pay, as implied, because nearly 50 percent of the $1.34 trillion gain in DPI over the last five years is due to transfer payments, and much of the remainder stems from the fiscally swollen HES complex.
So in yet another twist in the endless Keynesian circle of debt and more debt, the household sector is now purportedly ready to borrow again because its debt service-to-DPI ratio has been artificially deflated by deficit financed transfer payments and central bank interest rate repression. In truth, the household sector’s trivial amount of deleveraging to date is just the beginning of its corrosive impact on PCE growth and GDP expansion. The nation’s households are not even close to having repaired their balance sheets, meaning that the next phase of deleveraging will actually result in a body slam to the Keynesian aggregates.