By: John Greenwood, Chief Economist, Invesco Ltd.
In most developed economies, the post-war years since 1945 saw sustained business cycle expansions alternating with shorter recessions. In general, the problem authorities had to confront at the end of each expansion was inflation, which they dealt with by raising interest rates and slowing credit growth. When inflation subsided, interest rates were lowered again. So long as balance sheets remained broadly healthy, recovery occurred quite quickly as companies and households increased borrowing in response to lower rates. However, when an expansion was accompanied by a bubble in asset prices and then a bust, the recovery process became more difficult and protracted. Can a model be developed to explain this process? And what does it suggest for the current recovery, particularly in the US?
The emergence of a credit bubble and its aftermath — or the process of bubble-and-burst — may be visualized as two overlapping bell curves (Figure 1), where each curve measures leverage or a ratio of debt to income. The left-hand side of the first bell curve (Phase 1) represents the leveraging up of the private sector as it increases its ratio of debt to income (gross domestic product, or GDP) during the bubble phase, followed by the deleveraging phase (Phase 2). The second bell curve represents the ratio of government debt to GDP, which also follows the same pattern but does not necessarily reach the same levels.
When the bubble bursts, the private sector typically tries to deleverage rapidly, reducing spending and repaying debt (Phase 2). But the onset of recession causes government revenues to decline abruptly, government budget deficits to emerge, and the ratio of government debt to GDP to increase. In addition, as the recession intensifies, the government may commit to additional fiscal stimulus measures, further expanding the public sector's deficits and debt ratio. This explains why — in a modern economy — the government's debt ratio typically starts to rise steeply at exactly the moment when the private sector begins to deleverage. However, the process is not completed until the government has deleveraged (Phase 3).
So far, this model describes developments in the US quite well (Figure 2). US private sector debt — which includes the debt of the household sector, nonfinancial corporate sector and financial sector — peaked at 311% of GDP in the first quarter of 2009 (this date has shifted with revisions to GDP data), marking the end of Phase 1. Since then, the private sector leverage ratio has declined to 258.5% as of the fourth quarter of 2012. This means that the private sector has returned to a leverage ratio equivalent to that last seen in the third quarter of 2004, unwinding roughly half of the leverage built up since the start of 2000 (relative to income).
The US public sector debt ratio — which includes federal, state and local debt —began rising in 2008, soon after the start of the US recession in the fourth quarter of 2007 — as designated by the National Bureau of Economic Research. So far, the government debt ratio has risen from 60.2% of GDP in the second quarter of 2008 to 96.5% in the fourth quarter of 2012.
The financial sector
The main contributors to private sector deleveraging in the US have been the financial sector — especially banks and shadow banks1 — and the household sector. During the housing bubble of 2002 to 2007, more credit was created in the nonbank, or shadow banking, sector than in the bank sector, although some of the nonbank credit growth was actually accounted for by the creation of off-balance-sheet vehicles by the banks themselves. Following Lehman Brothers' bankruptcy in 2008, bank credit (loans plus securities holdings) declined only slightly during the credit squeeze of 2008 and 2009. Total bank credit peaked at $9.4 trillion in the fourth quarter of 2008, then declined modestly before rising again recently to reach $9.881 trillion in the fourth quarter of 2012, whereas nonbank credit expanded to a peak of $14.99 trillion in the fourth quarter of 2008 (from $6.35 trillion in the first quarter of 2000) and has subsequently contracted to $9.785 trillion in the fourth quarter of 2012 (down 35% from its peak).
The banking sector has therefore largely stabilized, while the shadow banking sector continues to shrink, although the pace of balance sheet shrinkage among the shadow banks has slowed. In contrast to the UK or the eurozone, US bank lending has been on a gradual recovery path since March 2011, with increases in adjusted loans and leases averaging 4.1% per year since March 2011.
The nonfinancial corporate sector
As we turn from the financial sector to the nonfinancial corporate sector, the important point to understand is that, whereas the tech bubble of the late 1990s was mainly a corporate phenomenon, nonfinancial corporates generally did not participate in the bubble from 2003 to 2008. As a result, balance sheets were not significantly damaged by the crisis of 2008 and 2009, and the recovery in the corporate sector has been fairly rapid. Thus in the year to 2012, fourth-quarter corporate debt growth was 8.2%. This means that nonfinancial corporations are releveraging at a moderate pace, but they are unlikely to leverage up aggressively.
The reason is that despite the combination of good cash flow and relatively weak investment trends since 2009 — which have enabled companies to build up substantial reserves of cash — corporate treasurers have remained risk averse. They are unlikely to commit to large-scale investments in the US until household balance sheets are more fully repaired and consumers return to precrisis rates of spending growth. Of course, they could embark on investments in overseas markets where demand is strong. However, companies could use some of their cash reserves to make acquisitions within the same industry with the purpose of strengthening their pricing power. But again, the motivation to do this will be limited so long as perceived final demand conditions are soft. In the meantime, companies appear likely to continue to build cash reserves.
Net new corporate borrowing at annual rates jumped to 5.7% of GDP in the fourth quarter of 2012, while net equity issued (or share issues net of buybacks) declined by 2.7%. The combined result was net fundraising (debt plus equity) at an annual rate of 3% of GDP, the highest rate since the end of the tech bubble in 2000.
During the credit boom when credit was cheap and readily available, corporate treasurers took advantage of strong cash flows to buy back firms' shares — rather than making new investments — as a means of enhancing returns to shareholders and/or avoiding takeover threats from private equity groups. In some cases, strong cash flows were used to increase dividends or make acquisitions.
Net debt raised by the nonfinancial corporate sector relative to GDP increased sharply until the third quarter of 2007 and temporarily exceeded the level seen at the height of the tech bubble from 1998 to 2000 (as a percentage of GDP). The combination of share buybacks (reducing equity) and increased borrowing had the effect of raising corporate leverage from both sides of the balance sheet. Since the onset of the credit crunch and the recession, corporate treasurers have been mainly repaying bank debt and replacing it with longer-term corporate bond issues.
Turning to the household sector, we have already seen (Figure 2) how the household debt-to-GDP ratio has declined. In fact, a sea change is under way in US household balance sheets. Seven years beyond the peak of the housing market in mid-2006, we are still seeing a reduction of household indebtedness: Overall household debt declined by -0.6% in the year to the fourth quarter of 2012, while mortgage borrowing declined by 2.4% year-on-year in that quarter — giving the 16th successive negative year-on-year figure. This is the first such series of declines since quarterly data began to be tracked in the Flow of Funds data in 1952. Meanwhile, consumer credit has picked up, though this is not yet enough to offset the downtrend in the much larger volume of mortgages.
In terms of levels, total household debt has declined from a peak of $13.17 trillion in the second quarter of 2008 to $12.21 trillion in the fourth quarter of 2012, a decline of $960 billion, or 7.3%. Home mortgages have declined from $10.647 trillion in the first quarter of 2008 to USD $9.43 trillion in the fourth quarter of 2012. Consumer credit peaked at $2.549 trillion in the fourth quarter of 2008, fell for about two years and has subsequently regained its precrisis levels, reaching $2.779 trillion in the fourth quarter of 2012.
In a broad sense, this implies that in the consumer sector — which accounts for about 70% of GDP — deleveraging is still winning out over leveraging up. The priority that consumers are giving to balance sheet repair implies that consumption growth must be financed entirely out of the income that remains after taxes and the increased savings required for debt repayment. It has not —so far — been funded by means of net new credit.
Household deleveraging: What will the future bring?
How much deleveraging can we expect in the US (or the UK or the eurozone) in the wake of the bubble bursting in 2007 and 2008? Will households wish to return to the ratios of debt to income that they had in 2004, or 1997 or even earlier?
The only good "case history" we have among the four economies is for the UK in the period after the Lawson Boom of the late 1980s, a period of rapid expansion associated with the policies of Chancellor of the Exchequer Nigel Lawson. UK house prices peaked in 1989 when interest rates rose sharply, and this was followed by widespread negative equity among indebted households. After 1989, the ratio of household debt to income in the UK gradually declined, not just for a year or two, but for a whole decade until 1998.
In the wake of the recent credit and housing bubble-and-burst, we are seeing another prolonged period of balance sheet adjustment in both the US and the UK, as well as in other indebted economies, such as those of Spain and Ireland. The only thing that may shorten the period of balance sheet adjustment is the fact that central banks have lowered interest rates so drastically. (This applies especially in economies where there is a high degree of dependence on variable rate mortgages, as in the UK.) On the other hand, it is possible that consumers may simply use low rates as a reason to postpone balance sheet repair.
From the mid-1980s until 2008, US household debt was rising relative to various measures of income. However, an endless uptrend in debt relative to income is fundamentally unsustainable because the interest burden would use up too large a share of income. The only questions were when and how the uptrend would end —voluntarily by a rational, preemptive debt-reduction process, or involuntarily by a major economic crisis of falling asset values, debt liquidation and foreclosures?
In 2007 and 2008, the answer became clear. Now the questions are how long the adjustment of household balance sheets will take and what level of debt will be regarded as optimal for the future? Experience of housing busts in other developed economies suggests that such adjustments take an average of six to seven years, not just a few quarters. Given the magnitude of the US housing boom and the high levels of debt, this implies that the balance sheet repair process may still take a few more years to complete.
How can we establish a norm to judge when household balance sheets have normalized or returned to equilibrium?
- Since the recent financial and economic downturn may be viewed as a result of asset prices being driven to excessive and unsustainable levels relative to income, a strong argument can be made that the crisis will not be fully resolved until the ratio of asset prices to incomes has returned to a more normal value.
Compared with long-term averages of 3.36 for household net worth to GDP and 4.70 for household net worth to personal disposable income — arguably equilibrium levels — both ratios have fallen steeply and then recovered modestly — to 4.17 and 5.44, respectively, in the fourth quarter of 2012 — since their peaks in 2006. While these series may not be exactly mean-reverting (due to innovations in the credit industry), the real estate assets owned by households may still be overvalued, and further declines in both ratios are possible, especially when interest rates rise to levels more consistent with long-term averages.
- Alternatively, the crisis can be viewed as resulting from the excessively high levels of debt used to acquire assets such as homes, equities and other tangibles. However, it is harder to establish any kind of norm for debt-to-income ratios, and therefore it is more appealing to rely on the net worth-to-income mean reversion thesis for a concept of household equilibrium.
One counterpart of the high level of indebtedness and debt-financed spending by the US consumer was the fall in the personal savings rate between 2000 and 2008. In addition, given households' large investment in housing by means of mortgage debt, the personal sector experienced a growing financial deficit. In the entire post-World War II period, the household sector had only occasionally and temporarily experienced small financial deficits, so the large and persistent deficits between 1995 and 2008 were unprecedented.
However, since house prices peaked out in 2006, investment spending on housing has fallen, and the personal-sector financial deficit has shifted back to surplus. Over the next few years, consumers are likely to be motivated to maintain a higher savings rate and reduce their indebtedness by repaying debt, borrowing less and holding down consumption. For the economy as a whole, this will imply less need to borrow from abroad and a smaller current account deficit. In the past two years, the personal savings rate appears to have stabilized around the 4% level. However, at 2.1% in January 2012, it remains volatile. For a fuller rebalancing of the US economy, it would be desirable for the personal savings rate to rise above the 5% level.
A combination of factors — including the declines in asset prices, tighter credit conditions, step-ups in mortgage rates and negative equity — has already caused consumers to slow their borrowing, leading to the deleveraging that has produced the decline in the debt ratio, the rise in the savings ratio and slower growth of consumer spending. These trends seem likely to continue while household balance sheets are being repaired.
The depth and duration of recession-like conditions in the US economy since 2008 are a direct result of the damage done to private-sector balance sheets, first by the expansion of the housing and credit bubble and then by the bursting of the bubble. The slow, subpar recovery will not be overcome until balance sheets of the household and financial sectors are more fully repaired.
The lesson for investors is that economic and stock market downturns following bubbles tend to be more severe than normal and recoveries slower. However, the fact that the US is now repairing its balance sheets more quickly than either the UK or the eurozone helps explain the better performance of both the US stock market and the economy. As long as this divergent balance sheet repair process persists, the US should continue to outperform.