The US presidential election has ended, and looking back at the campaign, the state of the economy dominated much of the discussion. Leading into the election, various data points suggested that, while still sluggish, a recovery is indeed taking place and even intensifying. The latest unemployment report from the BLS all but confirmed this in many eyes – with a headline reading of 171,000 jobs created beating the most optimistic expectations by a fair margin. That prompted a few articles to be written over the weekend in praise of the recovery and placing it into the context of the election. The most complete of these – in terms of outlining the case for a strengthening recovery that will persist – seems to be this piece by Rich Miller and Steve Matthews at Bloomberg Businessweek.
Immediately, the authors put to bed any suggestions that the winner of the election will have a material impact on the economic fortunes of the country going forward. They write:
No matter who wins the election tomorrow, the economy is on course to enjoy faster growth in the next four years as the headwinds that have held it back turn into tailwinds.
Matt Yglesias over at Slate echoes that sentiment, writing:
Whoever wins is poised to preside over a return to economic normalcy that’s bound to make any kind of basically competent governance look fantastic compared to the last decade of misery.
Both of these views are correct in that it didn’t matter whether Mitt Romney or Barack Obama occupied the White House. The underlying currents of the economy seem to be set to carry it in a positive direction going forward. These currents, according to the Bloomberg article, present themselves in the shape of consumers spending more and deleveraging, the increase in home prices and an increase in bank lending. Add the firmer employment headlines and you seemingly have a maelstrom of factors that put the US economy in good stead. While I do appreciate the fact that in a very crude sense the data points are trending positively, I feel that a ‘very crude sense’ is a dangerous position to make economic conclusions from. Looking slightly deeper presents a different view of the US economy, in my opinion.
As mentioned before, the improvement in the employment picture has been at the heart of the calls insisting the recovery has picked up pace and is set to continue. The numbers indeed have been better on the surface, with jobs being added at a faster pace (an average of 162,000 per month over the last 18 according to Yglesias). The trouble with the data is twofold:
- The report suggests that the jobs that are being created are short term and of lower quality
- The increase in jobs has not been met with an increase in income.
The truth is that these points aren’t exactly separate issues but for the purposes of this discussion I’ve chosen to treat them as such. The October employment report indicated that the vast majority of the jobs created last month came in the service sector, more specifically in professional services, healthcare, retail, leisure and hospitality. With the exception of professional services, these parts of the job market are amongst lowest paid and work the least hours, suggesting that the jobs are either low quality jobs or part time jobs. A recent study by the National Employment Law Project reports similar findings, stating that:
During the recovery, employment gains have been concentrated in lower-wage occupations, which grew 2.7 times as fast as mid-wage and higher-wage occupations. Specifically:
Lower-wage occupations were 21 percent of recession losses, but 58 percent of recovery growth.
Mid-wage occupations were 60 percent of recession losses, but only 22 percent of recovery growth.
Higher-wage occupations were 19 percent of recession job losses, and 20 percent of recovery growth
Looking closer at earnings, the recent employment report indicated that average hourly earnings fell slightly over October. While the average hourly earnings have risen 1.6% year over year, the increase in inflation as measured by the CPI over the same period was 2.0%, rendering a 0.4% decline in wages in real terms. This phenomenon has been a staple of the ‘recovery.’ The graph below represents the Hourly Earnings minus the change in CPI.
What this shows is that the real wage has, for all intents and purposes been stagnant since the recovery. In terms of households, income has fallen by 4.8% in real terms during the recovery, a figure larger than the recession that preceded it.
Within the context of a lasting recovery, none of the above is good news, particularly the trends in real incomes. Those trends suggest that the standard of living in average households is at best merely being maintained and therefore are not indicative of the sort of ‘fast growth’ Miller and Matthews feel is around the corner, at least in real terms.
Another apparent headwind turned tailwind is the state of the consumer deleveraging process. The story of boom time leveraging by consumers is well documented –as is the subsequent deleveraging that has been a staple of the bust. The key here is that the model for economic growth extant in the US (and the west in general) is largely predicated on consumer spending. This, in turn has become more and more dependent on households increasing their levels of debt. The effectiveness of this model for growth is questionable at best, but that is a subject beyond the scope of this post. What is important is that within that model for growth, the ability for households to increase debt and thus spending is critical.
It follows then that deleveraging is detrimental to growth, in this model. The following is a chart of household debt over the last few years.
As you can see, the household sector has spent past four years delevering, notwithstanding the recent uptick. This phenomenon has been at the basis of the sluggish consumer spending over the last number of years, but notably the recovery period coincides with constant household deleveraging. This runs counter to the narrative I just laid out, in which ‘growth’ increasingly depended on increased leveraging by households. The missing piece here is the activity of the government. The reduction of debt by households has been countered by the increase in government debt, as per the following table:
Note the fact that total credit market debt has actually increased over the series, meaning the household deleveraging has been comfortably absorbed by the government, and then some. This is standard Keynesian policy, which recommends that the government must act to ‘pick up the slack’ should the private sector lack the ability to spend (or to undertake the debt that was driving spending).
This action, along with the action of the Federal Reserve has served to prop up prices and maintain a level of spending, even though the actor doing the spending may have changed. In the view of mainstream economics, this prevention of deflation has been unequivocally positive. It is also, dangerously, an unequivocally incomplete assessment. In propping up the economy, via increased government spending and expansionary monetary policy by the Federal Reserve, it is true that the decline in prices have been arrested. What is also true is that arresting the fall in prices leaves the household sector in a precarious situation over the long term.
To understand why, first note that the deleveraging process began because the household sector had become overlevered in the last cycle. This cycle ended when home price appreciation stalled and the housing bubble burst. As I mentioned above, the debt driven consumer spending model of economic growth requires increasing amounts of debt. This debt provided the continual marginal demand that drove prices higher. Before the bursting of the bubble, the household sector carried this burden. After the burst, the government sector has carried the burden. The disconnect here is that the economic function of household delevering is to get rid of the burden completely, not simply transfer it from one sector to the next.
At a certain point in the previous business cycle, the debt required to provide the marginal demand fueling the bubble prices was too much to bear, relative to incomes. What followed was the household sector attempting to reduce that debt load to more manageable levels. This, in turn reduced demand, and therefore reduced the overall price level to a point more in line with prevailing incomes. This lower level of prices was short lived, thanks to the efforts of the government and Federal Reserve. In counteracting this process by preventing falling prices and even pushing them back up towards bubble levels, the government creates a situation in which the household sector is subject to a price level it cannot support without an unsustainable level of debt. The only prescription offered by the most policy makers (since allowing prices to fall is ruled out) is to somehow goad the household sector back on the proverbial horse and saddle itself with debt, ignoring the fact that the consequences of that strategy are already well known. This situation is further influenced by the deterioration in the income level of average households, as discussed above. To now maintain in an environment in which real incomes are flat to negative, the pressure mounts on households to relever, and as a sector inch back towards a level of debt that proved catastrophic in the last cycle. In other words, we’re talking about reflating the last bubble, or at least attempting to.
The above analysis is lost in the mainstream economic discussion, which only sees it fit to stop short at ‘deflation = bad.’ The Federal Reserve has essentially based policy on that simplistic mantra, and its role has been even greater than the government in attempting to prop up the deflating housing bubble. In justifying the most recent round of Quantitative Easing efforts, chairman Bernanke cited the ‘wealth effect’ as one of the main reasons why that policy would be beneficial:
There are a number of different channels [to affect asset prices] — mortgage rates, I mentioned other interest rates, corporate bond rates, but also the prices of various assets, like, for example, the prices of homes. To the extent that home prices begin to rise, consumers will feel wealthier, they’ll feel more — more disposed to spend. If house prices are rising, people may be more willing to buy homes because they think that they’ll, you know, make a better return on that purchase. So house prices is one vehicle.
Stock prices — many people own stocks directly or indirectly. The issue here is whether or not improving asset prices generally will make people more willing to spend.
One of the main concerns that firms have is there’s not enough demand. There are not enough people coming and demanding their products. And if people feel that their financial situation is better because their 401(k) looks better or for whatever reason — their house is worth more — they’re more willing to go out and spend, and that’s going to provide the demand that firms need in order to be willing to hire and to invest.
In the context of the debt driven consumer spending model, rising asset prices do indeed lead to growth in the way the chairman stated. The problem is that what the chairman stated was literally a description of the housing bubble that burst so spectacularly in 2007 and led to the crisis of 2008. Right down to the idea that buying a home with a view to ‘making a better return’ on the purchase constitutes wise investing. Of course, during that bubble, the ‘wealth effect’ was in full effect, with rising asset prices leading to increased leverage and consumer spending. That cycle of increased leverage –> increased demand —> increased prices —> increased leverage collapsed when the ‘increase leverage’ part inevitably broke down. In explicitly seeking to replicate that cycle today, the Fed hopes to engineer a similar boom, however it will also be followed by a similar bust.
The US Economy IS Getting Better – At Reflating
Bernankes’ stance isn’t a new one; the wealth effect was cited back in November 2010 after a prior round of monetary stimulus had been announced. The entire goal of Federal Reserve policy since the depths of 2008 has to spur reflation, a return to the debt driven consumer spending economy that existed before the crash. The recent upturn in the relevant data points suggest that the efforts in reflating might just be gathering some traction. From the Businessweek article:
Consumer confidence climbed in October to a more than four-year high as Americans took comfort from an improving job market, according to figures from the New York- based Conference Board.
Households that put off purchases during the recession and its aftermath are starting to buy amid rising optimism about their prospects.
Retail sales jumped 1.1 percent in September as Americans snapped up goods from cars to iPhones, according to Commerce Department data. The gain followed a 1.2 percent increase in August, the best back-to-back showing since late 2010.
Demand for auto loans and residential mortgages increased last quarter, the Fed survey found. Households are feeling more comfortable about credit after reducing their cumulative debt as a share of disposable income to 113 percent in the second quarter, the lowest in nine years, Fed figures show.
The housing market is one of the beneficiaries. New-home sales climbed 5.7 percent in September to the highest level in two years, based on Commerce Department data. Demand was 27 percent higher than a year ago.
These facts, particularly the increase in auto and mortgage loan demand, point to a resumption of the debt driven consumer spending machine. Another point that hasn’t been mentioned thus far is the improvement of the stock market, which is up roughly 10% year to date. In keeping with Bernankes’ wealth effect argument, rising asset prices is at least in part responsible for the increase in confidence, which in turn is spurring demand for consumer goods.
Again, stopping the analysis here gives the impression that the recovery is indeed back on for good, as is the battle cry among mainstream commenters. In order to determine the sustainability of the recovery, it is important to examine and understand how the demand is being generated. Earlier, I discussed the lack of income growth in average households, and this fact brings forth the mystery of how consumers can ramp up spending while seeing incomes fail to increase. The answer, as I wrote above is the slow but sure return to debt increases by households. From the article:
Easier credit terms are contributing to the rise in consumer spending. Banks reported that they continued to ease standards on auto loans and credit cards last quarter, according to a Fed survey of senior lending officers.
With respect to home mortgages, in the last iteration of debt driven consumer spending growth, the main source of marginal demand was the subprime loan market. According to this Federal Reserve paper, subprime is loosely defined as ‘a lender-given designation for the group of marginal borrowers that have some sort of credit impairment or lack of credit history. These credit impairments imply that subprime loans are riskier and higher-priced than loans to prime borrowers.’ In the build up to the housing bubble this group of borrowers was serviced by an explosion of exotic and ultimately toxic forms of loans such as Alt-A, interest-only loans, ARMs, low documentation, etc. By now that part of the story is well documented and within the knowledge of most observers. The cessation of the origination of these loans, and the failure for these loans to be repaid in growing amounts spelled the end of the boom. With respect to the mechanism behind the consumer spending model, its driver (increased debt) was cut short when the vehicle behind its existence (the subprime market) collapsed. This triggered the lack of demand and subsequent implosion of the housing market in general.
It follows that for the market to reflate, a new vehicle for increasing debt to marginal buyers would have to establish itself. The FHA has stepped up in this regard, and over the last six years has taken a bigger and bigger role in serving the ‘subprime’ market:
Over the past six years, FHA has been the turnaround champ of residential real estate, offering down payments as low as 3.5 percent despite the recession and housing bust, growing its market share from 3 percent to 25 percent-plus. The program is now financing 40 percent or more of all new home purchases in some metropolitan areas and is a crucial resource for first-time buyers and moderate-income families, especially minorities.
The last boom saw spikes in delinquencies and defaults being the beginning of the end. The same is true now, even though this new housing boom shouldn’t be as large or as pervasive as the last one. From the Fed paper, the 2006 subprime delinquency rates clocked in at a median of roughly 12% across the areas it tracked. The analogous figure today, focusing on FHA loans, is 17.3%. The interesting thing to note is the fact that this rising rate is occurring at a time when home prices have fallen, notwithstanding the recent stabilization/increase. Even at lower home prices, marginal buyers are starting to show an inability to afford them, suggesting the price is too high. Given that even further increases in the amount of mortgage debt are needed to prolong the reflation, and in turn growth under the current model, the fact that cracks are already appearing does not bode well.
Another interesting thing to note is the impact these loans are having on the banks. From Fitch:
For eight of the largest U.S. banks with substantial portfolios of FHA-guaranteed loans on their books, combined 90-day past due delinquencies totaled $79.4 billion at June 30. Of that total, 83%, or $66.0 billion, represented government-guaranteed mortgages.
This highlights the dimension of the growing delinquency problem for the FHA, given the predominant position of FHA-guaranteed loans in the troubled asset categories of major banks. While delinquency rates for nonguaranteed loans have been improving steadily at these institutions, the trend for FHA-guaranteed loans is starkly different.
The increase of these loans on banks’ books presents a problem going forward, given the increasing delinquency problem and the longer term trend of downward home prices. The last sentence about nonguaranteed loans improving highlights the moral hazard issue still in effect today. While many roll their eyes at the use of the term by critics of reflationary policies, it is clear that banks are not lending without the guarantee of the government. They are more than happy to take on riskier loans as long as the tax payer is there to backstop them. With their own funds (‘own’ being a questionable description given their bailouts), the banks have opted to take on less risk by presumably lending to better quality lenders and thus have better performing loans in that category.
The same phenomenon can be observed in the subprime auto market. From this recent Reuters piece about subprime auto ABS:
The volume of subprime auto loans is set to increase. Experian Automotive recently announced that loans to customers in subprime accounted for more than one in four new vehicle loans during the second quarter of 2012.
With 25.41% of all new vehicle loans to customers in the non-prime, subprime, and deep subprime risk tiers, loans to credit-challenged customers were up 14% compared to the second quarter of 2011.
And a visual from Zero Hedge (via S&P):
Again, as with home mortgages, the marginal demand for autos is being supplied by an increase in loans to people who are increasingly less able to maintain and service those loans. Particularly striking is the drop in average FICO scores for subprime borrowers to levels below the height of the boom time period. The bottom line is that while the US economy is seeing increased sales and better consumer data, it is coming via a route that cannot be sustained.
The Rise of Junk
A feature of the debt driven consumer spending model of the last decade was the rise in asset backed securities, which helped enable the standardization of the several types of debt on offer to be traded. Of course, these securities proved to be toxic, but the attraction to them at the time was the higher yield they offered in a world of relatively lower yielding safe options. Fast forward to today, and we are seeing the same scenario repeating itself. Given the insistence on reflation by the government and Federal Reserve, it should not be a surprise that replicating bubble conditions leads to bubble irrationality and related practices. However, this is left out from the various reports cheerleading the recovery as sustainable. From the above Reuters article about subprime auto loans:
The Federal Reserve’s low interest rate policy has caused demand for auto-loan bonds to skyrocket. The high-quality, short-duration, higher-yielding nature of auto ABS makes it a desirable alternative to Treasuries.
In fact, bond investors’ rabid appetite for auto ABS this year means that subprime auto lenders have found an eager audience for their bonds, allowing them to originate more loans at more attractive rates. At the same time, robust car sales have promoted a spike in auto financing, paving the way for increased subprime lending.
This could have been written in the midst of the housing bubble of the last decade, with some minor edits of course. As with the housing bubble, the incentive to pile into these assets, increasingly backed by lower and lower quality loans with a rising potential for delinquency and default, is worrying to say the least. Another area in which this phenomenon has taken place is the junk bond market. This NYT article chronicles the increased funds entering that market as well, seeking higher returns:
Companies with junk credit ratings have been increasingly issuing bonds for riskier purposes that could hinder their ability to pay back bondholders.
Demand for junk bonds has touched record levels this year as investors reach for their rich yields, a stark contrast to the meager returns available on Treasury securities and money market accounts. But the voracious demand has allowed companies to easily raise money for things that may actually end up weakening them.
Once again, driven by an incentive to earn higher yields in an environment of depressed yields, demand for assets of potentially dubious quality has risen. As retail investors pile into junk bond funds in greater numbers, the potential for catastrophe increases.
At the heart of all of this, again is the drive for reflation. The mechanism by which the Federal Reserve seeks to reflate the debt driven consumer spending model is the reduction of interest rates to make it easier to borrow and afford an elevated price level. The byproduct is a scramble amongst investors for assets yielding higher than the depressed yields available in that environment imposed by the Fed. These assets, in turn are bid up in price, regardless of their underlying fundamental quality. This makes them susceptible to extreme overvaluation and puts institutions (and individual investors) at risk of insolvency when those valuations normalize.
The US recovery that has picked up in recent months has been given the stamp of approval by various mainstream economic commentators, almost safe in the belief that the next few years will be years of growth and prosperity. This view requires a surface-only analysis of the data. It requires the rather simplistic belief that a higher number is always better with respect to certain data points such as GDP, inflation, and consumer spending. In the context of this current recovery, it posits that the reflationary efforts of the Federal Reserve and government are unequivocally positive. These views ultimately show little understanding for what sustained recovery actually looks like, and even what economic growth is in the first place. Reflating a bubble does not constitute growth, but rather an attempt to reinstitute a paradigm that had already broken in the past (hence the attempt to RE-flate). If one is successful in reflation, as the US seems to be making a case for being, then it will be the case that boom time prosperity may return. However, just like the prior bubble the reflation efforts are meant to emulate, the current boom will meet its end in a similar fashion.
The exact means by which it comes about are not entirely clear, but it is unquestionable that the underlying lack of real income growth among households will prevent the increase of debt that is so dear to that consumer spending model. This means that if that model of growth is to persist after households can no longer support it, increased government and Federal Reserve action will be required. This is the ultimate dislocation for this model for growth: the need to keep interest rates tied to the floor to encourage prices rising is directly at odds with the capability for income deficient households to demand goods at the rising prices. It is also directly at odds with the value of bonds purchased at the current low yields, in an environment of higher inflation. The increasing number of bond holdings among institutions and individuals is potentially a powder keg in this situation, with the potential capital losses returning institutions and individuals to the brink of insolvency yet again. This – not the oft discussed Fiscal Cliff – is the real issue facing the economy going forward. That issue, unlike the Fiscal Cliff cannot be punted by politicians. When we reach that crossroads, perhaps it will feature as prominently as the stories of the Fiscal Cliff and the supposed recovery which is under threat as a result. But for now, enjoy the boom.