The end of deleveraging is approaching

On Friday the Fed released its estimate of households' financial burdens as of March 31, 2012. "Financial burdens" are calculated by comparing debt service payments and total financial obligations to disposable income. This is very different from the number bandied about in the press these days, which compares total debt to income and implies that there is still a lot deleveraging to come. The problem with the latter is that it is an apples-to-oranges comparison, since total debt is a stock—a fixed amount—whereas income is an annual flow. The Fed's method compares flows (annual payments) to flows (annual income). Owing $100,000 with an interest rate of 10% is much more burdensome than owing the same amount with a 3% interest rate, just as it is easier to service a debt with a 10% interest rate when one's income rises 10% a year, than it is when one's income rises only 3% a year.

The data for March showed a very modest reduction in financial burdens that was effectively offset by some modest upward revisions to prior data. Nevertheless, the story remains the same: financial burdens have declined significantly in the past 5 years because a) households have paid down debt, b) households have defaulted on their debt, c) households have refinanced and taken on new debt with much lower interest rates, and d) household disposable income has risen. With the exception of the unfortunate cases in which households have had to default on their debt obligations, the story is a virtuous one, and it has been driven by an increase in overall risk aversion.

It is also worth noting that a significant amount of deleveraging has effectively occurred even as the economy has managed to grow. Deleveraging does not have to be synonymous with deflation or recession. Deleveraging occurs when the demand for money increases, and the demand for money tends to increase during periods of rising uncertainty. Increased money demand can be satisfied by increasing one's holding of cash and cash equivalents and/or reducing one's debt. (Conversely, increasing one's leverage is equivalent to a decline in one's demand for money, since debt is equivalent to "shorting" money.)

Deleveraging can be bad for an economy's health if the central bank fails to respond to the increased demand for money. The Federal Reserve was a little slow in responding in late 2008, but they more than made up for that mistake by engaging in two unprecedented quantitative easing programs which have resulted in the creation of $1.5 trillion of excess bank reserves. When the supply of money equals or exceeds the demand for money, then an economy can undergo lots of deleveraging without major problems, and that is precisely what has happened since 2008. The problem with deleveraging arises when the supply of money fails to meet the demand for money, because that creates an effective shortage of money, and that in turn leads to deflation, which can trigger a recession. We saw that briefly in late 2008, when inflation expectations collapsed, as illustrated in the chart below

In any event, households' aggregate debt and financial burdens are now about as low as they have been for the past three decades. That amounts to some considerable adjustments, and I would argue that these adjustments have set the stage for some big changes in the years to come. For example, if confidence in the future increases, households' risk aversion is likely to decline, and the demand for money is likely to decline as well. There are trillions of dollars in savings deposits that households could decide to spend. Banks' desire to sit on $1.5 trillion of excess reserves could decline, and that would mean a huge increase in banks' ability to generate new loans and expand the money supply. If the Fed fails to respond to these changes by reversing QE, this could result in an excess of money in the system, and that could fuel a significant rise in the general price level.

In short, the next several years could be very different from the past several years. The deleveraging story has largely played out; what awaits us now is a releveraging.

The most risk-averse recovery ever

The recovery from the recent Great Recession has been the weakest ever, and that may have a lot to do with the fact that this has also been the most risk-averse recovery ever. Households have deleveraged like never before; the world has stocked up on cash and cash equivalents like never before; banks have accumulated massive amounts of excess reserves; and business investment has been weak despite record-setting profits. Contrary to popular perception, these facts suggest that the real function and purpose of the Fed's Quantitative Easing program was to satisfy the world's voracious appetite for risk-free, safe assets. QE has not boosted the economy, because QE only serves to treat the symptoms of risk aversion that have held the economy back. 

The chart above shows the leverage of the household sector, which is calculated based on the Fed's Flow of Funds data through Q2/13. Total liabilities as a % of assets have fallen by almost 25% in just over four years, taking household leverage back to levels last seen in the mid-1990s. In the past 70 years there has never been such a dramatic deleveraging of household balance sheets.

The chart above shows another way of looking at households' leverage. It compares monthly debt service and financial obligation payments to disposable income. By this measure, households currently have the lowest financial burdens in the past 30 years. We've never before seen such a significant decline in financial burdens. Households have seriously hunkered down, which is not surprising given the unprecedented financial and economic turmoil unleashed in the Great Recession. Once burned, twice shy, as they say. 

The chart above shows the average delinquency rate on credit cards and all consumer loans as of Q3/13. Both of these measures of the health of household finances have fallen dramatically since the Great Recession, to the lowest level in over 20 years. Moreover, as of last October, the average 30+ day delinquency rate on credit cards issued by the top six issuers (Amex, B of A, Capital One, Chase, Citibank, and Discover) was a mere 1.9%. It's never been this low, and that is very good news for banks as well as households. Banks' profit margins are up, and households' financial health is greatly improved, thanks to deleveraging and more responsible risk-taking. But we've only seen this improvement thanks to lots of risk aversion.

Since late 2008, the Fed has pumped up the supply of bank reserves by $2.4 trillion through its purchases of Treasuries and MBS. More than 97% of those additional reserves currently are held by banks in the form of "excess reserves." Those reserves are not needed to back up deposits and are available to support an almost unlimited expansion of new loans. Bank lending should be soaring.

But it isn't, as the chart above documents. Bank credit has expanded at a very slow rate since late 2008, even as banks' ability to make new loans has become virtually unlimited. This can only mean that a) banks have tightened their lending standards, and/or b) businesses and households have been reluctant to take on more debt, preferring instead to deleverage. No matter how you look at it, this is powerful evidence of risk aversion across the entire economy.

Instead of using their ballooning reserves to support a huge increase in new lending, banks have been content to hold onto them, even though they pay only 0.25%. (Prior to late 2008 they paid nothing, so banks always sought to minimize their holdings of reserves since they were nonproductive assets.) In effect, banks since late 2008 have preferred to lend money to the Fed at 0.25% rather than lend money to consumers and businesses at higher rates, which is yet another example of risk aversion.

As the chart above shows, savings deposits at U.S. banks have soared by over $3 trillion since late 2008. Banks have been the recipients of a virtual flood of new savings deposits from consumers and businesses even though the interest rate on those deposits has been the lowest in modern banking history. Banks have apparently been quite content to hand over all of that additional deposit inflow to the Fed in exchange for risk-free bank reserves. (Here's what has happened behind the scenes: The Fed bought about $2.7 trillion of Treasuries and MBS from the public, and after all was said and done, the public decided to put all the proceeds into bank savings deposits. Banks then used the new deposits to acquire bank reserves.)

In a sense, banks have simply become intermediaries, funneling cash from households and businesses to the Fed, which has purchased notes and bonds with the proceeds. At the end of the day, the Fed has been effectively "transmogrifying" Treasury notes and bonds and MBS into T-bill equivalents (aka bank reserves). The Fed hasn't been printing money, it's been exchanging bank reserves for notes and bonds. The public and the banking system have been quite happy holding on to deposits and reserves paying almost nothing, rather than riskier notes and bonds yielding more. Why? Because risk aversion has been intense.

The two charts above illustrate just how risk-averse the corporate sector has been in this recovery. The bottom chart shows that after-tax corporate profits are at all-time record highs, having more than doubled since the end of 2008 and having more than tripled since the end of 2000. Yet as the top chart shows, capital goods orders—a good proxy for business investment—are just barely higher today than they were prior to the 2001 recession. The same goes for private sector jobs, which today are about 1 million less than they were in early 2008, and only 3% higher than they were in 2000. Businesses have been VERY reluctant to invest their profits and expand their operations. For their part, investors are only willing to pay modest multiples to own equities today, despite record levels of profitability and record-low interest rates. This is risk aversion on a grand scale.

Why so much risk aversion? There are undoubtedly lots of reasons, but the obvious ones are 1) the profound shock that accompanied the Great Recession, as the global economy and financial markets teetered on the brink of disaster; 2) the great uncertainty that has accompanied the Fed's unprecedented foray into Quantitative Easing (you can see that uncertainty reflected in the surge in the price of gold to $1900/oz.); 3) the increased regulatory burdens imposed by Dodd-Frank and Obamacare; and 4) the trillion-dollar deficits that arose from a massive increase in government spending in 2008 and 2009.

Many of these problems are still with us, but arguably they are fading. The federal deficit has plunged by more than half, to "only" $650 billion. The Fed is getting ready to taper QE, and a reversal of QE is on the horizon. Obamacare is slowly but surely imploding. Global equity market capitalization has recovered to pre-recession highs—surely this reflects at least a decline in pessimism if not the return of some optimism. Swap spreads in most major markets are at very low levels, suggesting an almost complete absence of systemic risk. At this rate, risk aversion will sooner or later be replaced by an budding appetite for more risk.

If policymakers want to accelerate the process, they should direct their efforts towards reducing the sources of risk aversion (e.g., less monetary uncertainty, reduced regulatory burdens) and increasing consumers' and businesses' willingness to take on risk (e.g., lower marginal tax rates which increase the rewards to work and risk taking).

The bad news is that there are a lot of problems out there and not much confidence in the future. The good news is that it shouldn't be too hard for things to get better.

Good news: risk aversion is declining

This post is an updated and somewhat expanded version of one I made last December. I think it was insightful then, and the major themes still hold today. Importantly, however, things look a little better now than they did just seven months ago, mainly because there are growing signs that risk aversion is beginning to decline.

The recovery from the Great Recession of 2008-09 has been the weakest ever, and that has a lot to do with the fact that this has also been the most risk-averse recovery ever. Households have deleveraged like never before; the world has stocked up on cash and cash equivalents like never before; banks have accumulated trillions of dollars of excess reserves; and business investment has been exceptionally weak despite record-setting profits. Contrary to popular perception, these facts suggest that the real function and purpose of the Fed's Quantitative Easing program was to satisfy the world's voracious appetite for risk-free, safe assets, which in turn was a by-product of the scariest recession ever. The reason QE has not boosted the economy is because QE has only served to treat the symptoms of risk aversion that have held the economy back. With QE now winding down, and risk aversion beginning to decline, the economy is facing reduced headwinds and growth could therefore begin to pick up.

Why so much risk aversion? There are undoubtedly lots of reasons, but the obvious ones are 1) the profound shock that accompanied the Great Recession, as the global economy and financial markets teetered on the brink of disaster; 2) the great uncertainty that has accompanied the Fed's unprecedented foray into Quantitative Easing (you can see that uncertainty reflected in the surge in the price of gold to $1900/oz.); 3) the increased regulatory burdens imposed by Dodd-Frank and Obamacare; and 4) the trillion-dollar deficits that arose from a massive increase in government spending in 2008 and 2009.

Many of these problems are still with us, but they are fading. The federal deficit has plunged by fully two-thirds, to only $490 billion in the 12 months ending last May. The Fed is tapering QE and should finish within a matter of months. Obamacare is slowly but surely imploding, and market-based reforms are the only viable and sensible solution. Global equity market capitalization has reached new highs, and this surely reflects at least a decline in pessimism if not the return of some optimism. Swap spreads in most major markets are at very low levels, suggesting an almost complete absence of systemic risk. PE ratios are now at above-average levels. As risk aversion declines, risk taking increases, and that is an essential ingredient for healthier economic growth.

The chart above shows the leverage of the household sector, which I've calculated using the Fed's Flow of Funds data through Q1/14. Total liabilities as a % of assets have fallen by almost 30% in the past five years years, taking household leverage back to levels last seen in the early 1990s. In the past 70 years there has never been such a dramatic deleveraging of household balance sheets. This has come about as a result of an unprecedented five-year decline in total liabilities (from a high of $14.6 trillion to $13.8 trillion), and a five-year rise in total assets (financial assets rose by $21.4 trillion and real estate values increased by $4.1 trillion).

The chart above shows another way of looking at households' leverage. It compares monthly debt service and financial obligation payments to disposable income. By this measure, households currently have the lowest financial burdens in the past 30 years. We've never before seen such a significant decline in financial burdens. Households have seriously hunkered down, which is not surprising given the unprecedented financial and economic turmoil unleashed in the Great Recession. Once burned, twice shy, as they say. Of note, however, is the fact that financial burdens are relatively unchanged over the past year, which in turn suggests that households' deleveraging is nearly complete. Risk aversion, by this measure, may have run its course.

The pronounced deleveraging of the household sector has predictably resulted in a huge improvement in households' financial health. The first chart above shows the average delinquency rate on credit cards and all consumer loans as of Q1/14. Both of these measures of the health of household finances have fallen dramatically since the Great Recession, to the lowest level in decades. As the second chart shows, credit card debt outstanding has plunged by almost 25% since late 2008. Banks' profit margins are up, thanks to more responsible risk-taking on the part of both banks and households.

Since late 2008, the Fed has pumped up the supply of bank reserves by over $2.6 trillion through its purchases of Treasuries and MBS. About 94% of those additional reserves currently are held by banks in the form of "excess reserves." As I explained over a year ago, banks have essentially used strong inflows of savings deposits to purchase bonds, then sold those bonds to the Fed in exchange for reserves which they were content to hold. Banks have in a sense been "investing" their deposit inflows in bank reserves, which are functionally equivalent to T-bills. The public's demand for the safety of savings deposits (which carry a government guarantee but yield almost nothing) has been very strong, and banks' demand for reserves (which have an implicit government guarantee and pay almost nothing) has also been very strong, and both reflect lots of risk aversion. The Fed's massive purchases of bonds have only served to satisfy the world's massively increased demand for safe, risk-free assets. The world's demand for money has been extraordinarily strong, and that explains why bank lending has been relatively weak. (Strong demand for money is the opposite of strong demand for credit; significant increases in bank lending reflect a declining demand for money.) 

As the chart above shows, bank credit has expanded at a very slow rate since late 2008, even as banks' ability to make new loans has become virtually unlimited as a consequence of the Fed's prolific supply of bank reserves. This can only mean that a) banks have tightened their lending standards, and/or b) businesses and households have been reluctant to take on more debt, preferring instead to deleverage. No matter how you look at it, this is powerful evidence of risk aversion across the entire economy. I would note, however, that bank credit has been accelerating of late: total bank credit grew only 1.2% last year, but grew at an 8% annualized rate in the first six months of this year. This is a good sign that risk aversion is beginning to decline, to be replaced by more risk taking. On the margin, banks are more willing to lend, and households and businesses are more willing to borrow, and this points to less risk aversion, more confidence, and more investment in the future.

As the chart above shows, savings deposits at U.S. banks have soared by over $3 trillion since late 2008. Banks have been the recipients of a virtual flood of new savings deposits from consumers and businesses, even though the interest rate on those deposits has been the lowest in modern banking history. Meanwhile, banks have been content to hand over almost all of their deposit inflows to the Fed in exchange for risk-free bank reserves that pay only 0.25%.

Most of the increase in the M2 measure of the money supply since the onset of the 2008 financial panic has come from a $3.4 trillion increase in bank savings deposits. There's also been a substantial increase in currency in circulation, which has been driven in large part by strong overseas demand for U.S. currency. Both of those are symptomatic of very strong money demand: the world has been pouring money into bank savings deposits despite extremely low interest rates, and the world has been craving U.S. dollar cash, even though it pays no interest at all and has been losing about 2% of its purchasing power every year.

Think of M2 has a handy measure of the economy's cash on hand—readily available, spendable cash. Think of nominal GDP as a proxy for the economy's annual income. The ratio of the two, shown in the chart above, is similar to the percentage of the average person's income that he or she wants to hold in cash or cash equivalents (checking accounts and savings deposits). The demand for cash relative to incomes has never been higher than it is today, and it has risen by about 30% since the onset of the 2008 financial crisis. The world has been stockpiling liquidity instead of spending it. The Fed's expansion of the money supply has only accommodated an increased demand for that money; that's why it hasn't been inflationary. But this should soon start to reverse, if the other indicators mentioned above are any guide.

The two charts above illustrate just how risk-averse the corporate sector has been in this recovery. The first chart shows that after-tax corporate profits have tripled since the end of 2000, and have increased by much more than nominal GDP. Yet as the second chart shows, capital goods orders—a good proxy for business investment—are only moderately higher today than they were prior to the 2001 recession, and are still significantly lower in real terms. We see the same story with private sector jobs, which today are only about 1% above their pre-recession high. Businesses have been extremely reluctant to reinvest their soaring profits.

For their part, investors only recently have been willing to pay above-average multiples to own equities, despite record levels of profitability, record-low interest rates, and an expanding economy, as the above chart shows. Everyone has been very risk averse, but risk aversion is declining, and the outlook is therefore likely to improve in the months and years to come.

The aftermath of the housing bubble looks good for equities

Back in the early 1980s, when I was working for him at Claremont Economics Institute, John Rutledge came up with a version of this chart. He used it to argue that relative prices of things can and do change as inflation fundamentals change. With inflation soaring throughout the 1970s, households responded by attempting to increase their holdings of tangible assets. That's a rational response, since tangible assets tend to hold their value during periods of inflation, whereas financial assets (especially bonds) tend to lose their value. The attempt by households to increase their tangible asset exposure was most noticeable in the real estate market, and it resulted in a sharp rise in housing prices relative to the prices of financial assets (indeed, bond prices collapsed and stock prices went sideways). When inflation began to fall in the early 1980s, he argued that households would reverse their earlier plunge into real estate, with the result that financial asset prices would experience a boom. And he was right.

In updating his chart, I'm struck by how the surge in real estate prices in the early 2000s was not accompanied by rising inflation. It was a bubble that was inflated not by the desire to acquire inflation protection, as happened during the 1970s, but by other factors, such as the invention of mortgages that required little or no down payment or documentation, and creative financing options like interest-only or negative-am loans. It was a massive leveraging-up spree that inflated the housing bubble.

The chart now suggests that housing prices have come back down to earth, and are consistent with the relatively low and stable inflation of the past two decades. In the process of coming back down to earth, the sudden collapse of the housing market and the ensuing financial panic of late 2008 sent households scurrying for the shelter of savings deposits (up over $2 trillion in the past three years), and for the relative safety of bonds—everyone wanted to deleverage and de-risk. That phase is winding down now, however, and the next phase is underway. As households regain confidence in the economy, they are beginning to attempt to shift the money socked away in savings accounts and bonds into both housing (which has become incredibly cheap given the plunge in financing costs) and equities. That's why we're likely to see rising housing prices, rising equity prices, and falling Treasury bond prices in coming years. A shift in households' desired portfolio holdings could create more than enough demand to absorb all the foreclosed houses that banks may end up dumping on the market.

It's not that all the cash on the sidelines goes into the equity market, it's that the desire of households and investors to shift the composition of their portfolios causes a change in relative prices. If the urge to reduce cash holdings is strong enough, and if the Fed doesn't act to offset the decline in the demand for money (by raising rates) this process could fuel a rise in a wide range of prices, and this could show up as higher inflation.

Why households would benefit from higher interest rates

Today the Federal Reserve released its first quarter '10 estimates of U.S. Households' Balance Sheets. As shown in the bottom chart, Household Net Worth rose by $1 trillion during the period, driven mostly by a rise in equity prices. I note that there was yet another reduction in Household Debt, which has been declining for the past three years, and a marginal $27 billion reduction in the value of real estate holdings, which has declined by over $7 trillion since its peak in 2006. Separately, it is comforting to see that disposable personal income reached a new all-time high ($11.1 trillion). On balance, the data reflect a year-long improvement in the financial health of the nation's households.

I've disaggregated the Fed's data in order to estimate how much exposure households have to fixed and floating rate debt (top chart). The most important result is that households have far more floating rate assets (e.g, about $10 trillion of bank CDs and money market funds) than floating rate liabilities (e.g., about $2.6 trillion of adjustable rate mortgages and about $2 trillion of other short-term debt subject to rising rates). If interest rates were to rise as a result of an unexpected Fed tightening, household cash flow would immediately benefit because the increase in interest received would exceed the increase in interest paid out.

As for exposure to fixed interest rates, households would suffer somewhat from higher interest rates, since they have about 20% more exposure to fixed rate assets (mainly in the form of bonds whose price would decline as prices rise), than they do to fixed rate debt (mainly in the form of fixed rate mortgages that would be immune to higher interest rates). However, this loss would be only on a mark-to-market basis, since cash flows would be largely unaffected.

I should note that aggregate exposure to changes in interest rates is mostly a zero-sum game. Households would benefit from higher interest rates because of their very large cash holdings, but institutional investors and foreign holders of Treasury debt that have little in the way of cash, for example, would lose.

Households have finished deleveraging

I've been following this issue for more than two years because I think it has very important implications for the future of Fed policy. One of the defining characteristics of the current recovery has been a widespread risk aversion, which in turn has led to a significant amount of deleveraging and a simultaneous increase in money demand on the part of U.S. households. The Federal Reserve's Quantitative Easing operations were essentially designed to accommodate this, since the net result of QE was to transmogrify notes and bonds into risk-free, short-term assets which, in turn, satisfied the risk-averse public's increased demand for money and money-like balances.

One important consequence of risk aversion is the desire/need to deleverage and otherwise reduce debt burdens. (Jargon note: reducing debt and debt burdens is equivalent to an increasing demand for money; having debt is like being short money—reducing debt is equivalent to going long money.) There are many ways to do this: paying down debts, canceling debts, refinancing debts at a lower interest rate, saving more money, and accumulating more assets. The massive increase in risk aversion in the wake of the financial crisis of 2008 manifested itself in an equally massive increase in the demand for money, money equivalents (e.g., bank savings deposits), and safe assets (e.g., short-term TIPS, gold). The Fed accommodated that risk aversion by buying notes and bonds and creating bank reserves. Banks have invested essentially all of their $3.5 trillion increase in bank savings deposit inflows since late 2008 in excess bank reserves which they still, apparently, are content to hold.

As the chart above shows, as of June 2014, households' financial burdens (debt and related payments relative to disposable income) had fallen significantly from their pre-recession high, but they have been unchanged for more than a year. Households responded to too much indebtedness by going bankrupt, writing down debt, paying down debt, getting new jobs, earning more income, refinancing debt at lower interest rates, and by saving more. But it is becoming increasingly apparent that households'  desire to delever has all but evaporated. That implies that the next chapter in this story, whenever it begins, will involve increasing indebtedness and a decline in the demand for money and safe assets. There are already signs that this is happening, most notably the increased growth rate of C&I Loans that we have seen year to date, the weakness in gold prices, and the decline in the real yield on 5-yr TIPS.

The chart above shows that, as of June 2014, households' leverage (total debt as a % of total assets) had declined by more than 25% from its recession-era high. As with debt burdens, leverage has declined thanks to a variety of factors: less debt, lower interest rates, more savings, and rising equity and housing prices. Household leverage is now back to the levels of the mid- to late-1990s, a period that saw low inflation and strong economic growth. The "bubble" that was created in the runup to the 2008 financial crisis has completely popped. Households have adjusted to new realities, so perhaps we'll see more normal, less risk-averse behavior going forward.

Even the federal government's borrowing binge has faded. The FY 2014 federal budget deficit was a mere 2.8% of GDP, down from a high of over 10% in late 2009. In dollar terms, the federal deficit declined by an impressive two thirds in just over the past four years. The federal government hasn't yet actually deleveraged (federal debt outstanding is now at a post-war high of about 72% of GDP, as shown in the chart above), but it is no longer leveraging up by leaps and bounds.

An important part of the big decline in debt burdens and the big deleveraging of household's balance sheets has been an increase in holdings of "money" and money equivalents. The M2 measure of the money supply is arguably one of the best measures of money, and the chart above shows the current composition of M2. Savings deposits are by far the largest component, and they have grown by $3.5 trillion since the onset of the 2008 financial crisis. But the growth rate of savings deposits has been declining in the past year or so, from a high of 18% in 2010 to just 5% in the past 6 months. This is consistent with a decline in risk aversion and a decline in the demand for money on the margin.

The big increase in money demand shows up clearly in the chart above. It plots the ratio of M2 to nominal GDP. Since the onset of the 2008 financial crisis, the public has increased its holdings of "money" relative to nominal income by more than 20%. That's equivalent to the typical household deciding that they need to increase their holdings of cash by an amount equal to one-fourth of a year's income. That's a lot of money that has been "stockpiled" on the sidelines—upwards of $2.2 trillion. If the demand for that money should ever decline—because, say, risk-taking becomes the vogue—it would be like opening the floodgates: a wave of extra liquidity would wash through the economy, boosting nominal GDP and likely raising prices. Unless, of course, the Fed tightens monetary policy by enough to offset the decline in money demand. It would probably take much higher interest rates to convince households to continue to hold their sizable savings deposits in a world with much less risk aversion.

So this is where we stand today. The great era of risk aversion and deleveraging is fading into the past. It is gradually being replaced by a new era of more confidence and a desire to embrace risk and shun safe assets that yield almost nothing. This bodes well for equities and the economy, but it also creates a serious risk of inflation, should the Fed fail to accommodate the declining demand for money in a timely fashion.

Households' balance sheet repair continues (2)

According to the Federal Reserve's calculations, the net worth of U.S. households as of last December had increased by $5.7 trillion (up 11.6%) from the low of last March. The gains came from a combination of higher equity and bond prices and reduced debt that overwhelmed declining real estate values. This reflects a healthy realignment of households' balance sheets (lower debt ratios, less reliance on real estate), as well as healthy improvement overall. However, it will take a few more years before households have recovered their peak net worth.

I note that the ratio of household's tangible asset holdings to total assets is now 33.7%, which is below the average of this ratio (36.6%) since records began to be kept in 1950 (see chart below). To me, this suggests that the correction in real estate prices has largely run its course. You might say that real estate is now somewhat "cheap" relative to financial assets. Think of the "tangible asset ratio" as a measure of how enthusiastic households are to own real estate instead of other sources of wealth such as stocks and bonds. Also note that the public's willingness to pay up for real estate is roughly correlated with underlying inflation, as the chart suggests. Tangible assets are a natural inflation hedge, so this makes a lot of sense. If inflation has bottomed out this past year and begins to rise in the years to come, then we could expect tangible asset prices to recover.

The end of deleveraging: update

In a post three months ago, "The end of deleveraging," I noted signs that households' risk pendulum had stopped swinging in the direction of risk-aversion, and that the public was beginning to embrace risk rather than shun it. That had important implications for monetary policy, since the underlying rationale for QE, which in essence amounts to the "transmogrification" of bonds into T-bill substitutes, was to satisfy the world's seemingly unlimited demand for safe, short-term assets. If risk-aversion is on the decline and risk-taking is on the rise, there is no need for the Fed to continue QE. I think this explains why the Fed has been able to taper QE without there being any adverse effects on the economy or the markets. We don't need QE any longer, and the Fed is acting appropriately. 

The Fed has recently released pertinent data from the first quarter of this year which reinforces this view. What follows are some updated charts and commentary.

As the chart above shows, households' financial obligations (i.e., debt payments as a % of disposable income) reached a high in 2008, but have since declined significantly. Importantly, financial burdens are essentially unchanged in the past year. This means households have rebuilt their balance sheets and restructured their finances to the point where they no longer need to tighten their financial belts. Financial burdens today are as low as they have been at any time in the past three decades, and they are unlikely to decline meaningfully going forward. This is a very healthy development and it justifies the Fed's ongoing tapering of QE.

As the chart above shows, households' overall leverage (liabilities as a % of total assets) has declined significantly—by almost 30%—since hitting an all-time high in early 2009. Leverage is now back to levels that prevailed through much of the 1990s. All of the excessive speculation that helped fuel the housing boom in the 2000s has been reversed. This is also a very healthy development that is ongoing: household liabilities are no longer declining, but the value of households' financial and real estate assets are rising. This is healthy deleveraging, not risk-averse deleveraging.

As the chart above shows, as of Q1/14 the delinquency rates on consumer loans had fallen to its lowest level in decades. Consumers haven't been so careful with their finances for a very long time.

Gold prices, shown in the first of two charts above, have been relatively unchanged for the past year, even as tensions in the Mideast have risen. As the second chart shows, real yields on 5-yr TIPS have also been relatively unchanged for the past year. Both of these developments reflect a decline in risk aversion.

Capital goods orders—a proxy for business investment—were relatively flat for most of the past year, but in recent months (the most recent data, released today, cover May) have begun to rise. This is a good sign that corporations are shedding some of their risk aversion and are beginning to be more optimistic about the future.

PE ratios have been rising for several years, and are now above their long-term average, a good sign that risk-taking is beginning to come back into fashion. This is likely to continue, given all the other signs of the risk-pendulum swinging in a favorable direction, which means that there is still plenty of room on the upside for the stock market.

I should note that all of these changes are moving at a somewhat glacial pace—nothing dramatic is happening on the margin. It's all part of a slow but relatively steady improvement in the economy that is likely to persist until Congress adopts more growth-friendly policies. 

Household Balance Sheet update

Today the Fed released its Flow of Funds report, which includes their calculation of households' net worth (chart above). It doesn't reflect any significant improvement over the levels of last year, and indeed it shows that net worth in the second quarter declined by about $1.5 from the first quarter, largely due to the 12% decline in the stock market. It's interesting to note, however, that the value of households' real estate holdings has been increasing, albeit only modestly, since the first quarter of 2009, and that tracks with the modest increase in the Case-Shiller housing price index over the same period. Also of note is the ongoing modest deleveraging of the household sector, with liabilities in the second quarter of $13.9 trillion, down from $14.3 trillion at the end of 2008.

In addition, the report shows that the household sector has been an important source of financing for our exploding federal deficit: households increased their holdings of Treasury holdings by $820 billion between the end of 2008 and the end of Q2/10. I can't help but think that if it weren't for the huge, deficit-financed federal spending that has occurred over the past few years, households might well have put that money to more productive use. Instead, we have households today holding over $1 trillion of Treasury debt that is yielding a paltry 1.5% on average.

Households' balance sheets continue to improve

The Fed recently released flow of funds data for the second quarter, which includes an update to Household's Balance Sheet. The decline in real estate prices has reduced the value of real estate holdings by about $1 trillion in the past year. However, this loss was more than made up for by a $5 trillion surge in the value of total financial assets and a modest decline in liabilities, resulting in an increase in net worth of $4.4 trillion over the past year. Most of the gains in financial assets have come, not surprisingly, from equity holdings and pension reserves. Despite the fact that the equity market at the end of June was still down about 15% from its 2007 highs, financial assets were only down about $2 trillion from their highs, or about 5%—a testimony to household's ability to add significantly to their savings.

It's also interesting to note that over the past year, households have reduced their holdings of Treasury securities from $1.15 trillion to just $0.84 trillion, despite the $1.3 trillion increase in Treasury debt over the same period, reflecting the important role that foreigners have been playing in financing our huge federal deficit (which, if Treasury yields rebound, may prove to have been a wise move on the part of households, and an unwise move on the part of foreigners). Another important story here is that households have been deleveraging—liabilities have declined by almost $1 trillion over the past four years—as they have been forced to adjust to lower home values, and it has been very painful. Nevertheless, it is encouraging to see that households' equity as a % of real estate holdings, which peaked at almost 60% in 2005, was unchanged in the second quarter at 38.6%, suggesting that most of the downward adjustment is complete.

More impressive financial milestones

The Fed last week released its Q2/18 estimates for Household Net Worth and related measures of prosperity. Of note, households' leverage (liabilities as a % of total assets) fell to a 33-yr low, and households' net worth hit hit a new all-time high in nominal, real, and per capita terms. Total household net worth is now almost $107 trillion, up over 50% from pre-2008 highs, whereas liabilities are up only 7% from their Great Recession highs. Housing values have increased by about 15% since their 2006 bubble highs, but are still about 6% lower in real terms. Households have been busy deleveraging, saving, and investing, and the housing market is back on its feet and healthy. Major trends are all virtuous and consistent with past experience.

Chart #1

As Chart #1 shows, private sector (households and non-profit organizations) leverage (liabilities as a percent of total assets) has now fallen 36% from its early 2009 high, and has returned to levels last seen in early 1985, when the economy was in full bloom. Our federal government, in contrast and very unfortunately, has borrowed with abandon, raising the burden of federal debt (federal debt owed to the public, as a percent of GDP) from 37% to 83% over the same 33-year period. If our government were run with the same discipline as households have displayed, that might be termed nirvana. We're as well off as we are today despite the ministrations of our government.

Chart #2

Chart #2 summarizes the evolution of aggregate household balance sheets. Note the very modest increase in liabilities over the past decade, the gradual recovery of the real estate market, and the strong gains in financial assets, driven by increased savings and rising equity prices.

Chart #3

Chart #3 shows the long-term trend of real net worth, which has risen on average by about 3.5% per year over the past 66 years. Note that recent levels of real net worth do not appear to have diverged appreciably from this long-term trend. That wasn't the case in 2000 or 2007 however, when stocks were in what we now know was a valuation "bubble."

Chart #4

Chart #4 shows real net worth per capita. The average person in the U.S. today is worth about $327K, and that figure has been increasing by about 2.2% per year, adjusted for inflation, for the past 67 years. (Note: the difference in the trends of Chart #3 and #4, 1.3%, is the average rate of population growth over this period.)

To be sure, there are lots of mega-billionaires these days who are skewing the statistics upward, but that doesn't imply that the average person's living standards have declined. Virtually all of the wealth of the mega-rich is held in the form of equity or real property investment, and all of that is available to everyone on a daily basis. A person making an average income in the U.S. enjoys all the advantages that our nation's net worth has created. Regardless of who owns the country's wealth, everyone benefits from the infrastructure, the equipment, the computers, the offices, the homes, the factories, the research facilities, the workers, the teachers, the families, the software, and the brains that sit in homes and offices all over the country and arrange the affairs of the nation so as to produce over $20 trillion of income per year. Would the average wage-earner (or, for that matter, the average billionaire) in the U.S. enjoy the same quality of life if he or she earned the same amount while living in a poor country? I seriously doubt it.

Healthy households

A few weeks ago, I had some charts (the last two in this post) that showed how our net worth as a country on a real and per capita basis has reached new all-time highs. Our collective prosperity rests on the value of our savings, our investments, and our capital stock. Regardless of who owns all that money (as of June 2017 the net worth of the private sector was over $96 trillion, with total assets worth over $111 trillion), we all enjoy the fruits of those assets in the form of jobs, services, products, and infrastructure. Does a worker really care who owns the building he works in? Who pays his salary? Who owns the toll road he drives to work on? Who owns the tools he uses? He shouldn't. What's important is that the assets that have generated our record-setting wealth are available to all of us, everyday.

The Fed recently updated its calculation of households' debt service burdens, as of Q2/17. Total household liabilities climbed to a record $15.2 trillion, but that represents less than 14% of total household assets. As the charts below show, households' financial burdens (the cost of servicing debt as a percent of disposable income) are about as low as they have been for decades. And households' overall leverage (total debt as a percent of total assets) has fallen by one-third since its record high in early 2009.

On balance, U.S. households are in very healthy financial shape, and that in turn means that the fundamentals of the U.S. economy are also in good shape.

Household financial burdens fall to 30-yr low

According to the Fed's latest calculations, as of June 30, 2012, households' debt and overall financial burdens had fallen to a 30-yr low. From the peak in Q3/07, the burden of households' total financial obligations has fallen by almost 17%: from 19% of disposable income to 15.8%. This is big deal.

"Financial burdens" are calculated by comparing debt service payments and total financial obligations to disposable income. This is very different from the numbers bandied about in the press, which compare total debt to income or GDP in order to argue that there is still a lot deleveraging to come. The problem with the latter is that it is an apples-to-oranges comparison, since total debt is a stock—a fixed amount—whereas income is an annual flow. The Fed's method compares flows (annual payments on the stock of debt) to flows (annual income). Owing $100,000 with an interest rate of 10% is much more burdensome than owing the same amount with a 3% interest rate, just as it is easier to service a debt with a 10% interest rate when one's income rises 10% a year, than it is when one's income rises only 3% a year.

The data for June showed a modest reduction in financial burdens of all types. But financial burdens have declined significantly in the past 5 years, and are now back to levels last seen in the early 1980s. Households have accomplished this rather impressive task by a) paying down debt (i.e., deleveraging), b) defaulting on debt, c) refinancing and taking on new debt with much lower interest rates (mortgage rates are at all-time lows), and d) increasing their disposable income. With the exception of the unfortunate cases in which households have had to default on their debt obligations, the story is a virtuous one, and it has been driven by an increase in overall risk aversion, increased work, and an increase in savings.

It is also worth noting that a significant amount of deleveraging has effectively occurred even as the economy has managed to grow (albeit slowly). Deleveraging does not have to be synonymous with deflation or recession. Deleveraging occurs when the demand for money increases, and the demand for money tends to increase during periods of rising uncertainty. Increased money demand can be satisfied by increasing one's holding of cash and cash equivalents and/or reducing one's debt. (Conversely, increasing one's leverage is equivalent to a decline in one's demand for money, since debt is equivalent to "shorting" money.) Deleveraging can be bad for an economy's health if the central bank fails to respond to the increased demand for money. The Federal Reserve was slow in responding in late 2008, but they more than made up for that mistake by engaging in two unprecedented quantitative easing programs (with another just beginning) which have resulted in the creation of $1.4 trillion of excess bank reserves to date. When the supply of money equals or exceeds the demand for money, then an economy can undergo lots of deleveraging without major problems, and that is precisely what has happened since 2008.

There have been some major adjustments made in this economy in recent years, and this lays the groundwork for a healthier economy in the years to come. What's lacking now are the proper incentives to spur growth.