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 demand 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 (American Express(NYSE:AXP), B of A (NYSE:BAC), Capital One (NYSE:COF), Chase (NYSE:JPM), Citibank (NYSE:C), and Discover (NYSE:DFS)) 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:
- The profound shock that accompanied the Great Recession, as the global economy and financial markets teetered on the brink of disaster.
- 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.).
- The increased regulatory burdens imposed by Dodd-Frank and Obamacare.
- 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.