After the financial crisis, a new normal seems to have appeared where growth is subdued, inflation almost non-existent, debt levels elevated and increasing.
As we explained in an earlier article, this is a toxic combination that tends to be self reinforcing:
- High debt tends to reduce spending and borrowing in an attempt to improve balance sheets (deleveraging).
- Deleveraging renders monetary policy powerless (liquidity trap 'pushing on a string').
- A prolonged deleveraging process is likely to produce damage to the supply side, and thereby affecting future growth through hysteresis effects (the reduction of quality and quantity of factors of production through inactivity).
- The reduced growth, lowflation (or even deflation) and slow decay of the supply side worsens debt dynamics as the debt/nominal GDP ratio worsen.
- The worsening of balance sheets can lead to forced asset sales, declining the asset values that underpin debts, thereby worsening bank balance sheets, which is likely to negatively impact the supply of credit.
At its worst, these processes can result in a 'Minsky moment' where balance sheets collapse, triggering a chain reaction and an acute financial crisis results. At best, this is a slow, lingering corrosive 'Japanese style' process resulting in low growth and declining dynamism.
To a certain extent, much of the developed world (and even emerging markets) has fallen into this process, but perhaps surprising to some the US has fared relatively well. To some extent, the US can even serve as something of a model, as it has:
- Avoided outright deflation.
- Boosted growth and created lots of private sector jobs (14M+) and unemployment has fallen to 4.9%.
- Forced banks to clean up their balance sheets and increase capital.
- Reduced financial leverage considerably.
- Reduced household leverage.
- Drastically cut the public sector deficit without slowing the economy down to zero.
While growth and inflation could still be a little higher to ease the debt burden faster, at least the US hasn't fallen into a debt-deflationary cycle, and overall debt has actually decreased. US household debt as a percentage of income:
Here is Sam Ro:
"Leverage, as measured by debt in relation to book equity, has fallen dramatically and now stands at the lowest level since the late 1980s," Barclays' Jonathan Glionna wrote in an April 22 note to clients. "After increasing steadily from the mid-1980s until 2007, leverage has now declined seven years in a row.
If one compares this internationally, the US comes out rather well, relatively:
Before we celebrate too much, here is Richard Koo from Nomura:
In spite of the United States' relatively strong economy, inflation remained subdued because the private sector still maintained a financial surplus of over six percent of GDP, at least through the year ending in the third quarter of 2015, according to the flow of funds data. This is worrying because it means that the private sector continued to save in spite of zero interest rates, a disturbing trend that began when Lehman Brothers collapsed in 2008. It also indicates that businesses and households are still recovering their balance sheets, which may have been hurt when the housing bubble burst in 2008.
In essence, the deleveraging process isn't quite finished.
Financial leverage has decreased markedly, here is Matt O'Brien describing the graph above:
It shows how much the financial system as a whole has borrowed the past 35 years. The simple story is that the more debt the banks have, the more vulnerable they are to even small losses. Think about it like this: If you have $10 and borrow $90 more, it'd take a 10 percent loss for you to be bankrupt, but if you only have $3 and borrow $97 instead, then it'd just take a 3 percent loss for you to be wiped out. Bankers, though, love leverage, because it supercharges their returns -and, as a result, their bonuses.
There is a marked difference in how US banks fared relative to those in the EU, From the FT:
Bad loans are twice as big a problem for European banks as they are for banks in the US - despite lenders' many efforts to clean up balance sheets in troubled eurozone hotspots such as Spain, Ireland to Greece. New official figures show that almost 6 per cent of European banks' entire loan books are impaired, double the impairment rate of 3 per cent in the US.
The US dealt with this problem much earlier and more decisively, and has reaped the rewards.
The public sector did leverage up, this isn't very surprising as most of this happened automatically as a result of the deep economic crisis, producing record deficits.
You see there is an alarming worsening of public finances as a result of the financial crisis, but most of the bleeding has at least stopped.
While there is no immediate crisis, on the other hand, the relatively good times need to decrease the debt ratio, not just stabilize them as another economic crisis will ratchet up the debt ratio again.
The level of total debt to GDP has declined from a top of 366% in 2009 to 334% now, but that is still very elevated:
Compare that internationally (the figures are not entirely comparable to the previous tables as the financial sector debt isn't included in the figure below):
As far as US households go, the deleveraging process seems to have come to an end already (from Marketwatch):
Americans accelerated their pace of borrowing in December, entering 2016 ready to spend despite turmoil in financial markets and overseas economies. Outstanding consumer credit, a measure of all debt besides mortgages, rose by $21.3 billion or at a seasonally adjusted annual 7.2% rate in December, the Federal Reserve said Friday. That's the fastest pace since September, and an acceleration from November's rate of 4.8% and October's downwardly revised rate of 5.2%.
The consequences of the unprecedented build up of private debt and financial leverage that led to the financial crisis are still with us today. Even the cleanest dirty shirt, the US, has managed only relatively modest deleveraging overall, and that process already seems to have come to a halt.
The reality of this produces a significant drag on the investment climate. Deleveraging itself is slowing growth and reducing inflation, making the whole process more protracted and difficult.
The countervailing force is coming from unconventional central bank policies, but deleveraging is also rendering these less effective.
Any further slowdown in growth and inflation is complicating the issue further. Although the US isn't first in the firing line, it cannot isolate itself from developments elsewhere in the world.
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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.