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Scrooge Businesses


Stocks rallied today, as did commodities, in thin year-end trading (I am very tired of this latter phrase, which it seems we could have accurately used since October). The putative reason for the rally was that Initial Claims remained low (364k) rather than bouncing to 380k as the consensus estimate had predicted. The quality of the Initial Claims data will deteriorate rather sharply over the next couple of weeks and for the first few weeks of January, but it does seem likely that we have moved out of the old range of 400k-425k and into a new lower range. This is consonant with a general improvement in the overall data (and in the mood in the country!).

M2 money supply leapt $32bln last week. So much for the possibility I mentioned a few weeks ago that the pace of money growth might be slowing. The 52-week rise in M2 is back up to 9.8%. One of the restraints on inflation, despite this money growth, has been the slower rise in transactional money in Europe, where the year-on-year rate of rise in M2 as of the end of October was only 2.1%. This is soon to change, however, thanks to the ECB’s new operation. As a blog post from The Economist pointed out yesterday, ECB President Mario Draghi has stopped the stern denials about the ECB engaging in quantitative easing.

“Each jurisdiction has not only its own rules, but also its own vocabulary. We call them non-standard measures. They are certainly unprecedented. But the reliance on the banking channel falls squarely in our mandate.” (The source of the quote is an interview with the Financial Times here, but the Economist article makes for better reading.)

The ‘news’ of the day being thus dispensed with, I can proceed directly into a belated observation or two about the Fed’s Z.1 “Flow of Funds” release that was posted in early December. The Z.1 is a rich source of bauxite with just a little alumina within it, but one does occasionally find something valuable and/or interesting. I like to plot the debt numbers in various ways, because the Fed helpfully slices up the debtors into convenient categories (although they seem to still include Fannie Mae and Freddie Mac debt in “private” domestic financial institutions, which is a ridiculous fiction. More on the impact of that fiction in a moment).

I have published charts with roughly quarterly regularity simply to provide a concrete reminder that the popular story about household deleveraging is largely a myth. The chart below shows it very clearly: most of the deleveraging has come from domestic financial institutions. This will continue, as the Fed moves to implement substantially all of the Basel III recommendations and demands an extra layer of “protection” in the form of capital from systemically important institutions. Households have de-levered somewhat as well, but not really very much in the grand scheme of things. It just feelslike deleveraging compared to the wild leveraging behavior seen prior to 2008. Relative to income, consumers are carrying less debt, and it is the first decline in a generation, true. But it isn’t very much.

Businesses are adding debt!

But here’s the interesting thing in the chart above. Businesses are re-levering. Okay, technically they are not re-levering, but they are adding debt. This also spears a popular story, that of the cash-hoarding trolls that run businesses in America today. We are told that if businesspeople would only have confidence (those lousy one percenters!) the economy would be healed. Well, it’s a wonderful story, except for the fact that ‘taint so. Business owners are behaving like Scrooge, all right, but it’s Scrooge after the visitation by Marley’s ghost.

It is true that there is more cash on corporate balance sheets than there was five years ago. In some cases, it looks as if companies are issuing debt to hold cash! But that may not be far from the truth. After credit lines evaporated in 2008 and 2009, a prudent business will need to keep lots more cash on hand as an insurance measure. It is a good sign that business debt is growing, and it means this measure confirms the recent expansion in commercial bank credit that I mentioned and illustrated in a comment last week.

The second interesting chart is shown below. It computes the total federal, state, and local government debt as a proportion of GDP. The ratio currently stands at 86.6%.

U.S. public debt is approaching 100% of GDP.

That would not be a big story in itself, but the red line is. The red line is the ratio if you simply recognize that Fannie Mae and Freddie Mac debt are de facto obligations of the Federal government. And that ratio is at 96.1%, and will almost certainly exceed the magical 100% level by the middle of next year.

[Of course, you could plausibly argue that if you include Social Security and Medicare obligations, the obligation ratio is wayyyyy over 100%. But there are two differences with those obligations. One is that the government can decide to stop paying those benefits and it would not constitute a default. An abrogation of the social contract, yes; a default, no. The other difference is that Social Security and Medicare are inflation-linked, so the government can’t inflate out of them. Therefore, the existence of those obligations shouldn’t influence whether or not a calculated decision is made to spur inflation to reduce the real burden of the debt.]

Have a very Merry Christmas, a Happy Hanukkah, or be otherwise jolly no matter what your religious or secular persuasion. There will be one more article before the new year – but not this week!

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  1. usikpa
    December 23, 2011 at 9:59 am | #1

    It feels like you draw a picture that’s well backed up by the facts, yet you just stop short of the conclusion. So, in a grand scheme of things, deleveraging has just started. In fact it has not as whatever private debt (and more) was shed, was picked up by the Governemtnts What do you make of this, then?

    • December 23, 2011 at 10:47 am | #2

      Well, it means that the money that was added to offset the decline in velocity was likely too much (as evidenced by the fact that prices never fell). And it should be pulled back, unless there’s reason to think that there will be much more deleveraging, lest it lead to inflation. Of course, I think it will NOT be pulled back, and it WILL lead to inflation, and some of that is already baked in the cake…

      OR it could mean it is just starting, and the next wave of deleveraging will be more abrupt and painful – bankruptcies, not paydowns.

      Personally I think we missed our chance this time around to cleanse the system, and if so that’s very bad for the next time around.

      Note that moving leverage from private to public, though, matters – nations with heavy private debts tend to have trouble getting a robust inflation going, but nations with heavy public debts tend to have a much easier time and a clearer incentive to try (from the government’s perspective). So even though the total leverage hasn’t changed much, the allocation of that leverage is not insignificant.

  2. Jim H.
    December 23, 2011 at 10:00 am | #3

    Good (and indisputable) point about including Fannie and Freddie’s obligations in public sector debt! Today Bloomberg has an article from a former Fannie exec who got some libertarian religion after joining the private sector (the real one, not the formerly quasi-private one). His beef concerns the perverse incentives that risk-based capital rules provide for banks to load up on sovereign interest-rate risk at what may be a secular low in long rates.

    http://www.bloomberg.com/news/2011-12-23/new-bubble-may-be-growing-in-30-year-mortgages-commentary-by-edward-pinto.html

    A question pertaining to your forthcoming asset allocation commentary. Say that I want to establish a simple, binary rule to decide whether my fixed income allocation should be in nominal bonds or TIPS. How do I go about it?

    As a first pass, one could simply run a horse race between (say) TIP and IEF, buying the one with superior momentum. Then one doesn’t even need to know whether inflation is rising or falling; it’s implicit in the relative prices. What decision rule would you use?

    • December 23, 2011 at 10:52 am | #4

      Jim – Enduring Investments’ “Four-Real” strategy implements just such a rule. I can’t tell you a whole lot about it, although it isn’t black-box…I just don’t want to post on-line. The quick answer is that such a tilt based on where real yields are compared to nominal yields is the right answer (duh!), but there’s a neat regularity in that relationship that you need to account for when you’re asking whether real yields are too high or low relative to nominal yields.

      I keep playing with the idea of publishing our findings in a short scholarly piece, since it isn’t rocket science and we’d like to get credit if everyone is eventually going to know (I started having this thought after reading Emmanuel Derman’s book ‘My Life As A Quant’), but haven’t so far. We run into this problem a lot, because as specialists we find all kinds of quirks and arbs that no one else has noticed yet. But the real/nominal one is broadly applicable and probably worth publishing eventually.

      Sorry I can’t say much more than that. Become a client and I can! :-)

      As always, thanks for your generous comments!

  3. Jim H.
    December 23, 2011 at 11:07 am | #5

    Thanks … I fully understand that one can’t just give away an insight that took time and effort to develop. But as you say, one also wants to take pioneering credit before someone else publishes it. (I read Derman’s book too.) The ‘intellectual property’ approach of patenting financial algorithms rubs me the wrong way (and is probably unenforceable).

    If your ‘neat regularity’ is obvious enough (blind squirrel, nut, etc.) maybe I’ll blunder into it while torturing the numbers in Excel!

    • December 23, 2011 at 11:15 am | #6

      Jim, send me a note via the Enduring Investments website – I don’t mind sharing (as long as you’re not a potential competitor! so please set my mind at ease on that point)…just don’t want to post it.

  4. Morgan
    January 4, 2012 at 3:26 pm | #7

    I have a question that needs sorting out regarding the chart of household debt. Local folklore would have us believe US households have just undergone a massive deleveraging
    accompanied by untold agony and consumer goat sacrifice.
    But somewhat miraculously the Household credit line on your chart is relatively flat.
    How is this possible?
    Could it be that the villains of the piece (the banks) are rolling over credit to insolvent borrowers? Because it looks like the banks are a bad credit conduit to households who cannot repay but are instead adopting the attitude of US gov’t funding.
    Where have all the Home equity loans gone- to Fed heaven?
    To the uninitiated it looks like the banks were bailed for a reason.
    I need a real economist to straighten this out?

    Good blog BTW.

    • January 4, 2012 at 3:33 pm | #8

      Glad you like it. I think the point of that chart is that the deleveraging is either not happening, or it’s very uneven – that is, some households are deleveraging (probably the solvent ones) and some are increasing leverage (probably the ones that can’t make their payments – which is your point). That would explain the goat sacrifices while keeping the data. Of course, the other explanation is that the press enjoys the anecdotal stories of woe and doesn’t really look closely at the data.

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