The $54 Trillion Question: Can the Credit Crisis be Fixed with More Credit?
Easy money and bad decisions tanked our economy, and we're not out of the woods yet. The fix applied so far: more easy money. Will it work, or are we going to create a new asset bubble without solving the problems caused by the last one?
The use of credit has been building in the United States economy over the last 50 or so years. Credit is self-reinforcing on the way up. As credit expands, financial asset prices rise, which creates a wealth effect for all involved. Households, corporations and the government are able to consume at levels not possible previously. However, expanded levels of credit can't last forever unless incomes rise at a comparable pace.
If so much credit is created that it can't be serviced, or eventually paid back, you end up with a bubble, which must burst at some point or, at the very least, a long de-leveraging process results. Just ask Japan. So do we have too much credit in the U.S.?
During the financial crises, total debt to GDP approached 400% and now stands near 355%.
During the last 30 or so years, credit market debt has grown more than twice as fast as income (GDP) and household net worth in the U.S. Not the best trend for the worlds largest economy.
All debt grew at much faster rates than income. Two lesser cited examples: consumer credit grew faster than retail sales; and now student loan debt is expanding rapidly. Are trends like these positive for the overall economy?
Even with these trends, the balance sheet for U.S. consumers remains strong on an aggregate basis, but has weakened. And there are large percentages of the population that have dreadful balance sheets. You can see the trend in assets and debts below.
In a credit bubble, one expects defaults to start when promises to pay become so large that debtors begin having trouble servicing debt levels. We saw this in housing as adjustable mortgage rates reset. Often homeowners could no longer afford to make the mortgage payment. Or the home's value dropped, and some borrowers strategically decided to default. Cheap credit had helped push up the real estate prices. When prices dropped, much of this credit was related to assets that had dropped significantly in value.
We do see a positive trend in U.S. household debt service as a percent of disposable income. It peaked as the U.S. entered recession and has since dropped back significantly. (That, of course, doesn't include the rising federal debt now over $15 trillion, which consumers are ultimately on the hook for. More on that below.)
The drop in debt service was driven by household cutbacks and efforts by the Federal Reserve to ease the consumer debt burden. The Fed has repeatedly set rates very low since the early 80's highs. This reduces debt expenses for households, the U.S. government and corporations and stimulated spending. It also enables credit to expand rapidly. At issue, the Fed Funds rate is now at about 0%. You can't really go lower than 0%.
So what's next? If you control your currency like the U.S. does (sorry Greece -- you're stuck with the Euro for now), the central bank can buy up shaky bank assets and government debt. The Fed has done this in a big way. You can see in the chart below that overall credit is relatively flat, as is household credit. But financial sector credit has been reduced from $17 trilion to $13 trillion and transferred into government debt and to the government-sponsored enterprises, or GSEs.
As a result, the financial sector has been nicely recapitalized. Bank of America (BAC), Citigroup (C), Wells Fargo (WFC), Morgan Stanley (MS) and Goldman Sachs (GS) have all increased their tangible common equity ratios significantly. But there are still trillions in credit market debt on the balance sheets of banks, GSEs and the Fed.
Another strategy in play: run large government deficits to prop up government spending and GDP. Government spending has been higher than revenue as a percent of GDP since 2001. Unfortunately, this adds even more debt as we try to juice the economy via government spending.
The Federal Reserve is facilitating all of this with quantitative easing (QE) in an effort to get the economy back on track and stabilize the banks. However, the level of existing debt limits the investment choices. The new money is often invested in inflation hedges like gold, commodities, other currencies and held as reserve balances at the Federal Reserve. You can see the dramatic rise in U.S. reserve balances with Federal Reserve banks and cash in bank accounts below. Even with the recent stock market rally, retail investors have stayed cautious, leaving much of their cash in bank accounts for now. Cash balances are at record highs. If this cash gets deployed, all that spending, and/or investing, could drive up some prices, thus raising the threat of inflation.
As always, many experts --including Fed board members -- are focused on controlling inflation. Doing so helps the U.S. to keep GDP growth, or income, above nominal interest rates, thus expanding incomes faster than debts and fostering a smooth de-leveraging process. Controlled inflation sounds great in theory. For a smooth deleveraging to work, we need inflation in the right asset classes and that is the hard part. Inflation in everyday goods and deflation in real estate is a recipe for more pain. You can see this relationship in the chart below.
If Fed policy increases general prices but isn't able to get housing prices rising, then all of this QE is actually hurting all but the recipients of the QE dollars. Just ask anyone who retired recently. Savers are having a tough time given the ultra low rates. In this scenerio, all of the new money increases the price of financial assets and commodities but does little to solve the fundamental issue of rising debt levels and falling real estate assets.
To quote the Federal Reserve of New York, "a large foreclosure pipeline hangs over U.S. housing markets, creating headwinds for housing market recovery. What began as a nonprime mortgage problem has evolved into a prime mortgage problem with the onset of the recession. The inability to afford a home has been replaced by declining house prices and high unemployment as the primary driver of new foreclosures".
Credit has no doubt reached levels that start to make some a little uneasy. Growing debts faster than income is generally not smart. At some point, the debt service level starts to consume a large percentage of income that would otherwise be used on more crucial and productive expenditures. Buying assets on credit is great when the assets are going up but when they stagnate or decline, not so much.
The current path of solving credit problems with more credit seems counterintuitive to many. Is this the path to prosperity or should we try something else?
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