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Monday 20 April 2009
How Deep a Hole Has the U.S. Dug for Itself?
It may take several years for the U.S. consumer to cut household debt to acceptable levels and the world would do well not to depend on resumption of spending as the way out of the recession.
It may take several years for the U.S. consumer to cut household debt to acceptable levels and the world would do well not to depend on resumption of spending as the way out of the recession.
Ivan Lee, Citigroup’s former head of fixed income research in Asia 20 April 2009
Since the outbreak of the U.S. subprime crisis in 2007, most economists have significantly underestimated the extent of its adverse effects and, in turn, dimensions of the U.S. economic downturn. In early 2008, many expected a V-shape recovery in the second half of the year. They were miserably wrong. Today, many expect a bottoming of the economy in the second half of this year, a solid recovery in 2010 and a trend-like growth beyond that. They may turn out to be wrong yet again, i.e. we may see a deep and prolonged recession in the U.S. that could last well into 2010. Beyond that, the country could see below-trend growth for a few more years, as its economy remains hostage to the effects of deleveraging by households.
My pessimism is driven by an inevitable and potentially sharp reversal of the rapid increase in U.S. household leverage since the turn of the decade. Many economists have correctly pointed out that the current U.S. recession, triggered by the bursting of the housing bubble and the near-collapse of the financial sector, was fundamentally caused by very high U.S. household leverage. However, many still fail to appreciate how the unwinding of household leverage will affect the U.S.’ economic future.
The chart above shows aggregate U.S. household and business debt as percentage of GDP (i.e. private-sector leverage) in the past 40 years. Historically, economic cycles have been characterized by expansions and contractions of private-sector leverage. Whenever the economy became significantly overheated, there would be a sharp rise in private-sector leverage (most notably business debt as a percentage of GDP). It would then be followed by a recession and deleveraging.
A very worrisome trend has been that while the U.S. business debt as a percentage of GDP hovered between 50-70 percent in most of the past four decades, household debt has grown exponentially. As a percentage of GDP, it grew from below 50 percent before the mid-1980s to 70 percent (of GDP) by 2000 and finally crossed the 100 percent mark in 2007.
In the current economic cycle, growth in U.S. household debt significantly outpaced that of business debt, rising to 100 percent of GDP in 2007, implying a staggering 30 percent increase in six years, which was unprecedented in recent history. In contrast, recessions of 1992 and 2001 were triggered by excessive corporate borrowings or business debt, which had grown by only 12 percentage points in the preceding six years. It would not be imprudent to assume that the current recession is almost certain to be much worse than any of the post-war recessions.
In absolute terms, the U.S. household debt figures are mind-boggling. At the end of 2007, U.S. household debt stood at US$13.8 trillion (see chart below), three quarters of which was represented by home mortgages. In the six years from 2001 to 2007, U.S. household debt increased $6.26 trillion, almost equal to the outstanding debt in 2001.
The $6.26 trillion increase in U.S. household debt in 2001-07 was almost 3x China’s average annual GDP during that period. In other words, U.S. households were accumulating debt at a pace equal to about one half of China’s national output every year, between 2001 and 2007. And China is the world’s third largest economy!
How is the unwinding of U.S. household leverage going to play out? Household debt at 100 percent of GDP is obviously not sustainable; it is clear that many of the borrowers are not creditworthy sub-prime or Alt-A borrowers. It is also known that much of the debt taken on by households was used to finance two kinds of assets, housing and equities, and valuations of both were inflated significantly, beyond their underlying intrinsic values. The significant declines in prices of both asset classes are an abrupt wake-up call to the U.S. households. A significant deleveraging is inevitable now. In the next few years, U.S. household leverage should see a prolonged period of contraction, voluntarily or involuntarily.
Debt can be reduced through only two means: repayment by borrowers or write-offs by lenders. Both will take place in the U.S. household deleveraging process.
Assuming U.S. household leverage will revert to its historical mean and move to a more sustainable long-term figure of, say, 75 percent of GDP (against an average of 65 percent in the 1990s), then about $3.4 trillion of household debt needs to disappear. Let us further assume that one-third will be written off and the remaining two-thirds will be repaid.
Under this assumption, household debt (mortgages and other consumer debts) that needs to be written off will be around $1.1 trillion. U.S. banks and insurance companies clearly don’t have enough capital to absorb this magnitude of losses. It is, therefore, reasonable to assume a large chunk of the U.S. financial sector will be nationalized in one form or another in the next few years.
Another $2.3 trillion of household debt will need to be repaid, mainly through future income (i.e. savings) and, to a lesser extent, asset liquidation. In other words, U.S. households will have to spend $1.5-2.0 trillion less in the coming years, a direct dollar-for-dollar hit for an economy which relies on consumer spending for more than 70 percent of its GDP. The amount is equivalent to 11-14 percent of the current GDP.
That will no doubt push the U.S. into a deep and prolonged recession. If U.S. household deleveraging is going to be spread over a period of about five years, GDP growth will be knocked down by 2-3 percent every year, before taking into account the multiplier effect of the reduced consumer spending. This contraction will be on top of the current downward recessionary pressure on the economy coming from corporate retrenchment that has already taken place, as well as the overhang of the woes of the housing sector and excess capacities in several sectors of the economy.
The only way the U.S. can avoid such a frightening scenario is to resort to a very large fiscal deficit on an ongoing basis to fill the demand gap and cushion the potential free fall of economic activity in the country. Effectively, the U.S. government needs to incur outsized ongoing fiscal deficits as long as the private sector is still in a deleveraging mode. The $1.7 trillion budget deficit (12.3 percent of GDP) that the Obama administration has announced is apparently a step in the right direction. However, it is uncertain whether such a large budget deficit is economically (and politically) sustainable in the long run. It would be unwise to expect too much from fixing of the banking system and quantitative easing as U.S. households, after having realized the implications of their astronomical leverage, are perhaps more keen to repay debt than to resume spending.
In summary, the basic laws of economics suggest that once the private sector goes into a significant deleveraging mode, which is almost certain, aggregate consumption of the economy will shrink as more income is set aside as savings, rather than being spent. This deleveraging is going to be a multi-year, rather than a multi-quarter, process. Only a forceful and ongoing fiscal pumping can cushion this downward spiral but that may not be sustainable. Hopefully, and eventually, the U.S., which is still among the most competitive and efficient economies in the world, would regain its vibrancy at some point of time. But this is unlikely before its household leverage gets reduced to a more reasonable level. Those who expect a recovery in the second half of this year are likely to be disappointed. Meanwhile, the rest of the world should adapt to the reality that the U.S. economy is unlikely to pull us out of the current recession.
Ivan Lee runs a credit fund. He is Citigroup’s former head of fixed income research in Asia 1998-2008.
1 comment:
How Deep a Hole Has the U.S. Dug for Itself?
It may take several years for the U.S. consumer to cut household debt to acceptable levels and the world would do well not to depend on resumption of spending as the way out of the recession.
Ivan Lee, Citigroup’s former head of fixed income research in Asia
20 April 2009
Since the outbreak of the U.S. subprime crisis in 2007, most economists have significantly underestimated the extent of its adverse effects and, in turn, dimensions of the U.S. economic downturn. In early 2008, many expected a V-shape recovery in the second half of the year. They were miserably wrong. Today, many expect a bottoming of the economy in the second half of this year, a solid recovery in 2010 and a trend-like growth beyond that. They may turn out to be wrong yet again, i.e. we may see a deep and prolonged recession in the U.S. that could last well into 2010. Beyond that, the country could see below-trend growth for a few more years, as its economy remains hostage to the effects of deleveraging by households.
My pessimism is driven by an inevitable and potentially sharp reversal of the rapid increase in U.S. household leverage since the turn of the decade. Many economists have correctly pointed out that the current U.S. recession, triggered by the bursting of the housing bubble and the near-collapse of the financial sector, was fundamentally caused by very high U.S. household leverage. However, many still fail to appreciate how the unwinding of household leverage will affect the U.S.’ economic future.
The chart above shows aggregate U.S. household and business debt as percentage of GDP (i.e. private-sector leverage) in the past 40 years. Historically, economic cycles have been characterized by expansions and contractions of private-sector leverage. Whenever the economy became significantly overheated, there would be a sharp rise in private-sector leverage (most notably business debt as a percentage of GDP). It would then be followed by a recession and deleveraging.
A very worrisome trend has been that while the U.S. business debt as a percentage of GDP hovered between 50-70 percent in most of the past four decades, household debt has grown exponentially. As a percentage of GDP, it grew from below 50 percent before the mid-1980s to 70 percent (of GDP) by 2000 and finally crossed the 100 percent mark in 2007.
In the current economic cycle, growth in U.S. household debt significantly outpaced that of business debt, rising to 100 percent of GDP in 2007, implying a staggering 30 percent increase in six years, which was unprecedented in recent history. In contrast, recessions of 1992 and 2001 were triggered by excessive corporate borrowings or business debt, which had grown by only 12 percentage points in the preceding six years. It would not be imprudent to assume that the current recession is almost certain to be much worse than any of the post-war recessions.
In absolute terms, the U.S. household debt figures are mind-boggling. At the end of 2007, U.S. household debt stood at US$13.8 trillion (see chart below), three quarters of which was represented by home mortgages. In the six years from 2001 to 2007, U.S. household debt increased $6.26 trillion, almost equal to the outstanding debt in 2001.
The $6.26 trillion increase in U.S. household debt in 2001-07 was almost 3x China’s average annual GDP during that period. In other words, U.S. households were accumulating debt at a pace equal to about one half of China’s national output every year, between 2001 and 2007. And China is the world’s third largest economy!
How is the unwinding of U.S. household leverage going to play out? Household debt at 100 percent of GDP is obviously not sustainable; it is clear that many of the borrowers are not creditworthy sub-prime or Alt-A borrowers. It is also known that much of the debt taken on by households was used to finance two kinds of assets, housing and equities, and valuations of both were inflated significantly, beyond their underlying intrinsic values. The significant declines in prices of both asset classes are an abrupt wake-up call to the U.S. households. A significant deleveraging is inevitable now. In the next few years, U.S. household leverage should see a prolonged period of contraction, voluntarily or involuntarily.
Debt can be reduced through only two means: repayment by borrowers or write-offs by lenders. Both will take place in the U.S. household deleveraging process.
Assuming U.S. household leverage will revert to its historical mean and move to a more sustainable long-term figure of, say, 75 percent of GDP (against an average of 65 percent in the 1990s), then about $3.4 trillion of household debt needs to disappear. Let us further assume that one-third will be written off and the remaining two-thirds will be repaid.
Under this assumption, household debt (mortgages and other consumer debts) that needs to be written off will be around $1.1 trillion. U.S. banks and insurance companies clearly don’t have enough capital to absorb this magnitude of losses. It is, therefore, reasonable to assume a large chunk of the U.S. financial sector will be nationalized in one form or another in the next few years.
Another $2.3 trillion of household debt will need to be repaid, mainly through future income (i.e. savings) and, to a lesser extent, asset liquidation. In other words, U.S. households will have to spend $1.5-2.0 trillion less in the coming years, a direct dollar-for-dollar hit for an economy which relies on consumer spending for more than 70 percent of its GDP. The amount is equivalent to 11-14 percent of the current GDP.
That will no doubt push the U.S. into a deep and prolonged recession. If U.S. household deleveraging is going to be spread over a period of about five years, GDP growth will be knocked down by 2-3 percent every year, before taking into account the multiplier effect of the reduced consumer spending. This contraction will be on top of the current downward recessionary pressure on the economy coming from corporate retrenchment that has already taken place, as well as the overhang of the woes of the housing sector and excess capacities in several sectors of the economy.
The only way the U.S. can avoid such a frightening scenario is to resort to a very large fiscal deficit on an ongoing basis to fill the demand gap and cushion the potential free fall of economic activity in the country. Effectively, the U.S. government needs to incur outsized ongoing fiscal deficits as long as the private sector is still in a deleveraging mode. The $1.7 trillion budget deficit (12.3 percent of GDP) that the Obama administration has announced is apparently a step in the right direction. However, it is uncertain whether such a large budget deficit is economically (and politically) sustainable in the long run. It would be unwise to expect too much from fixing of the banking system and quantitative easing as U.S. households, after having realized the implications of their astronomical leverage, are perhaps more keen to repay debt than to resume spending.
In summary, the basic laws of economics suggest that once the private sector goes into a significant deleveraging mode, which is almost certain, aggregate consumption of the economy will shrink as more income is set aside as savings, rather than being spent. This deleveraging is going to be a multi-year, rather than a multi-quarter, process. Only a forceful and ongoing fiscal pumping can cushion this downward spiral but that may not be sustainable. Hopefully, and eventually, the U.S., which is still among the most competitive and efficient economies in the world, would regain its vibrancy at some point of time. But this is unlikely before its household leverage gets reduced to a more reasonable level. Those who expect a recovery in the second half of this year are likely to be disappointed. Meanwhile, the rest of the world should adapt to the reality that the U.S. economy is unlikely to pull us out of the current recession.
Ivan Lee runs a credit fund. He is Citigroup’s former head of fixed income research in Asia 1998-2008.
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