Federal Reserve Branch of San Francisco Economic Letter

Boy, were people happy two weeks ago, when a 30%+ stock rocket ride from the bottom convinced everyone that we were headed for a spectacular economic recovery.

Spirits have dampened somewhat since, with the market going limp day after day.  But stocks are still hanging around fair value, and a sense of optimism remains.

Well, regardless of what the market does over the coming weeks, don't embrace the happy talk that we're going to suddenly go right back to life as it was in 2007.

The key problem in the economy, remember, is debt--specifically, way too much of it.  See the chart from the SF Fed above, which compares debt, wealth, and income. The good news is that consumers have finally started deleveraging.  But their wealth has plummeted a lot faster than their debt. And if history is any guide, the deleveraging process is going to take decades, not years.

Take a look at that chart of Japan's experience to the right, from the San Fran Fed.  Look at where they are now compared to where we are now (the series aren't apples to apples, but the deleveraging process is similar).  Note that Japan's economy is in the middle of its second decade of stagnation.  And its stock market is trading at one-fifth of its pre-deleveraging peak.  (The analogous performance for us would be DOW 3500 in 2026).

In future years, US consumers will have to save money to pay down all that debt.  The savings rate will likely go back to its level in the good old days--8%-10% of GDP (see chart below).

All the money consumers devote to debt reduction, meanwhile, will be money that they aren't spending.  If our situation is similar to Japan's, the SF Fed estimates--if we go back to our pre-binge leverage ratios--this consumer deleveraging will shave 3/4 of a percentage point per year in consumption growth. (About half a point of GDP growth).

That doesn't sound like much?  Many future economic forecasts, and many stock-market forecasts, are based on long-term growth of 3%+ per year.  (The forecasts underlying Social Security and Medicare, for example.)  Cut the growth of consumption by 75%, and you're also going to have businesses investing less.  Add it all together, and you're probably shaving a point off GDP growth, so that the long-term growth rate might be 2%, not 3%.  That makes a big difference for tax revenue (not to mention Social Security contributions).

One of the core macroeconomic themes that Zero Hedge has been expounding on since inception, which mirrors some of the major concerns of David Rosenberg, has been the evaporation of consumer wealth, income and equity as a function of both declining stock and real asset values and persistently high consumer debt. In an economic paper, the San Francisco Federal Reserve confirms that these concerns are not unfounded, and could be the very core of the processes that undermine the administration's attempts to restore economic growth.

While the administration is doing all it can through various media conduits to imprint the idea that inflation is all but a guaranteed reality at this point, so that consumers begin borrowing at an expansive pace yet again, consumer leveraging is exactly the process that has commenced unwinding, and the obvious impact on the personal saving rate which has been growing at a dramatic pace, has been visible throughout the economy. And as the consumer deleverages additionally, deflation is a certainty, as the combined impact of asset value decline and associated leverage flow through the economy, further depressed prices of goods and services. The four charts below from the Fed's release strike at the heart of the administration's faulty attempt to relever the US consumer.



Unfortunately for Bernanke and Geithner, the deleveraging process has commenced, and regardless of how many treasuries are issued, and how much additional debt the U.S. incurs, the demand side for credit is just not there, sticking banks with basements full of shrinkwrapped packages of hundred dollar bills, that will sit dusty and unused for years. The only immediate impact is that at some point in the not too distant future, the U.S. will need to print bonds to satisfy just the interest payments on these very bonds, which is an unsustainable state and only has one outcome.

In a very amusing section from the release, the San Fran Fed is discussing the financial behaviour of the consumer, when in fact the very same words are 100% applicable to the U.S. Treasury itself:

    More than 20 years ago, economist Hyman Minsky (1986) proposed a “financial instability hypothesis.” He argued that prosperous times can often induce borrowers to accumulate debt beyond their ability to repay out of current income, thus leading to financial crises and severe economic contractions.

    Until recently, U.S. households were accumulating debt at a rapid pace, allowing consumption to grow faster than income. An environment of easy credit facilitated this process, fueled further by rising prices of stocks and housing, which provided collateral for even more borrowing.The value of that collateral has since dropped dramatically, leaving many households in a precarious financial position, particularly in light of economic uncertainty that threatens their jobs.

    Going forward, it seems probable that many U.S. households will reduce their debt. If accomplished through increased saving, the deleveraging process could result in a substantial and prolonged slowdown in consumer spending relative to pre-recession growth rates. Alternatively, if accomplished through some form of default on existing debt, such as real estate short sales, foreclosures, or bankruptcy, deleveraging could involve significant costs for consumers, including tax liabilities on forgiven debt, legal fees, and lower credit scores. Moreover, this form of deleveraging would simply shift the problem onto banks that hold these loans as assets on their balance sheets. Either way, the process of household deleveraging will not be painless.

The last paragraph is probably the most lucid explanation of the conundrum the Federal Reserve and the Treasury are in currently. And all that Bernanke and Geithner are attempting to do is not just make sure these very banks can survive another day with trillions of worthless loans on their books, but do all they can to relend them once again into private (consumer and hedge fund) hands.

This approach is flawed and as time passes and the consumer savings rate increases, the bifurcation between the Fed's plans and reality will only become more evident, with the cost being increasing deflation, while the U.S. accumulates higher and higher sovereign debt. The combined impact of both processes could end up having a devastating geopolitical impact on the United States.