Saturday, January 18, 2014

The Post-Crash Deleveraging Process Is Over

Investment Thesis: The post-crash unresponsiveness of the economy to monetary and fiscal stimulus has been due to the deleveraging phase of the credit cycle. However, the data suggests that the post-crash deleveraging process is nearing completion. Going forward, this should make conventional monetary policies more effective, and lay the groundwork for an eventual pickup in nominal growth. This will provide the basis for higher corporate earnings and higher inflation. Stocks should benefit, while bond yields will rise.

Economists, such as Larry Summers, have been seeking an explanation for the weak recovery. The need for an explanation is pressing, since the economy has been surprisingly unresponsive to conventional monetary and fiscal stimulus.

Here is Summers on the subject: “We are now 10%  below where we thought the economy would be now in 2007. There's been close to no progress in regaining potential measured relative to the judgments made at the time in 2007.”

Many explanations have been offered to explain the weak recovery, of both a structural and cyclical nature. Economists generally rule out structural factors because they are unmeasurable: if a factor cannot be measured, then it can’t explain anything. “Obama’s anti-business policies” and “Republican obstructionism” are both unmeasurable, and thus useless as explanations.

The weakness of aggregate demand (AD) is generally considered a cyclical phenomenon, not a structural one, and AD should be responsive to macro policy. Keynesians say that the weakness of AD is a consequence of  inadequate fiscal stimulus, while monetarists point to inadequate monetary stimulus. Paul Krugman, on a lucid day, mentions both. But the economy has had massive inputs of both fiscal and monetary stimulus, and yet has remained far below potential for the past five years. The Keynesians need to explain why massive deficits didn’t do what they said they would, and the monetarists need to explain why massive bond purchases didn’t work either.

I have argued that, despite QE1, QE2 and QE3,  monetary stimulus has not been “massive”, as evidenced by sluggish M2 growth since the crash, which provides support for to the monetarist viewpoint. But I contend that the sluggishness of money growth is a symptom of a deeper phenomenon which explains the failure of the Fed’s efforts.

That deeper phenomenon is the credit cycle. Credit cycle theory was first proposed by Irving Fisher in 1933 and elaborated by Hyman Minsky in the 1970s. Modern proponents include Richard Koo of Nomura, and Steve Keen of the University of Western Sydney. According to credit cycle theory, inflection points in the credit cycle (i.e., Minsky Moments) force economic actors (including banks) to deleverage, and as long as the deleveraging process continues, the credit aggregates shrink and money growth is retarded. The bigger the debt overshoot, the longer the required repair period.

The US credit cycle experienced a Minsky Moment in the 2008-9 crash. Before the Minsky Moment, high financial leverage (especially in households, housing finance, banking and the securities industry) was acceptable. After the Moment, high leverage became diabolic as did all associated debt structures and obligors. The credit market shut down, forcing indebted actors to rapidly deleverage

The credit market had a major shock when Lehman defaulted, and has suffered from PTSD ever since. The deleveraging process took three years, from the end of 2007 to the end of 2010. Total credit did not begin to grow again until late 2010, and a number of sectors took much longer to complete the debt reduction process. Only now has the process finally ended, although the PTSD remains.

The debt market’s standards for acceptable leverage changed overnight after Lehman, instantly rendering uncreditworthy huge swaths of the economy including households, securities firms, finance companies, and banks. In order to regain market access, these actors had to unwind their pre-Crash debt accumulation in order to conform to new leverage standards, which has taken them a long time to accomplish. It took 15 years for the cycle to build up to the Minsky Moment, and it has taken five years to dig out from it. The credit cycle is at its root an artifact of psychology, and the recovery from a major shock does not happen quickly.

Market monetarists such as Scott Sumner discount credit cycle theory, on the argument that it is a derivative of monetary policy and can be overcome by competent monetary policy. I agree (I have to, since I believe the quantity theory), but I would argue that the credit cycle explains why the Fed’s “massive” stimulus policies have failed: the down-leg of the credit cycle creates huge headwinds for conventional policy. Only truly radical policies (e.g., helicopters) can combat the credit cycle, and they haven’t been tried.

How can we measure the credit cycle? The Fed’s “Flow of Funds” report provides data on credit stocks and flows for:
  • Households
  • Nonfinancial businesses
  • Financial businesses
  • State & local governments
  • The federal government

Here’s a quick summary of  the 21st century credit cycle (all numbers are sectoral  liabilities):

Rapid (12%) growth before the crash, negative growth during the crash, now very low growth at 1%. No recovery yet: banks are not making mortgages.

Rapid (13%) growth before the crash, mild contraction during the crash, now fully recovered to almost 10% growth. Business credit has had the strongest recovery. (The business credit cycle inflected in 2001.)

Rapid growth (12%) before the crash, severe contraction during the crash (-13%), now flat at 0%. No recovery yet; the bleeding has just stopped. The PTSD remains strong, and regulation hasn’t helped.

Modest (6%) growth precrash, low growth during crash, negative growth since the crash. No prospects for recovery.

Moderate growth precrash (5-10%), extremely rapid growth during the crash (35%), and now moderate growth again at 6%. Despite running big deficits during the crash, federal borrowing was insufficient to fully offset credit contraction by the private sector. (This supports the Keynesian argument that fiscal stimulus was too small.) The outlook for federal credit growth is not good; the declining deficit means that the pace of government borrowing will decline further, which will dampen overall credit growth.

This is the single most important data series in explaining the credit cycle. Total credit was growing at 10% before the crash, contracted modestly during the crash (despite big federal deficits), and has since “recovered” to an anemic 3% growth rate. Three percent growth is nowhere near full recovery; 8% growth would signal full recovery. The credit market is still a bit traumatized.

A crucial credit sector with respect to economic behavior is the financial sector, which is a provider of both credit and money, since money is a liability of the financial sector. The cyclical volatility of financial credit has been pronounced. Financial credit grew at an unsustainable 13% before the crash, contracted very severely, and has not yet recovered (zero growth). Total financial credit remains 18% below its 2008 peak. This explains a large part of what has happened since the crash. Hospitalized banks don’t lend freely.

The current 3% total credit growth and 0% financial credit growth explain the inability of conventional monetary policy to stimulate money growth, inflation and NGDP growth.  The Fed has the ability to control the money supply, inflation and nominal growth, no less than do the central banks of Venezuela, India, Egypt, Iran and Argentina (which have all succeeded in creating inflation). 

The failure of the Fed to get control of the money supply is explained by the headwinds resulting from the credit cycle, particularly the financial sector, as well as its unwillingness to adopt sufficiently radical policies despite lip-service to the contrary. The Fed has missed its statutory employment and inflation targets for the past five years. The Fed allowed the credit cycle to overwhelm its stimulus efforts (as it did in 1930-33).

The crash had nothing to do with the corporate sector, which had already suffered its own inflection in 2001. Business credit growth rebounded quickly, which has been a major bright spot for the economy. The business sector today is very healthy, despite low nominal growth.

Money growth depends in part on the demand for credit, and the cyclical decline in credit demand has resulted in the buildup of excess reserves at the Fed (instead of bank loans). The reasons are: (1) a lack of credit demand because borrowers are repairing their balance sheets; (2) a lack of credit supply because credit providers are repairing their own balance sheets, and (3) credit providers have have raised their lending standards. 

Credit has not been flowing to the economy at a pace anywhere near the pre-crash rate. In fact, it’s even worse than that: credit growth today is lower today than at any point between WW2 and the Crash. Currently growing at 3%, it had never before dipped below 4% even during the worst postwar recessions. This is a huge drag on both AD and money growth.

(Yes, credit growth data is nominal, but I think that nominal data is more explanatory today than real data. Low nominal growth is the problem in the current circumstance, and it should not be disguised by the use of adjusted data.)

As I said above, the Fed has full control over the money supply, inflation and nominal growth, if it chooses to exercise it. The Fed has the power to overcome the credit cycle, as as did the Bank of England in 1931, FDR in 1933, and the Bank of Japan most recently. But, by refusing to adopt radical expansionary policies, the Fed has allowed the credit cycle to negate its efforts. Ultimately, the fault lies with the Fed, and Bernanke knows it.

The Outlook for the Credit Cycle
There’s good news and bad news in the outlook for credit growth. The dominant sectors are households (mortgages) and the federal government (deficits). Each sector has about $13T of debt outstanding. The good news is that households have stopped deleveraging and have (almost) begun to borrow again. Over time, household debt should grow as lending standards are relaxed, but that will take more time.

The bad news is that the pace of federal borrowing has declined sharply and will decline further given the current budget outlook. Taxes have been raised and the Budget Control Act remains largely in place. The period of federal pump-priming is over, and the private sector is now on its own. (This annoys Krugman and worries Summers.)

As I observed earlier, the all-important financial sector has stopped shrinking, and may be poised to start to grow, although there are many forces at play. The financial sector remains badly shell-shocked, and the revival of animal spirits will take time.

There is a better-than-even chance that private sector credit growth will more than compensate for the withdrawal of big deficits, and there is very little chance that credit growth will turn negative, since all of the confidence indicators are positive. Going forward, the Fed will no longer have to contend with fighting a credit contraction, and may get some wind at its back.

Summers has expressed the concern that the US economy is only able to grow during credit bubbles. I would restate that as: the US economy is only able to grow during periods of credit growth--and this is only true in the absence of competent monetary policy. The credit cycle can be fought.

The post-crash deleveraging process has ended, and credit has started to grow again. Much will depend upon the re-opening of the mortgage market and the pace of fiscal contraction. Nonetheless, the economy is now in a position to better respond to conventional monetary policy tools, which should give the Fed a greater ability to stimulate money growth. It is now up to the FOMC to do its job.

Investment Conclusion: Stronger nominal growth will increase earnings and support higher equity valuations, while exerting downward pressure on bond prices. The up-leg of the credit cycle will accelerate, and could last quite a few years: the last one lasted 15 years. This is good news for both investment and employment.

No comments: