Deflation and Liquidation Hits Household Balance Sheets

* Yesterday I made the comment that household net worth was still down $10 trillion from its high in 2007, even though this is better than the -$16 trillion reading registered at the end of 2009:Q1. The bulk of the increase in household net worth comes from gains in equity valuations. According to the Fed’s Z-1 statement which was released earlier this month, the following net worth categories had these increases, as of (the end of) 2010:Q1:


Stocks                               +2,636

Mutual Funds                         +1,195
Pension Fund Reserves                +2,450

Debt Pay-down                          – 177


While the report does not specifically state that the rally in equities is responsible for the increase in household net worth, the top 3 categories (above) are all equity driven categories. I threw in the modest amount of debt pay-down to highlight the fact that despite the government’s best efforts to borrow the US into oblivion, that total debt in the household sector is in fact declining, even if it is only at a modest pace.


In terms of total debt in the US, the Z1 report lists debts according to these sectors (all numbers in billions of US dollars, and changes are since the end of 2008):


Total Non-financial Debt           35,010,     + 1,395

Household Debt                     13,542        – 301

Corporate Debt                     10,921        – 243

State + Local Debt                  2,380         +134

Federal Debt                        8,167       +1,805


Financial Sector Debt              14,971       -2,137

Foreign Borrowings in the US        2,093         +228


Total Borrowings in the US         52,074         -514


Non-financial debt in the US continues to rise, mainly driven by increases in state and local debt, and the big elephant in the room, the federal government. In fact, corporate and household debt is down $544 billion, or 2.22% over the last 15 months, while state and local government’s debts are up almost $2 trillion. However, the greatest amount of debt liquidation occurred in the financial sector, which lost over $2 trillion of debt during the same period, or a whopping 12.5%. The interesting side observation here is that foreign debt in the US has gone up, which I will speculate is because foreigners are finding it easier to fund their dollar liabilities in the US, than from overseas counterparties.


Nonetheless, the objective in presenting this data is to highlight that the US is going through a period of debt liquidation/deflation. On a net basis, the US government’s spending spree has managed to offset a good portion of what the markets are doing on their own. However, the comment is that organic debt write-downs is the order of business for the financial sector, households, and non-financial corporations.


On the topic of deflation, a reader sent this in right before my jury duty:


“I believe, if you research it, you will find that something on the order of 20+ trillion dollars or more has evaporated from the economy since 2008 (Household net worth was down more than 18% in 2008 alone or 11 trillion dollars). Much of this money was owned in real estate which was acquired with loans. The economy was based upon a consumer being able to have access to these funds to make purchases. That access has been removed. This means we now have far fewer dollars chasing the same amount of goods. This is deflationary. The average consumer just does not have the ability to pay what they paid before for the same item. This situation creates a downward cycle where the typical consumer will put off purchases because the item is likely to cost less tomorrow. This cycle leads to financial panic because no investment is safe. If the Fed had not replaced some of these lost funds (nowhere near all of them) the panic would have been much worse. We are still in the downward cycle because the Fed has not created enough new money to replace the old money (look at retail spending numbers, real estate values and the stock market). The only way to stop the deflation is to create more money. While I agree the government could have done this better, they had to do it. I only wish we had something to show for the money at the end of the day (new ports, a new train system, better airports, new high tech hospitals, new schools) – anything the economy can use after the crisis is over. (end of comment #1).


The same reader sent this comment in response to my blog yesterday:


“Money has never been cheaper for the U.S. than it is right now. We should be using this opportunity to create things of value that we can use when the recovery begin (new ports, a new electric grid, new aviation system, new rail system).  The only way to battle the enormous deflationary pressures in the current economy is to create more money. The forces of deflation have been created because so much money was destroyed in the current economic downturn. The 10 trillion dollar drop in household net worth you mention is dramatically underreported because the banking system is hiding the extent of value drop on commercial properties and other assets because they and the Fed do not want to advertise the full extent of the weakness in the banking system. According to Korpacz national average capitalization rates for commercial properties have increased roughly 25% since 2006. Vacancies have grown dramatically. Rents have dropped by a 1/3 in many areas. The cap rate change alone means value shave dropped 25% add the rental decrease and vacancy increase means that commercial property values have dropped dramatically.  All of these characteristics mean, that the value of commercial properties, is down far more than any bank is willing to admit. Additionally this means that a far larger number of banks are undercapitalized than any one is admitting. With a much larger than 10 trillion dollars simply evaporating from our system, housing continuing to decline, consumer prices declining, unemployment actually increasing (don’t count temporary census jobs), banks are under-capitalized, and lending is frozen due to the lack of collateral; the government had better create more stimulus and direct it at the middle class in a way that it will get spent or we are in for a long spiral of deflation. Such a spiral can only be halted with the creation of more dollars. There are not enough dollars to change hands at this point to fuel or economy. Austerity would only escalate the downward pressures.” (end of readers comment #2)


The reader’s comments are self-explanatory, and elaborates on the nature of the deflationary factors at work in the economy. And here is the $1.5 trillion question: how long can the US government continue to run 10+% deficits in their pursuit of a growing economy? If you were to ask President Obama this, or any members of his Counsel of Economic Advisors, (CEA), I think they would tell you as long as we need to. And here is the problem: if you factor in the deflationary factors at work, the government cannot spend enough money to forestall the inevitable.


With total debt in the US at 3.56 times the current GDP, a tremendous amount of non-government debt has shrunk, and has the potential to shrink further. Along these lines, bank loans are down over the last 15 months, from $7.7 trillion to $7.24 trillion at the end of 2010:Q1. This consists of the following 15 month changes:


Real Estate loans                    -305 billion
Credit Card Loans                    +272 billion

Commercial & Industrial Loans       -306 billion

Non-current Loans & Leases           +176 billion


The surprising category is the increase in consumer loans by banks, of which the jump by $272 billion occurred in the first quarter of 2010. A look behind the scenes reveals that the increase in bank’s consumer loans is offset by a decrease in the securitized consumer loans, according to the Fed’s consumer credit report. Was there a $300 billion shift from banks balance sheets and payoffs in consumer loans? That seems a bit high for a one quarter shift. My best guess is that banks have likely re-classified how these loans were counted. Nonetheless, if you ignore the drop in credit card loans, bank lending has dropped over $600 billion during this time period, or about 8% of total lending. During this same period, unused loan commitments dropped from $7.1 trillion to $6.1 trillion, indicating that banks are also shrinking the amount of credit they are offering, by an additional $1 trillion.


While I agree with this reader’s general conclusion that something must be done, the problem with the concept that the government’s plans to continue its spending spree, is that we are going to destroy the ability of the government to operate, since 10%+ deficits cannot be rolled into new debt indefinitely. My suggestion would be for the US to suck it up, and cope with the inevitable deflationary depression, along the lines of the rest of the G20. While this will not be pleasant, it will be better to have a solvent government who can direct resources where they are really needed, than a government which will ultimately default on its debt. The chaos which will result from a debt default will be far more debilitating than dealing with a deflationary depression with a fiscally solvent government.


I am going to leave it right here, with the weight of the deflationary data there for you to contemplate, and to imagine what path you would take if you were calling the shots.