conversableeconomist

Consumer Financial Obligations Nearly Back to 1979 Levels

One reason underlying the Great Recession that followed the financial crash is that U.S. households had over-committed themselves with excessive borrowing. As households were faced with the task of paying off these debts and reducing their debt burdens, they weren\’t consuming as much as they otherwise would have done–which slowed the economy.

This pattern can be tracked with a couple of statistics that the Federal Reserve calls the \”debt service ratio\” and the \”financial obligations ratio.\” The terms are defined in this way: \”The household debt service ratio (DSR) is an estimate of the ratio of debt payments to disposable personal income. Debt payments consist of the estimated required payments on outstanding mortgage and consumer debt. The financial obligations ratio (FOR) adds automobile lease payments, rental payments on tenant-occupied property, homeowners\’ insurance, and property tax payments to the debt service ratio.\”

Here\’s the household debt service ratio, as generated by the ever-useful FRED website at the St. Louis Fed:

Christoffer Koch and J.B. Cooke of the Dallas Fed point out that the \”financial obligations ratio\”–that is, financial obligations as a share of disposable income–has now nearly dropped back to the lower levels observed in the last few decades. Here is their figure:

It\’s clearly good news that U.S. households as a group have largely worked through the problem of dealing with their oversized debt obligations. However, this success in reducing debt service and financial obligations remains a bit fragile. These obligations have two major ingredients: how much debt you have, and the interest rate you are paying on that debt. As Koch and Cooke explain: \”

\”Debt-to-income ratios are still elevated; they have been receding, but some of this improvement can be attributed to lenders writing down mortgage debt at unusually high levels. Improvements in household debt burdens positively impact consumer spending by affecting both housing-related consumption and—via net wealth and liquidity effects—overall consumption. In the same vein, financial obligations ratios (FOR) suggest de-levering may be nearing an end, with these ratios nearly back to post-1979 lows (Chart 4). The decline reflects increased write-downs on and paying off of mortgage debt, amplified by lower interest rates across the maturity spectrum.\” 

In short, household debt levels are still \”elevated,\” but household financial obligations are nonetheless low because of the ultra-low interest rates in the U.S. economy. The low interest rates are, in a way, buying some time for U.S. households to continue reducing their debt burdens.

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Will Federal Debt Lead to High Inflation?

In the Fall 2011 issue of the National Interest, John H. Cochrane explores the \”Inflation and Debt\” connection. He points out that most economists don\’t see it as very likely that government debt will be the proximate cause of inflation. They point to the sluggish economic recovery, which tends to hold down price and wage levels. They believe that if inflation gets started, the Federal Reserve can act to nip it in the bud.

Cochrane takes the other side of this argument. He writes: \”As a result of the federal government\’s enormous debt and deficits, substantial inflation could break out in America in the next few years. … The key reason serious inflation often accompanies serious economic difficulties is straightforward: Inflation is a form of sovereign default. Paying off bonds with currency that is worth half as much as it used to be is like defaulting on half of the debt. And sovereign default happens not in boom times but when economies and governments are in trouble.\”

Can the Federal Reserve stop inflation? Cochrane argues that much of the conventional economic thinking about anti-inflation policy assumes a background of a reasonably sound fiscal policy. \”[R]easonably sound fiscal policy .. is the central precondition for stable inflation. Major explosions of inflation around the world have ultimately resulted from fiscal problems, and it is hard to think of a fiscally sound country that has ever experienced a major inflation. So long as the government\’s fiscal house is in order, people will naturally assume that the central bank should be able to stop a small uptick in inflation. Conversely, when the government\’s finances are in disarray, expectations can become \”unanchored\” very quickly. … But what if our huge debt and looming deficits mean that the fiscal backing for monetary policy is about to become unglued?\”

Cochrane cites familiar evidence that federal indebtedness  is on an unsustainable path. He suggests that a process of \”fiscal inflation\” will unfold in this way:

 \”[O]ur government is now funded mostly by rolling over relatively short-term debt, not by selling long-term bonds that will come due in some future time of projected budget surpluses. Half of all currently outstanding debt will mature in less than two and a half years, and a third will mature in under a year. Roughly speaking, the federal government each year must take on $6.5 trillion in new borrowing to pay off $5 trillion of maturing debt and $1.5 trillion or so in current deficits.\”

\”As the government pays off maturing debt, the holders of that debt receive a lot of money. Normally, that money would be used to buy new debt. But if investors start to fear inflation, which will erode the returns from government bonds, they won\’t buy the new debt. Instead, they will try to buy stocks, real estate, commodities, or other assets that are less sensitive to inflation. But there are only so many real assets around, and someone has to hold the stock of money and government debt. So the prices of real assets will rise. Then, with \”paper\” wealth high and prospective returns on these investments declining, people will start spending more on goods and services. But there are only so many of those around, too, so the overall price level must rise. Thus, when short-term debt must be rolled over, fears of future inflation give us inflation today — and potentially quite a lot of inflation.\”

Cochrane argues that investors are already worrying about even the current low rates rates inflation, given the prevailing ultra-low interest rates, and that the result could be a slow-motion financial run:

\”Just how low are today\’s rates? The one-year rate is now 0.2%; the ten-year rate is about 2%, and the 30-year rate is only 4%. We have not seen rates this low in the post-war era. Furthermore, inflation is still running at around 2-3%, depending on exactly what measure of inflation we choose. If an investor lends money at 0.2% and inflation is 2%, he loses 1.8% of the value of his money every year. Such low rates are therefore unlikely to last. … But both the Fed\’s desire to keep rates this low and its ability to do so are surely temporary. …

\”A \”normal\” real interest rate on government debt is at least 1-2%, meaning a 4-5% one-year rate even if inflation stays at 2-3%. A loss of the special safety and liquidity discount that American debt now enjoys could add two to three percentage points. A rising risk premium would imply higher rates still. And of course, if markets started to expect inflation or actual default, rates could rise even more. …

\”These dynamics essentially add up to a \”run\” on the dollar — just like a bank run — away from American government debt. Unlike a bank run, however, it would play out in slow motion. … The United States rolls over its debt on a scale of a few years, not every day. So the \”run on the dollar\” would play out over a year or two rather than overnight…. Like all runs, this one would be unpredictable…. For that reason, I do not claim to predict that inflation will happen, or when. This scenario is a warning, not a forecast. Extraordinarily low interest rates on long-term U.S. government bonds suggest that the overall market still has faith that the United States will figure out how to solve its problems…. But we are primed for this sort of run. All sides in the current political debate describe our long-term fiscal trajectory as \”unsustainable.\”… As with all runs, once a run on the dollar began, it would be too late to stop it…. Neither the cause of nor the solution to a run on the dollar, and its consequent inflation, would therefore be a matter of monetary policy that the Fed could do much about. Our problem is a fiscal problem — the challenge of out-of-control deficits and ballooning debt. Today\’s debate about inflation largely misses that problem, and therefore fails to contend with the greatest inflation danger we face.\”

As Cochrane readily states, his analysis of the threat of a fiscal inflation is unconventional, and I\’m not yet a  convert. But I do think that his analysis hits a number of key points that deserve serious consideration.

The current path of federal borrowing is unsustainable–not this year or next year, but probably in the middle-term and certainly in the long term. Investors are not going to be eager to hold these burgeoning levels of debt. If the very low nominal interest rates and negative real rates that such debt is currently paying continue, investors will start looking for other assets. (Gold, anyone?)  If the interest rates on federal debt start rising, the federal debt problem will become much more severe in a hurry–and investors will continue to be less interested in investing. In this setting, the Federal Reserve is likely to be in an unpleasant pickle. The Fed has already taken up, at least in part, the task that it had during and after World War II of making it cheaper for the government to borrow–if necessary, by having the Fed buy Treasury debt directly. There will be heavy political pressure on the Fed to keep doing this–in effect, protecting the U.S. government from the costs of heavy borrowing by printing money. This scenario could play out as inflation, although I\’m less confident of that prediction than Cochrane. It might result in a heavy shock to the U.S. financial system, which is still struggling to recover from the problems of 2008 and 2009.

The bottom line is that the government needs to enact actual policies–not vague promises about policies that could be enacted in the future–that will reduce the path of future budget deficits. I\’d start with some steps that should be relatively (if not actually) easy, like phasing in a later retirement age a month per year over the next few decades. This step would make a substantial difference to Social Security and a modest difference to Medicare (because  such a large share of Medicare expenses happen later in life, not in the year or two right around retirement). A next step might be to resurrect many of the recommendations of the National Commission on Fiscal Responsibility and Reform–the so-called Bowles-Simpson commission–that  President Obama first appointed, but then ignored. I don\’t know whether Cochrane is correct that the federal debt problems will cause an inflation problem in the next few years, but on the present path, federal borrowing is going to bring a highly unpleasant crunch of some sort.

conversableeconomist

Will U.S. Government Debt Lead to Higher Interest Rates?

As the PIIGS economies of Europe–Portugal, Ireland, Italy, Greece, and Spain–have staggered into a sovereign debt and monetary crises, the interest rates on their government debt have risen substantially. Pedro Amaral and Margaret Jacobson of the Cleveland Fed point out that on certain basic measures of government indebtedness, the U.S. seems to be in the same neighborhood as the PIIGS countries. However, drawing on analysis from the IMF\’s September 11 Fiscal Monitor Report, they also point out some ways that the holders of U.S. debt are significantly different from holders of government debt in these other countries, which at least so far has helped to shelter the U.S. government from an interest rate spike.

Here\’s a table that puts U.S. borrowing in the context of the PIIGS. The first three columns apply to 2011. The first column shows \”Maturing debt\” as as share of GDP: that is, how much of what was borrowed in the past comes due in 2011. The second column shows the budget deficit: that is, how much additional borrowing in 2011. The third column, \”Total Financing Needs,\” adds up the first two, for the total amount that needs to be borrowed in 2011 both to roll over past borrowing and to cover new borrowing. The next three columns show the same calculations as projected for 2012. The last two columns show the \”Average years to maturity\” of government debt, because obviously it matters how soon the debt needs to be paid off. The final column shows the debt-to-GDP ratio for these countries.

What jumps out from the table is that the \”Total financing need\” for the U.S. is larger than in any of the PIIGS economies in 2011 and 2012. The U.S. budget deficits as a share of GDP are larger in 2011 and 2012 than for any of the comparison countries, except Ireland. The U.S. debt has a shorter average maturity than the other countries. And while the U.S. debt-to-GDP ratio is mercifully nowhere near that of Greece or Italy, and well behind that of Portugal, it is similar to Ireland and substantially larger than Spain.

These other countries have faced higher and rising interest rates in 2011, as shown in the figure for Spain and Italy, while U.S. borrowing has faced lower and declining interest rates. Why? 

Amaral and Jacobson provide some discussion of why U.S. interest rates haven\’t been rising. They draw on  the IMF Fiscal Monitor for September 2011, which has a Chapter 3 called \”The Dog that Didn\’t Bark (So far): Low Interest Rates in the United States and Japan.\”  The IMF writes (references to figures and tables omitted):

\”The relatively benign treatment by market participants of sovereign bonds issued by Japan and the United States, however, may not fully reflect fiscal fundamentals: current general government debt and deficits, and projected increases in debt over the next five years, are at least as high for the United States and Japan as they are for several euro area economies under market pressure or the euro area in general. In addition, projected long-term increases in pension and health care spending in the United States are larger than in many euro area economies. Japan and the United States face the largest gross financing requirements among all advanced economies this year and are projected to do so in 2012 and 2013 as well, reflecting their large deficits and debt stocks as well as their still relatively short debt maturity profiles, notwithstanding some success in lengthening maturities in recent years. Fiscal adjustment in the United States and Japan is lagging that in other advanced economies.\”

The IMF lists a number of  \”structural factors\” that have kept the the U.S. and Japan to keep interest rates on government borrowing low, at least so far. Most of the reasons relate to the basic idea that if government debt is held by large domestic investors, then those investors are less likely to flee to other financial investments. Here\’s the IMF on such factors (again, footnotes and references to tables and figures omitted):

Low interest rates in the United States and Japan partly reflect structural factors, including some that do not seem likely to change abruptly in the near term:

  • A substantial share of domestic debt holdings. In Japan, close to 95 percent of public debt is held domestically. The share is lower for the U.S. federal government, but rises to 70 percent for the general government. Moreover, the share of debt held domestically increases further for the United States if holdings by foreign central banks are excluded. This is significant, because private nonresidents may be more willing to shift their investments out of a country than are domestic investors, and foreign central banks may follow different investment practices than do other market participants …
  • Significant local central bank debt purchases. The U.S. Federal Reserve has purchased 7½ percent of GDP in Treasury securities (cumulative, under its quantitative easing programs), an amount equivalent to 12 percent of publicly held Treasury securities. …

  • Strong demand by a relatively stable investor base. Institutional investors—including insurance companies, mutual funds, and pension funds—hold 24 percent of government securities in Japan and 12 percent of Treasury securities in the United States. A further 22 percent of U.S. Treasuries and an estimated 2 percent of Japanese government bonds are held by foreign official entities. In addition, more than one third of U.S. Treasuries issued by the federal government are held by other government agencies, including the Social Security Fund …
  • Lower banking sector risks. Banking risks, which as the recent crisis has shown can dramatically affect fiscal developments, are perceived to be lower in the Unites States and Japan than in Europe …\”

So, can the U.S. government keep borrowing with impunity? After all, the dog of higher interest rates hasn\’t barked yet. The IMF offers a few cautionary remarks:

\”The widening crisis in the euro area shouldnevertheless serve as a cautionary tale for the United States and Japan, as well as other countries with high debts and deficits. Recent developments in Spain and Italy demonstrate how swiftly and severely market confi dence can weaken and how even large advanced economies are exposed to changes in market sentiment. … Low borrowing costs in Japan and the United Stateshave arguably created a false sense of security, but should be viewed instead as providing a window
of opportunity for policies to address fiscal vulnerabilities. In the absence of a new round of quantitative easing, higher interest rates could be required to attract new buyers of sovereign debt. …  Perhaps most importantly, Japan and the United States have also benefited from large stores of credibility—in other words, the implicit belief among investors that both countries will implement policies to ensure the sustainability of their debt. Such credibility might weaken suddenly if market participants became less convinced that such policies were forthcoming.\”

conversableeconomist

Using Financial Repression to Reduce Government Debt

The usual ways of reducing a government debt burden over time are fairly well-known: cut spending or raise taxes; have the economy grow faster than the debt burden, so the ratio of debt/GDP declines over time; a burst of inflation, which reduces the real value of past debt; and in some cases an outright default or restructuring of the debt. To this list, Carmen Reinhart, Jacob F. Kirkegaard, and M. Belen Sbrancia offer \”Financial Repression Redux.\”Here are some main themes (references omitted for readability):

Here\’s their definition of financial repression:
\”Financial repression occurs when governments implement policies to channel to themselves funds that in a deregulated market environment would go elsewhere. Policies include directed lending to the government by captive domestic audiences (such as pension funds or domestic banks), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between government and banks, either explicitly through public ownership of some of the banks or through heavy “moral suasion.” Financial repression is also sometimes associated with relatively high reserve requirements (or liquidity requirements), securities transaction taxes, prohibition of gold purchases, or the placement of significant amounts of government debt that is nonmarketable…. \”

How financial repression works like a tax
\”One of the main goals of financial repression is to keep nominal interest rates lower than they would be in more competitive markets. Other things equal, this reduces the government’s interest expenses for a given stock of debt and contributes to deficit reduction. However, when financial repression produces negative real interest rates (nominal rates below the inflation rate), it reduces or liquidates existing debts and becomes the equivalent of a tax—a transfer from creditors (savers) to borrowers, including the government. But this financial repression tax is unlike income, consumption, or sales taxes. The rate is determined by financial regulations and inflation performance, which are opaque compared with more visible and often highly politicized fiscal measures. Given that deficit reduction usually involves highly unpopular expenditure reductions and/or tax increases, authorities seeking to reduce outstanding debts may find the stealthier financial repression tax more politically palatable.\”

How is financial repression currently operating in the U.S.?
One potential example of how financial repression is operating in the U.S. is the super-low interest rates. In part, of course, these are an attempt to stimulate the economy, but it also seems plausible to me that they are intended to help the U.S. government in financing its debt. But a more straightforward example is that when the Federal Reserve and other central banks buy U.S. Treasury debt directly—debt that might very well need to pay a higher interest rate if it was sold to outsiders. Back in 1990, outsiders owned about 75% of U.S. Treasury debt; now they own about half.

How is financial repression happening in other countries? 
Central banks in many other countries–for example, the UK, Ireland, Portugal, and Greece–have sharply increased their holdings of government debt. In France and Ireland, major pension funds have been required to invest in government debt.

How much can financial repression reduce government debt?
These authors cite research that financial repression can have a major effect in reducing government debt, through what they call \”the liquidation effect.\” Many of their calculations focus on how government debt burdens were reduced after WWII. They write: \”For the United States and the United Kingdom, the annual liquidation effect [between 1945 and 1980] amounted on average to between 3 and 4 percent of GDP a year. … For Australia and Italy, which recorded higher inflation rates, the liquidation effect was larger (about 5 percent a year).\”


My point here isn\’t to argue for or against what they call financial repression. But if their calculations are roughly right, it\’s an option for reducing government debt that could end up playing a major role, and needs to be better understood.

 

conversableeconomist

Too Much Debt? Jackson Hole II

This is the second of three posts on some of the papers presented at the Jackson Hole conference held in late August by the Kansas City Fed. The first post is here; the final post will be up later. All the papers from the conference are posted here.

Stephen G. Cecchetti, M. S. Mohanty and Fabrizio Zampolli of the Bank for International Settlements write about \”The Real Effects of Debt.\” They illustrate that a powerful trend during the last few decades toward more debt in a number of high income countries. For example, if one looks at a simple average debt/GDP ratio for 18 OECD economies, including the United States, the combined debt/GDP ratio for government, corporate, and household debt rose from 165% of GDP in 1980 to 310% of GDP in 2010. The biggest increase over this time is debt for the household sector, which tripled in real terms over this period. (Just to be clear, this is non-financial sector debt, so it doesn\’t count what financial institutions owe to other financial institutions in their role as intermediaries.)

While longer-run data on debt across sector isn\’t available for all 18 countries that they examine, they offer a longer-run picture of U.S. debt. As they point out, U.S debt tended to hover around 150% of GDP for most of the time until about 1985, when it started rising. (The bump in debt/GDP ratios in the Great Depression, of course, was because the denominator of GDP in that ratio fell so sharply.) Since the 1980s, household debt has been rising faster than private-sector debt.

With these facts in mind, they raise a broader question: \”At moderate levels, debt improves welfare and enhances growth. But high levels can be damaging. When does debt go from good to bad?\” They use a regression framework that adjusts for many factors and tries to discern threshold effects, which a perfectly reasonable first shot at the issue, although it\’s the kind of approach that always raises questions about whether the correlation is a causation and whether there are omitted variables. They find:

\”Our examination of debt and economic activity in industrial countries leads us to conclude that there is a clear linkage: high debt is bad for growth. When public debt is in a range of 85% of GDP, further increases in debt may begin to have a significant impact on growth: specifically, a further 10 percentage point increase reduces trend growth by more than one tenth of 1 percentage point. For corporate debt, the threshold is slightly lower, closer to 90%, and the impact is roughly half as big. Meanwhile for household debt, our best guess is that there is a threshold at something like 85% of GDP, but the estimate of the impact is extremely imprecise.\”

The financial crisis of 2007-2009 brought home how easily household borrowing or corporate borrowing, when it goes bad, can turn into government borrowing for bailouts. When thinking about the problems of debt burdens facing the U.S. economy, it seems unwise to look only at government borrowing.

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The IMF on the U.S. Economy #1: What About the Budget Deficits?

The IMF has released its annual report on the U.S. economy, with a number of interesting figures, tables and insights. Here, I\’ll offer some IMF comments on the U.S. fiscal situation and  how the U.S. should address its federal deficit problems. In a follow-up post, I\’ll look at an intriguing comparison that the IMF offers between the aftermath of the Great Recession and the previous nine U.S. business cycles. 

\”Fiscal policy. Consolidation needs to proceed as debt dynamics are unsustainable and losing fiscal credibility would be extremely damaging. However, the pace and composition of adjustment should be attuned to the cycle. A politically-backed medium-term framework that raises revenues and addresses long-term expenditure pressures should be the cornerstone of fiscal stabilization. The official deficit reduction proposals could be too front-loaded given the cyclical weakness and, at the same time, insufficient to stabilize the debt by mid-decade.\” (p. 1)

\”Unfavorable fiscal outcomes. These could take the form of a sudden increase in interest rates and/or a sovereign downgrade if an agreement on medium term consolidation does not materialize or the debt ceiling is not raised soon enough. These risks would also have significant global repercussions, given the
central role of U.S. Treasury bonds in world financial markets. At the opposite extreme, an excessively large upfront fiscal adjustment could significantly weaken domestic demand …\” (p. 11)

 \”Short-term U.S. spillovers on growth abroad are uniquely large, mainly reflecting the pivotal role of U.S. markets in global asset price discovery. While U.S. trade is important, outside of close neighbors it is the global bellwether nature of U.S. bond and equity markets that generates the majority of spillovers.\” (p. 13)

\”The authorities have a number of options to achieve fiscal sustainability without large negative short term effects on activity. Social Security reform would help reduce long-term fiscal imbalances without undermining the ongoing recovery—measures such as increasing the retirement age while indexing it to longevity and trimming future benefits for upper-income retirees would have a minimal impact on current private spending. Identifying additional saving in health care and other mandatory spending categories would also be highly desirable, including through greater cost sharing with the beneficiaries, curbs to the tax exemption for employer-provided health care, and targeted savings identified by the President’s Fiscal Commission. Meanwhile, the tax system is riddled with loopholes and deductions worth over 7 percent of GDP. Gradually reducing these tax expenditures (including eventually the mortgage interest deduction which largely benefits upper-income taxpayers) would help raise needed revenue while enhancing efficiency. In the
longer term, consideration could also be given to introducing a national VAT or sales tax, as well as carbon
taxes.\”