Senin, 01 Oktober 2012

Household financial burdens fall to 30-yr low

According to the Fed's latest calculations, as of June 30, 2012, households' debt and overall financial burdens had fallen to a 30-yr low. From the peak in Q3/07, the burden of households' total financial obligations has fallen by almost 17%: from 19% of disposable income to 15.8%. This is big deal.

"Financial burdens" are calculated by comparing debt service payments and total financial obligations to disposable income. This is very different from the numbers bandied about in the press, which compare total debt to income or GDP in order to argue that there is still a lot deleveraging to come. The problem with the latter is that it is an apples-to-oranges comparison, since total debt is a stock—a fixed amount—whereas income is an annual flow. The Fed's method compares flows (annual payments on the stock of debt) to flows (annual income). Owing $100,000 with an interest rate of 10% is much more burdensome than owing the same amount with a 3% interest rate, just as it is easier to service a debt with a 10% interest rate when one's income rises 10% a year, than it is when one's income rises only 3% a year.

The data for June showed a modest reduction in financial burdens of all types. But financial burdens have declined significantly in the past 5 years, and are now back to levels last seen in the early 1980s. Households have accomplished this rather impressive task by a) paying down debt (i.e., deleveraging), b) defaulting on debt, c) refinancing and taking on new debt with much lower interest rates (mortgage rates are at all-time lows), and d) increasing their disposable income. With the exception of the unfortunate cases in which households have had to default on their debt obligations, the story is a virtuous one, and it has been driven by an increase in overall risk aversion, increased work, and an increase in savings.

It is also worth noting that a significant amount of deleveraging has effectively occurred even as the economy has managed to grow (albeit slowly). Deleveraging does not have to be synonymous with deflation or recession. Deleveraging occurs when the demand for money increases, and the demand for money tends to increase during periods of rising uncertainty. Increased money demand can be satisfied by increasing one's holding of cash and cash equivalents and/or reducing one's debt. (Conversely, increasing one's leverage is equivalent to a decline in one's demand for money, since debt is equivalent to "shorting" money.) Deleveraging can be bad for an economy's health if the central bank fails to respond to the increased demand for money. The Federal Reserve was slow in responding in late 2008, but they more than made up for that mistake by engaging in two unprecedented quantitative easing programs (with another just beginning) which have resulted in the creation of $1.4 trillion of excess bank reserves to date. When the supply of money equals or exceeds the demand for money, then an economy can undergo lots of deleveraging without major problems, and that is precisely what has happened since 2008.

There have been some major adjustments made in this economy in recent years, and this lays the groundwork for a healthier economy in the years to come. What's lacking now are the proper incentives to spur growth. 

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