How the Loan/Bond Choice Helps the Private Sector Self-Determine the Money Supply — AND Yet Another Reason QE is a Non-Event for the Economy

NOTE: Just to be clear, this post does not describe any established theory. It was intended as a thought exercise to elicit feedback (with no results so far). What it describes may or may not be accurate — it does seem logical to me, but I am not an expert on the banking system.

UPDATE 11/11/2010: Thanks to commenter Ramanan for pointing out that the concepts in this post overlap to some degree with existing Post Keynesian / Circuitist work, such as by Marc Lavoie.

UPDATE 4/28/2011: If you read this post and are interested in further details including a graph of QE's impact on bank versus non-bank lending in the US, please also read this more recent post.

Two fundamental types of lending enable the private sector to borrow money. The first type is bank loans, which "create money". The second type is other lending in all its forms, in which a lender (typically not a bank) lends existing money to a borrower. Sometimes loans of existing money are directly between two entities, for example a household buying a bond issued by a corporation. Other times they go through a lending intermediary that pools together loans, for example securitized loan pools sold to investors, or Fannie Mae and Freddie Mac with their mortgage assets and "agency debt" liabilities. There is even a fledgling peer-to-peer lending industry that can involve either direct person-to-person loans or intermediary loan pools.

This post will explain how an economy with both forms of lending on offer allows the private sector to partially self-determine the broad money supply (i.e., according to its preference for holding liquid short-duration assets), semi-independently of the amount of private borrowing it desires. I have never seen this idea explained elsewhere before, so please comment below if you have seen it addressed elsewhere, or if you think my logic is incorrect.

One important conclusion of this is observation is that if the government attempts to force the private sector on aggregate to hold a larger quantity of money (short duration assets) than the private sector wants, then the private sector, given enough time, will counter the government's action by shifting from bank loans to non-bank loans (e.g., bonds), thus eliminating the increase in the money supply. Conversely, if the government offers insufficient short duration assets, the private sector will tend to favor bank loans (with their associated money creation) over non-bank loans, until the money supply increases enough to satisfy the private sector's liquidity desires.

However, this conclusion only holds to the extent that bank loans and other debt such as bonds can be used interchangeably to fulfill the needs of prospective borrowers. Clearly this is not entirely true, and substitutability between the two types may be limited by regulations, refinance cost frictions, or other factors. For example, investors may take some time to trust securitized loan pools again, and households can only borrow from banks, they can't issue bonds! (Though if peer-to-peer lending were to grow sufficiently, this limitation might be overcome...)

This conclusion also has implications for what to expect from quantitative easing. QE is nothing more than an asset swap that replaces long duration assets held by the private sector with new short duration assets (issued by the central bank). Modern Monetary Theory (MMT) authors have been saying this for years, and Paul Krugman has finally figured it out too. So, given enough time after quantitative easing and small enough frictions and impediments between the two types of lending, we should expect to see a relative reduction in bank lending (via money creation), and relative increase in other forms of lending (without money creation) as the private sector tries to eliminate its excess short duration assets ("money") by shifting into longer duration assets (e.g., newly issued bonds).

Thus yet another reason QE is a non-event for the real economy! Other authors have already shown that it will not cause any increase in bank lending (the money multiplier is a myth for today's currency systems!) But will QE even reduce long term interest rates? There is little evidence that it will. Long term rates rose during the Bank of England's recent QE program. James Hamilton, a frequently linked to traditional economics professor, summarizes estimates of the effects of Fed's QE at less than a 20 basis point reduction in long term yields, a trivially small amount that may also represent coincidence.

In fact, an implication of the theory explained above is that QE could actually accelerate the shrinking of banks' loan books, and aside from fee income from banks facilitating other types of bond-like lending, banks could actually be hurt by QE via the loss of expected loan income as loans are packaged into securities for yield-hungry investors or refinanced into bonds.

Japan's Experience

Does history show any evidence of this effect? Japan first experimented with a form of quantitative easing from 2001-2006. Here is a graph showing two types of liabilities summed up for Japan's private sector — loans and "securities other than shares" (which I am assuming are largely longer-duration liabilities such as bonds, but I am no expert on Japan's national accounts data and could be wrong on this).

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Funding via "securities other than shares" (bonds, etc?) (red line) jumped to positive growth during the QE period, even amidst ongoing contraction in bank loans (blue line). If deleveraging was ongoing, absent other factors, shouldn't it have been ongoing in both categories? It seems this data might lend some support for the idea that a forced increase in money might be counteracted by the private sector favoring bond-like lending over bank loans to reduce the balance of unwanted money in the system.

Technical Explanation of the Trade-off Between Bank Loans And Non-Bank Lending

First let's look at the difference between a bank loan and other forms of lending, then at how interest rates are determined. The following images are snapshots from a slightly edited (for demonstration purposes) copy of my Macroeconomic Balance Sheet Visualizer. You can try the "Bank Loan" and "Private Bond Issued" operations there yourself, as well as the "Bank Loan Is Securitized" operation (not shown here).

Bank Loan — Balance Sheets Before Lending Occurs:
(the "Households" balance sheet below represents the borrower)

Bank Loan — Balance Sheets After Lending Occurs:

Private Bond — Balance Sheets Before Lending Occurs:

Private Bond — Balance Sheets After Lending Occurs:

Discussion of Balance Sheet Change Details:

As you can see, loans create deposits (this is widely misunderstood, as people assume that banks lend out reserves, which is not true). Because of the way the central bank ensures sufficient reserves in the system to satisfy reserve ratios (though these ratios don't even exist in many countries), the only limitation to bank lending is finding enough credit-worthy borrowers and meeting capital ratio requirements. The capital requirements dictate how much balance sheet equity a bank must have relative to its loan assets, since such equity is a "cushion" for absorbing losses. Banks can generally raise more capital as needed if there are worthy borrowers, so this is no limitation either beyond the very short term.

Comparing bank loans versus other bond-like lending:

• In both cases, the borrower's balance sheet adds a new short duration asset (money) and a new long term liability (loan or bond).
• In both cases, the lender's balance sheet adds a new long duration asset (loan or bond).
• For a non-bank lender, adding the long duration asset requires giving up a short duration asset (money).
• For a bank lender, adding the long duration asset requires adding a short duration liability (bank deposits, which are money for the depositor).
• In both cases, total private sector debt is increased.
• Only in the case of bank lending is the broad money supply increased.
  

So the KEY difference from a lender perspective is that bank lending requires accepting a new short duration liability, while non-bank lending requires giving up a short duration asset.

What interest rates would banks offer on loans compared to rates offered by non-bank lenders? In both cases, interest rates have to be sufficient to cover credit risks (i.e., the risk of borrowers defaulting on their debt) and inflation and interest rate risks. On top of this, a bank lender has to price in the ongoing cost of the new liability (paying interest to the depositor), while the non-bank lender has to price in the opportunity cost of the foregone short duration asset (money). At any given point in time, both these costs will be the same, since both the liability and the foregone asset pay interest at the current deposit rate on offer by banks. So, based on these factors alone, bank lenders and non-lenders should offer comparable interest rates to borrowers at any given point in time.

So which would "win" in lending to prospective borrowers? At times when there is a surplus of short duration assets (bank deposits) in the system (i.e., "too much money"), some non-bank lenders will be more eager to trade short duration assets for longer duration assets, and will likely bid down the lending rate and out-compete the banks. This will limit the increase in the money supply as non-bank lending doesn't create money. Conversely, at times when there is a deficient amount of short duration assets in the system, non-bank lenders will want to hold onto the deposits they have, so they will not match the lower lending rates offered by banks, and will thus let banks extend the loans to borrowers, thereby increasing the money supply. Loans would keep beating out bonds until the money supply had increased to a point of equilibrium (i.e., the amount of money desired by depositors on aggregate to meet their liquidity preferences). In this way, the ability of banks to "create money" when they lend provides an interest rate anchor for the economy (a sort of private sector "lender of last resort"). And because of this, the private sector has some control over the broad money supply, independent from the amount of debt it issues.

And if the suggestion just above is correct (i.e., that bank loans help anchor long term interest rates independently from the supply of long and short term assets), it may help in explaining why even a post-QE reduction in private sector long duration assets may not have any meaningful impact on bond prices and yields. (Generally it is argued that reducing the supply of something increases its price.)

Of course the whole dynamic posited here would probably be a "medium term" thing, not instant, as it would take time for shifts between types of lending to occur, so in the short term, none of this may apply.

What do you think? Is this (A) logical (B) flawed, or (C) an amateurish summary of some existing theory in finance or economics?

UPDATE: I had intended to also mention the theory that QE will drive up asset prices (stocks, housing, etc). This post does not address that directly, but to the extent that a shift away from bank loans occurs and counteracts the increased "unwanted" money supply, some of the driver for such an effect on asset prices might disappear (in the medium term).

Rock Beats Scissors, Automatic Stabilizers Beat Debt Deflation...

I've been tracking the borrowing trends from the Z.1 Federal Reserve Flow of Funds report since last summer. Here is the Q2 2010 update:

Total US Government and Private Sector Borrowing Relative to GDP (Quarterly 2003 - 2010/Q2)

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Total borrowing (blue line) has been positive again for the last two quarters, with government borrowing (red line) increasing and private sector borrowing (yellow line) contracting less slowly.

US Borrowing by Sector (Quarterly 2003 - 2010/Q2)

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Government and the financial sector between them dominate all other sectors with respect to their effect on the overall trend.

Why do these graphs matter? For several reasons discussed in past posts... This is one way of showing that clearly the government is NOT crowding out the private sector in the debt markets, given how high total borrowing has been in the past. Fortunately this point has become obvious to most observers over the last year. Another is that it shows in rough terms the magnitude of the government support for the economy (much of it driven by automatic stabilizers) in the context of the peaking and collapse of a private sector credit bubble. (There are better ways to look at the government's role, as I admit the borrowing data is only a crude proxy).

With respect to the post title, it's not a given that debt deflation won't yet emerge (for example, if GDP double dips and private creditors are allowed to suffer more losses than they did in 2008, but we are missing smart policy to limit contagion). But Great Depression severity debt deflation has clearly been averted so far for a variety of reasons, a major one of which is stronger automatic stabilizers.

On the last update, I noted some ongoing questions, such as the extent to which the negative private sector rate of borrowing reflects a voluntary paying down of debt versus involuntary factors like defaults. In the past there has been evidence of each. However, several bloggers have recently cited this WSJ Real Time Economics post. It notes that in the last two years, mortgage debt and consumer credit have contracted at a 2.3% annualized rate. But after removing the effect of defaults, the contraction rate is only 0.08%! While that suggests defaults are the dominant factor, they note at least a little room for frugality taking place as well: "Defaults happen even in normal times, and are typically offset by even stronger growth in new mortgage and consumer loans. By holding their debts steady, consumers are actually being a lot less profligate than usual."

Real GDP Growth in the US and Japan: A Closer Look at Consumption, Government Spending, Net Exports, Investment, and Inventories

In a previous post on the historical "stocks" of wealth in Japan and the US, I promised a post on the flows, i.e., aggregate income (GDP). I imagine someone must have posted versions of these before but for some reason I haven't come across them (just charts for recent quarters). Here are three longer-term charts followed by some comments.

Japan: Contributions to Percent Change in Real Gross Domestic Product (1981 - 2008)

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US: Contributions to Percent Change in Real Gross Domestic Product (1980 - 2009)

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US: Contributions to Percent Change in Real Gross Domestic Product (2005/Q1 - 2010/Q2) (SAAR)

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Technical Note: The US data appears inconsistent if you compare the quarterly chart to the annual one. This is unmodified data directly from BEA's site so I have not introduced errors. It appears their annual data uses an average value of each flow (GDP, consumption, etc) for within each labeled year, rather than the end of year value. This would explain why, for example, the change in GDP for 2008 appears to be flat (i.e., 2008 average compared to 2007 average, rather than comparing end of year values) while the quarterly data confirms the plunge that was taking place in the second half of 2008.

Some Comparative Observations on Japan's Post-1990 Balance Sheet Recession and the US Post-2007 Balance Sheet Recession

Real GDP
Despite slowing in the early 1990s, real GDP in Japan only contracted in a single year — 1998 (at least, up until the 2008 global financial crisis). So far the US will only have experienced [just over] a year of actual contraction, though it was deeper. There is of course still the risk of "double dip", i.e., renewed contraction.

Household Consumption
Household consumption made a positive contribution to growth in Japan in every year except 1998, despite slowing after 1990 from over 2% to below 1%. In the US, consumption's contribution has been negative five out of six quarters starting in Q1 2008, but has since been positive in the quarterly data. Even if it remains positive in future quarters and years (TBD), it seems likely that ongoing deleveraging will cause the rate of increase to be smaller than the roughly 2% rate in the housing-bubble-and-home-ATM 2000s, which was in turn slower than the 1990s rate that ended at over 3% annually in the "new economy" tech bubble years.

Japan's household consumption was likely also supported by the fact that the household savings rate fell from around 13% in 1990 to around 3% in 2006. The US household savings rate is around 6% now, and unlikely to match Japan's decline (as it would have to go quite negative!). So it remains to be seen whether government deficits (boosting income) instead provide sustainable support for household consumption growth.

Direct Government Spending
Note that the measure shown is direct government spending, investment, and inventories, so it may be significantly less than the total government deficit during the same period. Hence these charts don't show the effect of the government giving the private sector more money to spend as it [the private sector] chooses, through lower taxes, larger transfer payments, etc.

Government spending growth represented about 0.5% to 1% of annual real GDP growth through most of the 1980s in Japan, and this increased a bit to over 1% in 1992 and 1993, likely in response to the deflating stock and real estate bubbles. (Were there large fiscal stimulus packages during these years?) Perhaps government spending going negative in 2007 is what helped tank the Japanese economy by 1998 — Richard Koo has mentioned pressure at that time to reduce government deficits and that this of course made the situation worse! The mid 2000s in Japan actually saw direct government spending contracting mildly each year.

In the US, government spending has grown every year except 1993, though at generally less than 0.5% of GDP it is not huge relative to other growth factors. Looking at the post-2007 recession and crisis response spending, the contribution is surprisingly small, at less than 1% in all but two quarters, and sometimes even negative! Part of the explanation is that this total includes state and local governments which have contracted to offset some of the federal spending, but the other possible partial explanation is that the Japanese may have been more aggressive in post-asset-bubble direct government stimulus spending (again ignoring tax cuts and other ways of government sustaining demand).

Investment
Private sector investment includes residential housing construction, commercial real estate, software, equipment, and other capital formation.

In Japan's late 1980s bubble, private investment contributed between 1.3 and 3.4 points to GDP growth each year. After slowing in 1991, it contracted for three years, taking almost 2 points off GDP in 1992 and again in 1993. 1998 saw a similar contraction.

In the US, investment was usually over 1% in the 1990s, but made a surprisingly small contribution to GDP in the mid 2000s housing bubble years (not much more than 1%, so much less than Japan's bubble-era investment). However, contracting private investment was the biggest contributor to falling GDP in late 2008 and early 2009. Late 2009 and the first half of 2010 have seen large a large bounce back in investment, perhaps reflecting the depth of the decline. Where might it go from here? I'll save that for a future post on outlook, but there is no obvious answer based on these charts alone.

Inventories
Changes in private sector inventories are the primary driver of typical recessions and business cycles (if inventories are increased by too much as optimism gets ahead of reality, the recession allows the inventories to be drawn down, but reduces income to manufacturing and other contributions to inventory growth during the recessionary period). But in balance sheet recessions arising from debt-fueled asset price bubbles, inventory effects are dominated by other factors, particularly private investment. This is evident in the Japan chart from 1990-1993 and the US quarterly chart in 2008 and early 2009.

To compare to more typical recessions, look how much larger the green (inventories) is relative to the yellow (investment) in the US in 2001, 1982, and 1980.

There has been a huge inventory rebuild in the US in Q3 2009 through Q2 2010, so this effect will likely fade and be more neutral going forward (though with risk of renewed contraction in the immediate quarters ahead if the rebuild was too large or consumption falters further).

Net Exports
One common statement about Japan is that they are an "exporting nation" and that this sustained them after 1990 and prevented a depression. But this chart shows that in the 1990s, changes in net exports were sometimes positive and sometimes negative, and did not dominate the trend in GDP growth at all. However in the 2000s net exports have made a moderate and steady contribution to growth every year from 2002-2007.

Through most of the 1990s and 2000s in the US, changes in imports and exports exerted a mild drag on growth (i.e., imports rose faster than exports, as an increasing amount of income was spent on imported goods and services). This is a little surprising for the 2001-2005 period, as the dollar was falling most of that period. A deeper dive into the data could answer this, but on the surface it seems the growing demand for imports exceeded the increased competitiveness of exports. Perhaps China's currency peg was a dominant reason. Since 2007, growth in net exports has provided some positive support for US GDP growth.

Summary
This was a limited comparison narrowly focused on one type of data set (contributions to real GDP) and not tied into historical accounts of the timing of recessions, government stimulus, etc. I'd welcome a bit more elaboration in comments on the real world factors that contributed to the GDP growth trends for each country and time period (or any other insights into the data), if anyone is inspired.

As a future project, perhaps I'll eventually correlate these charts with changes in private sector debt and changes in government deficits.

International CPI Trends: No Deflationary Spirals Evident So Far

While the US deflation risks seem to dominate discussion on the blogs I follow, there has been ongoing talk of the international deflation risks, especially for other housing bubble countries. The talk intensified in late 2009 as Ireland and Japan both experienced intensifying deflation. Discussion again picked up in spring to early summer of this year in the context of the anticipated deflationary pressures that austerity measures would bring to countries within the European Union.

Here's a long due update on price levels graphs for various housing bubble countries (the US, Australia, UK, Ireland, and Spain). Out of interest, I also include Japan, Iceland, Greece, and the EU27 area, as each has played a prominent part in crisis headlines over the last couple years.

Here are the actual price levels (not rate of change):

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• Price levels in Japan and Ireland appear to have bottomed out around January of this year.
  
• The US suffered the biggest decline in 2008 and has yet to reach its previous price level peak.
  
• The remaining countries have continued an upward price level trend, each to a different degree.

I had to stop including three-month rate-of-change graphs, as a lack of seasonally adjusted price level data for Europe made the result way too volatile to be useful. But here is the year-on-year inflation rate graph, i.e., the rate of change of the price levels above:

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• Inflation in the UK and Australia currently seems to be flattening out in the 3% range.
• Inflation in Greece has kept rising and is over 5%.
• Inflation in the US is falling.
• Inflation in Spain and the EU27 region is around 2%, with the trend unclear.
• Japan and Ireland both have a moderating level of deflation, moving toward flat line (this is more visible in the prior price level graph).
  

Will any countries within the EU experience a deflationary spiral as some commentators warn? It seems unlikely. Will they experience falling inflation and eventual possible mild deflation, following the Japan (and perhaps US) path? Maybe in some cases, but absent acute crisis conditions (a possibility), these price trend changes seem to take years to unfold. In addition, actual house prices don't seem to have corrected nearly as much in other countries as in the US (measured relative to incomes and rents). In the US house prices peaked around five years ago and while we have continued disinflation we don't yet have sustained deflation.

Here is the exact same graph zoomed out to a larger Y-axis scale to show Iceland in full:

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Iceland is the extreme outlier of the group, with the inflation rate peaking over 20%, and falling continuously in the last year and a half. I don't know all the reasons for Iceland's experience, but currency changes must be a large factor. In 2008 its currency value crashed to less than half of its previous level against the dollar, as shown in this ISK to USD chart:

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And as of 2008, it was more dependent on imports than most countries, with their value measured at around half of Iceland's GDP (via Google Public Data):

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Deflation Watch (July 2010): Still Disinflating Japanese Style, Actual CPI Deflation Probably Not Imminent

Three months of negative month-on-month CPI prints (a trend which broke in July) have generated an absolutely astounding amount of deflation commentary in the econoblogosphere! The Japanese-style-deflation-in-the-US meme has certainly reached critical mass in at least some circles...

I decided this month to finally update my charts. The format carried over from my original post comparing historical deflationary episodes overdoes the Great Depression comparison, despite being useful at the time (a year ago, negative year-on-year CPI reports had prompted a renewed surge in deflation chatter).

Some Relevant Current Articles

My list of relevant links has grown long, and in the interest of actually publishing a chart update today with the latest data, I'll save the links for a later post. (Some others are even labeling their posts "deflation watch" as well!)

Post-Bubble Consumer Price Index Trends: Current US (post-2007) versus Japan (post-1989) versus the US Great Depression (post-1929)

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The above chart shows the actual price levels for the three commonly discussed post-asset-bubble deflationary episodes. Here are the year-on-year inflation rates for the same time periods:

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Rather than attempting to align all three episodes of data at a CPI peak, they are instead now aligned at the dates that wealth (i.e., asset values such as real estate and equities) peaked. The goal is to compare the effects of the post-asset-bubble deflationary forces on the actual consumer price level trend in each case. I considered a few other possible alignment points, such as the peak in private sector borrowing (as debt-fueled asset bubbles tend to be the largest). However the peak private sector rate of debt-growth before the Great Depression was actually in 1925 (!), and overall the peak in balance sheet wealth seemed the most logical choice. The main reason for this choice is that falling asset values (along with a post-bubble consumer mentality) typically induce a higher attempted private sector savings rate, which will typically cause an aggregate demand deficiency and lead to downward pressures on prices and wages. Some charts of balance sheet wealth in the US and post-bubble Japan are in this previous post. The rough peaks I used (these are not terribly precise) for the charts were November 1929 for the Great Depression, mid 1989 for Japan, and mid 2007 for the US.

Key Observation: The US price level is currently following a similar path to Japan's experience (though slightly more rapid than Japan, still very far from the Great Depression experience), and it took many years of disinflation before Japan experienced sustained (mild) deflation. That said, the downside economic risks are much larger in the US today than in Japan post-1989. A number of factors still threaten a faster move through disinflation to deflation for the US today, including but not limited to:

• Higher unemployment in the US today than 1990s Japan
  
• Risk of negative global demand shocks due to such factors as deflating global housing bubbles (real estate prices in many countries are still nearer peak than trough by price/earnings and price/income measures).
• Anti-deficit political pressure that threatens reductions in US fiscal policy spending
• A low likelihood of any non-government sector (household or business) driving growth by reducing its savings rate significantly (Japan's consumers provided just this boost to demand by reducing their savings rate from around 15% in 1990 to under 5% by the early 2000s)
  

Still, it's probably premature to expect US deflation in the immediate months ahead.

Trends in Consumer and Producer Price Index Levels (CPI & PPI, Seasonally Adjusted)

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The chart above shows various CPI and PPI measures, aligned at 100% on July 2008 when the CPI peaked. It is intended to help in comparing the trends in absolute price levels (not rate of change). For example, crude materials (PPI) and energy (CPI) are clearly more volatile than finished goods (PPI) or headline or core CPI, but you can see at times (especially late 2008) how they can drag the other indexes around.

Annualized 3-Month Rate of Change for Components of US Consumer Price Index, Seasonally Adjusted

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This chart shows the short term (three month) rate of change of the components of CPI, to help identify underlying inflationary and deflationary forces within the overall CPI basket. Many components are quite volatile despite being seasonally adjusted.

A surprising number of components (food, housing, recreation, and overall headline) are showing a flat (0%) three month rate of change. But shelter (a subset of housing I have separated due to its importance) has broken its deflationary trend and continues with positive inflation! I am still looking for a good explanation (Calculated Risk has commented a little but is also unsure of details). If this continues, it removes a lot of the near-term deflationary impulse on the overall index, and perhaps actual lasting CPI deflation is still years away like Japan's was (or perhaps even not at all).

16% Trimmed CPI

The 16% trimmed mean CPI (generated from the Cleveland Fed site) removes the most extreme monthly price changes, and is still falling after only a brief interruption in the trend:

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Deflation Watch (May 2010): Headline Deflation Is Back!

April and May brought a renewed decline in the headline consumer price index, however it is not yet clear whether this trend is ready to stick. And curiously (and a little unexpectedly) rents seem to have stopped falling, at least for now.

Some Relevant Current Articles

• Have Residential Rents bottomed? - Calculated Risk says "There is some evidence that apartment rents have bottomed ... at least temporarily." And from the BLS: "The indexes for both rent and owners' equivalent rent were unchanged in May."

• Warren Mosler on oil prices (from March, but still relevant to the medium term trend):
  

"With supply following demand, as with any monopolistic arena, it looks like the world crude oil balance remains very much neutral leaving the Saudis in full control as swing producer where they set prices and let quantity adjust to market demand. Stable crude prices with 0 interest rates, high excess capacity and low aggregate demand should keep inflation at bay indefinitely, with productivity increases making deflation the greater risk."

Consumer Price Index Trends: Great Depression versus Today through May 2010 (US)

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I should note that this chart isn't intended to show we are following the Great Depression path, as we are clearly not (more details in the original deflation post), so perhaps a new chart is in order in the future.

However, it is looking like the headline CPI (red line) has been changing direction and may not make it back to the peak level from July 2008!

Annualized 3-Month Rate of Change for Components of US Consumer Price Index, Seasonally Adjusted (April 2006 - May 2010)

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The three month trend in CPI has gone negative for the first time since late 2008! However, transportation (dominated by energy prices) at -6.9% (annualized three month rate) and apparel at -3.6% (annualized three month rate) seem to be the primary drivers of the latest deflation. Housing (and its subset category, shelter) seem to have stopped declining, at least in recent months. The other components are all in positive (but sub 3%) inflation territory, with varying levels of volatility. Will we stay in negative price change territory? It seems likely the drag from energy prices will come to an end, so the answer is far from certain in the short term, though the overall dis-inflationary trend is nowhere near over.

Price Index Changes: Great Depression CPI versus Current PPI through January 2010 (US)

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Slowing in China, austerity in Europe, and the peaking of housing bubbles in countries such as Australia, Canada, and the UK could all contribute to a sustained end to rising commodity prices.

16% Trimmed CPI

The 16% trimmed mean CPI (generated from the Cleveland Fed site) removes the most extreme monthly price changes, and is still falling after only a brief interruption in the trend:

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CPI in Japan (Jan 1980 - Jul 2009)

From previous posts, for reference: "The peak of Japan's CPI occurred in October 1998, almost eight years after the stock market peaked, and Japan's notorious mild deflation has been in effect since then. A multi-year disinflation (of core CPI) leading to sustained mild deflation is one possible outcome for the US.

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Q1 Charts of Total Borrowing: Involuntary Deleveraging via Defaults, or Frugality?

I've been tracking the borrowing trends from the Z.1 Federal Reserve Flow of Funds report since last summer. Here is the Q1 2010 update:

Total US Government and Private Sector Borrowing Relative to GDP (Quarterly 2003 - 2010/Q1)

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The contraction in private sector borrowing (yellow line) appears to be in a declining trend. Total borrowing (combined private and public sectors) has gone marginally positive!

US Borrowing by Sector (Quarterly 2003 - 2010/Q1)

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The largest component of the private sector is the financial sector, and its contraction in borrowing (purple line) has been getting smaller, though at a slower rate. Notably, business borrowing (dark green line) was roughly flat in Q1 after contracting for four consecutive quarters. But home mortgage borrowing is contracting faster than before.

What best explains the private sector's negative borrowing rate? And why is the rate of decline getting smaller? In my last update I linked to some data that suggested "consumers haven't actually been paying down credit card debt since Q1 2009 — they've actually continued to add to debt, whether out of necessity or choice — so the overall contraction since then has been all due to charge-offs." Credit card debt is only one kind of borrowing, but it is likely correlated with consumer attitudes toward debt and therefore future trends in borrowing.

Edward Harrison, always a worthwhile read, is continuing to question whether consumers have really found frugality. In his latest post on the topic, he concludes: "Bottom line: people don’t change unless they are forced to do so. Americans are as spendthrift as ever. Wait until the economy hits a rough patch – and then we can talk about the demand for credit."

Many other commentators (myself included) have tended to assume that consumers are becoming more frugal after being burned by debt-driven asset bubbles and would both choose to incur less new debt and to pay down existing debt faster than before. This is the multi-year deleveraging process that so many expect. There is evidence to suggest this is occurring, but also conflicting evidence suggesting that defaults, not voluntary repayments, explain the primary trend. Understanding this dynamic is key to understanding likely economic outcomes and whether this is truly a non-temporary balance sheet recession as described by Richard Koo. Thoughts? Evidence I've missed?

New developments can of course change current attitudes and behaviors. Household wealth stands a good chance of declining again due to (a) a resumed decline in housing prices as the effects of the absolutely enormous government support for the housing market diminish somewhat, and (b) potential further drops in stock prices (more on that another time). Might lower asset prices (and especially directionally declining asset prices) lead to an increased frugality?

It would be tremendously useful in understanding macro trends to have government data like we have now in the Z1 and other reports, but disaggregated into various household wealth and income tiers. Such data could go a long way to distinguishing between trends driven by economic stress versus trends driven by choice. Unfortunately I don't know of any source of such data (and it would likely by necessity be collected from small sample sets, anyway).

Shadow and Flame

"Moria! Moria! Wonder of the Northern world! Too deep we delved there, and woke the nameless fear."
— Glóin from The Lord of the Rings 2 II The Council of Elrond

"The dwarves delved too greedily and too deep. You know what they awoke in the darkness of Khazad-dum... shadow and flame."
— Saruman

Apologies to non-Tolkien fans, but this example of life imitating art/literature struck me when I first read about the Deepwater Horizon explosion and oil spill. Tolkien powerfully captures the clash of nature and industry as one of the recurring themes in his Lord of the Rings trilogy, and tragically this disaster has some uncanny parallels. For those not familiar with the story of the Lord of the Rings, when the dwarves delve "too greedily and too deep" they awaken a Balrog, a demon of shadow and flame, and it proves too powerful to overcome. After much loss of life, the magnificent underground city and mining operation is abandoned.

Of course, the evidence is that this incident was avoidable, whether or not the driver was "greed" or a dysfunctional and reckless corporate culture (BP had an astonishing 760 egregious willful citations at refineries versus 1 for other companies in the same period!) . Yves Smith has provided solid coverage over recent weeks, and yesterday excerpted a letter sent from the government to BP: "In effect, it appears that BP repeatedly chose risky procedures in order to reduce costs and save time and made minimal efforts to contain the added risk." (much more via the link).

A guest post by George Washington and a link highlighted by Yves Smith both get into the possibility of undisclosed damage to the system and the threat of an accelerated flow of oil with no credible way to contain it at the well site. A knowledgeable commenter on Yves' site concludes "the relief well has to work. They will have to keep trying until they intersect the well."

If you need a less alarmist perspective, think of the oil spill relative to the Gulf of Mexico as "ONE raindrop in 10 olympic sized swimming pools" (and better mandate all wildlife to cease swimming or landing in the vicinity of said raindrop until further notice!) I suppose this is a bit sarcastic but I actually find it a worthwhile data point as food for thought, despite believing it to be rather misleading.

What To Expect From This Blog

I realize I haven't posted in a couple months, so I thought that a short status post might be valuable. The brief summary is that you are likely to see continued sporadic posts here in the future, though probably less often than before (not that they were ever frequent!) I'm less likely to do updates every month/quarter of certain series of posts I've been covering, though I will make an effort to update them when the data changes in a noteworthy way. For example, the deflationary CPI trend is now becoming apparent to more and more observers and bears revisiting. Remember, Japan's deflation took years to arrive after its asset bubbles peaked. Other past topics likely to be revisited include Modern Monetary Theory, flow of funds data and borrowing trends, macroeconomic and market outlook, stock dividend trends, deflation outside the US, etc. New topics won't be frequent but I do have some some in mind.

I didn't exactly plan to have an economics blog (I'm an engineer, for one thing). I initially set it up as an easy platform to share my macroeconomic and market outlook, distilled from much reading in the econoblogosphere, with a select set of real life acquaintances. However, I subsequently found myself becoming dissatisfied with some gaps in my knowledge and with some of the third party commentary I'd been reading, so I decided to do more digging in raw data myself, wherever possible, rather than only relying on the commentary and analysis of others. And at times the data has seemed worth sharing. I hope some have found it useful — this site has 60+ RSS subscribers via Google Reader (and I don't know how many in other readers) — a small number, especially given that many probably don't read all their feeds, but not zero!

Other than general time constraints, the other reason for the shortage of posts lately is I've been putting a little time into attempting a second macroeconomic visualization that I hope could have broader value, if successful, than the last one (which I know still needs further updates). So if I make progress on it, look for a future post introducing it.

As a bonus for reading this far, and so as to include some actual economic content, here is a chart from an April presentation by Richard Koo that I think is useful and have not seen posted elsewhere:

It's the first actual "picture" of the so-called reverse-square-root-sign recovery that I recall seeing, and nicely shows two things. First, that the "Lehman Shock" probably did contribute to a collapse in confidence and GDP beyond that attributable to the Minsky-style private debt dynamics alone (though contagion and adverse feedback loops were certainly a real risk that could have kept GDP on its downward path, even so). Japan's GDP never fell this dramatically, even after its own giant asset bubbles popped. Second, it shows the uncertain future with respect to the degree of ongoing private sector deleveraging versus government fiscal stimulus.

Total Borrowing Still Contracting at a Stable Rate in Q4 2009 ($577 billion annualized)

The Z.1 Federal Reserve Flow of Funds report is out for Q4 2009. Here are some updated graphs:

Total US Government and Private Sector Borrowing Relative to GDP (Quarterly 2003 - 2009/Q4)

(click on graph for a larger version)

US Borrowing by Sector (Quarterly 2003 - 2009/Q4)

(click on graph for a larger version)

The trend has been somewhat consistent over the last three quarters, with the size of government borrowing almost offsetting the contraction in private sector borrowing, which has been largest (as a percentage of GDP) in the financial sector. However, it seems the financial sector's rate of negative borrowing is shrinking, a trend which bears watching. Home mortgages, consumer credit, and business debt all show continued contraction, but there is no way to know which way their trends will go from here. A lot may depend on the future path of housing prices, which most likely aren't completely done falling. But it's possible there could be some surprises, for example Felix Salmon observes (and EconomPic charts) that consumers haven't actually been paying down credit card debt since Q1 2009 — they've actually continued to add to debt, whether out of necessity or choice — so the overall contraction since then has been all due to charge-offs.

In rough terms, I think these graphs show:

1. Fears of "massive" government debt supply driving up interest rates to any dangerous degree are misplaced. Government bonds (plus shorter duration instruments) are replacing disappearing private sector assets. (See further discussion of outlook for treasuries here).
   
2. Government deficit spending (a lot of it via the automatic stabilizers) has helped sustain incomes in the face of defaults and attempted private sector deleveraging, thus preventing a worse outcome to date. Of course, there is a lot that can still go wrong.
   

Some past posts discuss these graphs in more detail:

• Deadlock! Total Borrowing Has Stabilized at a Mild Contraction Rate as Private Debt Reduction Stops Increasing and Government Borrowing Stays Steady
• Total Borrowing Continues Contracting in Q2
• Why Treasuries Find Buyers and Interest Rates Will Not Rise (Much)

Balance Sheet Wealth in the US and Japan; Historical Data in the Context of Modern Monetary Theory

While gradually learning more about Modern Monetary Theory (aka Chartalism) I've started looking at the balance sheet tables in the official national accounts data of the US and Japan. MMT emphasizes stock-flow consistent modeling of the economy when analyzing the impact of various private sector and government actions. Separately, I've started creating a macroeconomic balance sheet visualization tool to illustrate this approach. But in this post I'll share some charts of the real world "stock" data (i.e., accumulated aggregate wealth). I'll likely share some related "flow" data (i.e., components of Gross Domestic Product as a measure of national income) in a subsequent post.

One of the principles of MMT is that the non-government sector (which includes the domestic private sector as well as the foreign sector) cannot change its own net financial assets. Only the government can, by running a deficit or a surplus. One of the key roles of a government deficit is to allow the private sector as a whole to net save (i.e., spend less than it earns). This results in an accumulation within the non-government sector of "wealth" (also referred to as balance sheet equity or net worth) in the form of government liabilities, which are a mix of treasury bonds (and notes and bills), physical currency (notes and coins), and bank deposits (matched by corresponding bank reserves). These are all just liabilities of the government with different durations and interest rates, and they never have to be paid back (though with a healthy growing economy they often shrink as a percentage of GDP). The emphasis that government liabilities are also assets is one of the most important insights of MMT, in my opinion. The primary limitation to running government deficits is inflation.

These aggregate "stocks" are illustrated in this simplified balance sheet diagram that excludes tangible assets — the government sector (combined treasury and central bank) has (as an indisputable accounting identity) negative financial net worth (i.e., when you exclude tangible assets like buildings and equipment) exactly equal to the positive financial net worth of the private sector. In this case $160 (just toy numbers for illustration) — the blue boxes labeled "equity" and "negative equity". Balance sheet equity or net worth equals assets minus liabilities. Note, this graphic leaves out the foreign sector for simplicity.

However, there are a few areas I still find myself disagreeing with MMT on (subject to change as I learn more!) and one is the treatment of equities/shares (in the stock market sense). In short, when the market bids up stock prices, owners of those stocks feel wealthier, but the corporations to which those shares are a liability do not act correspondingly poorer or reduce their propensity to invest or generate revenue in any way. I could elaborate but will leave it at that for now as that is not the focus of this post.

The charts of wealth below combine:

• Tangible assets (real estate, equipment, software, etc).
• Net government liabilities (since these are assets to the private sector and typically never have to be paid back on aggregate).
• Total valuation of publicly traded stock market (market prices of bonds and other securities may also have impacts on net perceived wealth but I have skipped those for now). [Note: Admittedly if we are only looking at net financial assets (assets minus liabilities) then perhaps we should subtract from this the total "paid in capital" liability entries across all corporate balance sheets, but aside from that data not being available in this source, from a behavioral standpoint I don't think those liabilities impact economic activity in the same way that debt liabilities do, so I'm not convinced they should be subtracted anyway.]
  

There are two totals in each graph, one including stock market valuation and one without, because as mentioned above the appropriate treatment of this seems debatable to me. You the reader can choose which total you prefer.

I don't know how directly comparable the Japanese and US data are. It is possible that the underlying accounting (for example what is included in tangible assets, how values are determined, etc) could differ substantially. But in a broad trend sense the comparisons are still interesting. One significant difference I know of is that the tangible assets data for the US only includes households, corporate non-financial business, and non-corporate business, whereas the Japanese tangible assets data includes all sectors (government and financial corporate being two large sectors that are not in the US data).

Balance Sheet Wealth in Japan (1980-2007)

(click on chart for a larger version in a new window)

Observations:

• Japan's stock market peaked (on an annual basis) in 1989 (yellow line). Its real estate bubble peaked in 1990 (red line, to which real estate and land are the largest contributors).
• Aggregate balance sheet valuation of tangible assets declined from 1990 until 2004. While this is probably due primarily to declining market prices (revaluation and/or depreciation), it's possible that quantity also changed.
• Government deficits have clearly helped stabilize nominal private sector wealth relative to what would have occurred otherwise (see the dark blue and light blue lines for totals with and without stock prices).
• Government liabilities are not particularly large as a percentage of total wealth. Of course the annual deficits that created the net liabilities would have contributed significantly to incomes, and that effect is not shown here.
  

Balance Sheet Wealth in United States (1980-2009/Q3)

(click on chart for a larger version in a new window)

Observations:

• NOTE: US tangible assets shown here does not include all sectors (see note above).
• The US had two stock market peaks (note that this is the entire public share market as captured in Flow of Funds data, not a particular index such as S&P500), first in 1999 (on an end of year basis), and second in 2007 (see yellow line).
• Tangible asset prices (red line, dominated by real estate) peaked in 2006 (on an end of year basis).
  

Balance Sheet Wealth in Japan (1980-2007) as Percent of GDP

(click on chart for a larger version in a new window)

Observations:

• Wealth relative to nominal GDP adjusts in rough terms for changes in price level (inflation), demographics, and productivity.
  
• Because Japan's GDP has partially stagnated, wealth relative to GDP does not look dramatically different to wealth in nominal terms (prior graph).

Balance Sheet Wealth in United States (1980-2009/Q3) as Percent of GDP

(click on chart for a larger version in a new window)

Observations:

• NOTE: US tangible assets shown here does not include all sectors (see note above).
• Wealth relative to GDP has slowed its fall and is in the rough vicinity of the level from before stock market and housing bubbles accelerated in the mid 1990s.
  
• I don't know whether wealth-to-GDP is mean-reverting or even meaningful over long periods of time, but if it is, perhaps this reversion is a positive sign of stabilization suggesting nominal wealth need not fall much further. Though given the likelihood of further falls in residential and commercial real estate prices (the opinion of many credible commentators), a not-so-positive alternative is that both nominal wealth and GDP could fall at the same time, still leaving their ratio semi-stable.
• Interestingly the Japanese and US stock markets both peaked at just over 200% of GDP! (Some have called the Japanese stock bubble larger, but perhaps it just rose more quickly from more undervalued levels). Yet at the end of 2007 (the latest Japanese data), Japan's stock market valuation was at 108% of GDP, and the US at 182% of GDP, and Japan's market has had the bigger fall since 2007. This suggests some potential combination of (please comment if you have insights!):
• Japanese stocks undervalued.
• US stocks overvalued.
• Japanese public companies inherently less profitable.
• Japan's market pricing in lower growth prospects.
• Japan's publicly traded companies commanding a smaller share of the economy (relative to private enterprise) than US publicly traded companies.
• US stocks still look overpriced relative to GDP, though a longer time line is needed to confirm this, and a valid justification for the higher level could be if public companies control a larger share of economic activity than in the past.
  

Year-on-Year Change in Balance Sheet Wealth in Japan (1980-2007)

(click on chart for a larger version in a new window)

Observations:

• The year on year change makes it easier to see the magnitude of the changes in the previous graphs.

Year-on-Year Change in Balance Sheet Wealth in United States (1980-2009/Q3)

(click on chart for a larger version in a new window)

Observations:

• From a wealth perspective alone, increases in US government debt (green line) have been small relative to tangible asset and stock market losses, however from an income perspective (money that actually contributes to GDP), it is very clear that government deficits have prevented (so far) a far worse outcome. (I'll include flow/income charts in a separate post).