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The end of deleveraging is approaching




On Friday the Fed released its estimate of households' financial burdens as of March 31, 2012. "Financial burdens" are calculated by comparing debt service payments and total financial obligations to disposable income. This is very different from the number bandied about in the press these days, which compares total debt to income and implies 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) 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 March showed a very modest reduction in financial burdens that was effectively offset by some modest upward revisions to prior data. Nevertheless, the story remains the same: financial burdens have declined significantly in the past 5 years because a) households have paid down debt, b) households have defaulted on their debt, c) households have refinanced and taken on new debt with much lower interest rates, and d) household disposable income has risen. 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.

It is also worth noting that a significant amount of deleveraging has effectively occurred even as the economy has managed to grow. 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 a little slow in responding in late 2008, but they more than made up for that mistake by engaging in two unprecedented quantitative easing programs which have resulted in the creation of $1.5 trillion of excess bank reserves. 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. The problem with deleveraging arises when the supply of money fails to meet the demand for money, because that creates an effective shortage of money, and that in turn leads to deflation, which can trigger a recession. We saw that briefly in late 2008, when inflation expectations collapsed, as illustrated in the chart below


In any event, households' aggregate debt and financial burdens are now about as low as they have been for the past three decades. That amounts to some considerable adjustments, and I would argue that these adjustments have set the stage for some big changes in the years to come. For example, if confidence in the future increases, households' risk aversion is likely to decline, and the demand for money is likely to decline as well. There are trillions of dollars in savings deposits that households could decide to spend. Banks' desire to sit on $1.5 trillion of excess reserves could decline, and that would mean a huge increase in banks' ability to generate new loans and expand the money supply. If the Fed fails to respond to these changes by reversing QE, this could result in an excess of money in the system, and that could fuel a significant rise in the general price level.

In short, the next several years could be very different from the past several years. The deleveraging story has largely played out; what awaits us now is a releveraging.

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