December 10, 2013

Q3: 2013 Flow-of-Funds Report – ‘Tis the Season to Be Jolly

I know that being a Debbie Downer gets more face time on cable news, but after looking at the Fed’s latest Financial Accounts of the U.S. report, formerly known as the Flow-of-Funds report, I cannot contain my optimism about the economy’s prospects in the New Year. First and foremost, the report shows that combined Fed and depository institution credit creation is not only accelerating, but is growing at a relatively high rate. Secondly, household balance sheets continue to improve, which implies that depository institutions will be more favorably disposed to lend in 2014. Thirdly, part of improvement to household balance sheets is related to the upward trend in the value of residential real estate. Fourthly, the reduction in federal government spending/borrowing is resulting in “crowding in” of spending/borrowing by other sectors. Thus, the wringing of hands and the gnashing of teeth by unreconstructed Keynesians (i.e., The Consensus) over the deleterious effect of budget sequestration on the pace of economic activity is not occurring. And lastly, federal government borrowing relative to the size of the economy is less than its post-WWII median value.

Okay, let’s go to the charts. Plotted in Chart 1 are the year-over-year percent changes of quarterly observations of the sum of Fed and depository institution credit and nominal Gross Domestic Purchases. Fed credit is defined here as the Fed’s holdings of securities obtained by outright purchases as well as repurchase agreements. The sum of Fed and depository institution credit is advanced by one quarter because the historical relationship between the two series suggests that changes in this particular credit aggregate lead changes in nominal Gross Domestic Purchases. Notice that year-over-year growth in the sum of Fed and depository institution credit has been accelerating since Q4:2012, which is when the Fed’s third round of quantitative easing (QE) commenced. Year-over-year growth in this credit sum reached 8.7% in Q3:2013, the highest since Q2:2006. The median year-over-year growth in this credit sum from Q1:1953 through Q3:2013 is 7.2%. The recent relatively rapid growth in this credit sum suggests that growth in nominal domestic spending will be gaining strength over the next couple of quarters.

Chart 1

Chart 2 shows that the growth acceleration in the sum of Fed and depository institution credit starting in Q4:2012 was due to Fed QE actions. Growth in depository institution credit alone has been decelerating. But with the Fed expected to start “tapering” the quantity of securities it purchases by the end of Q1:2014, won’t the sum of Fed and depository institution start to decelerate then with negative implications for the growth in nominal domestic spending? Not if growth in depository institution credit picks up. Chart 3 shows that starting in this past October and continuing through November, growth in commercial bank credit, the principal component of depository institution credit, has been accelerating. In the eight weeks ended November 27, bank credit increased by almost $58 billion. If this pace of bank credit increase were maintained, it would more than compensate for the anticipated decline in Fed securities purchases early in 2014.

Chart 2

Chart 3

 Which brings us to the balance sheet for households. Plotted in Chart 4 are quarterly observations of total liabilities of households and nonprofit organizations as a percent of their total assets. This ratio reached a post-WWII record high of 20.2% in Q1:2009. As of Q3:2013, this ratio had declined 520 basis points to 15.0%, the lowest since Q2:2001. This sharp decline in household leverage in combination with the sharp decline in the debt burden of households (see Chart 5) should make households appear more creditworthy in the eyes of depository-institution lenders.

Chart 4

Chart 5

 An improving residential real estate market has played an important role in the improvement of household balance sheets. Chart 6 shows the leverage of owner-occupied residential real estate. After reaching a post-WWII record high of 63.5% in Q1:2009, leverage has fallen to 49.2% in Q3:2013, the lowest since Q2:2007. The rise in the value of residential real estate in the past two years and the absolute decline in mortgage debt following the bursting of the housing bubble are responsible for the leverage decline in owner-occupied residential real estate. Again, this improves the creditworthiness of households. The rise in residential real estate values also reduces mortgage loan write-offs by depository institutions, which should increase their willingness to put new loans on their books.

Chart 6

Speaking of residential real estate, it still looks attractive as an investment, but not as attractive because of the increase in its value and the rise in mortgage rates. Plotted in Chart 7 are quarterly observations of the imputed yield on owner-occupied housing, the effective mortgage interest rate and the differential between the two. The imputed yield on housing is calculated by dividing the Commerce Department’s estimate of the nominal dollar value of imputed shelter services produced by owner-occupied houses by the Fed’s estimate of the market value of residential real estate (then multiplied by 100 to put the ratio into percentage terms). If the imputed yield on housing is higher than the mortgage rate, then one can purchase an asset that currently is yielding more than the cost of financing it. From Q1:1973 through Q3:2008, there has been only one instance in which the imputed yield on housing was above the mortgage rate – in Q2:2003, when the differential was a mere 0.04 percentage points. But after the bursting of the housing bubble, the market value of residential real estate plummeted, boosting the imputed yield on housing. The rise in the imputed yield on housing in combination with the plunge in mortgage rates brought the differential into positive territory starting in Q4:2008, where it has remained through Q3:2013. This positive differential, after having reached its zenith of 3.7 percentage points in Q4:2012, has drifted down to 2.3 percentage points in Q3:2013. At first blush, the narrowing in the positive differential between the imputed yield on housing and the mortgage rate might suggest that the pace of the current expansion in residential real estate would moderate in 2014. But if depository institutions “loosen” their mortgage qualification terms due to the improved balance sheets of households, then “effective” demand for owner-occupied housing could increase.

Chart 7

Remember how the sequestration-induced federal government expenditure cuts and the increase in the marginal tax rate for upper-income households were going restrain nominal total spending in the economy? Well, they didn’t because of “crowding in”. The reduction in federal government spending in recent years along with increased tax revenues has reduced federal government deficits. Those entities that had planned to lend to the Treasury had its deficits been larger, now have some excess funds on their hands. They can either lend to some other entity that will spend – a household, a business, a state or local government, a furiner – and/or they can spend these funds themselves. Either way, the decrease in spending caused by the decline in federal government expenditures and the increase in taxes is offset by increases in other nonfederal government spending. So, as the federal government borrows less, other nonfinancial entities save less, i.e., spend more. This is what is meant by the term “crowding in”. “Crowding out” is the opposite – the government borrows more, other nonfinancial entities save more, i.e., spend less.

This is shown in Chart 8. Notice that as federal government net borrowing decreased precipitously in the second and third quarters of 2013, net lending by the remaining entities in the nonfinancial sectors also fell precipitously. Conversely, as federal borrowing surged in 2009, in part due to the fiscal stimulus, nonfinancial sector net lending also surged. This is an example of “crowding out”. In analyzing the macroeconomic effects of changes in fiscal policy, it is a good idea to “follow the money”. The funds have to come from somewhere to finance an increase in government expenditures and/or a decrease in taxes. Unless there is a net increase credit created by the Fed and the depository institution system, i.e., unless there is a net increase in thin-air credit, it is likely that the funds will come from the nonfinancial sector, which means that the stimulus to demand emanating from the government sector will crowd out spending that otherwise would have emanated from other nonfinancial sectors. And when government spending is cut and/or taxes increased, the fiscal drag on spending emanating from the government sector will crowd in spending from other nonfinancial sectors. Think of the extra money that otherwise would have gone to purchase government bonds “burning a hole” in the pockets of the otherwise lenders.

Chart 8

Lastly, for all you fiscal hawks out there, Chart 9 should make you jolly. Plotted in Chart 9 are quarterly observations of seasonally adjusted at annual rates (SAAR) net lending / net borrowing by the federal government (obtained from the Fed’s Financial Accounts report) as a percent of SAAR nominal GDP. The median percentage from Q1:1953 through Q3:2013 is minus 3.2%. In the second and third quarters of 2013, this ratio was minus 1.3% and minus 1.9%, respectively. With some help from the Fed in getting thin-air credit back up to a more normal post-WII growth rate in order to stimulate nominal GDP, some restraint in federal government spending along with some tax increases and voilá! the federal government deficit relative to the size of the US economy looks quite reasonable in an historic context.

Chart 9

I hope to send out my airing-of-grievances Festivus letter next week. I have a lot of problems with you people!

Paul L. Kasriel
Econtrarian, LLC
econtrarian@gmail.com
http://www.the-econtrarian.blogspot.com
1 920 818 0236

Category: Economy, Think Tank

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

8 Responses to “Flow-of-Funds Report – ‘Tis the Season to Be Jolly”

  1. DeDude says:

    “the reduction in federal government spending/borrowing is resulting in “crowding in” of spending/borrowing”

    Except for the fact that there is no evidence whatsoever of this “crowding in” effect it sounds good if you like the right wing narrative. Evidence is actually to the contrary. Huge sums of money are sitting idle on the sidelines waiting for consumption (government or private) to increase.

    “The recent relatively rapid growth in this credit sum suggests that growth in nominal domestic spending will be gaining strength over the next couple of quarters.”

    No the sepaeration between the line and the bars in chart 1 is exactly what you expect when the Fed is engaged in QE (money printing). The normal coupling between these two parameters have been cancelled when the credit is expanded without regards to credit needs and consumer spending. They are pushing on a string and – Surprise – not moving much of anything.

    “Those entities that had planned to lend to the Treasury had its deficits been larger, now have some excess funds on their hands. They can either lend to some other entity that will spend – a household, a business, a state or local government, a furiner – and/or they can spend these funds themselves. Either way, the decrease in spending caused by the decline in federal government expenditures and the increase in taxes is offset by increases in other nonfederal government spending.”

    Sorry you are living in lalaland. There are not enough credit worthy entities to lend the money to to actually make up for the lack of federal government spending – and the pension funds and insurance companies cannot “spend these funds themselves”. Yes the private sector has picked up nicely but not enough to compensate fully for the austerity in the public sector. That is why we have an economy operating way below capacity with 7% unemployment and huge sums of capital as “cash on the sidelines” or pumped into Wall Street’s “buble of the day”.

    “So, as the federal government borrows less, other nonfinancial entities save less, i.e., spend more”

    Dead wrong. The 70% of our economy that is consumer spending does not organize itself according to how much government is spending. When is the last time you heard someone say: “ well since the government is not spending money I will go out and buy a new car”. Consumers will spend when they feel good about their current finances and future prospects for their income. After a slow and steady recovery with house values and unemployment moving in the right direction, many employed house owning consumers are feeling better and, therefore, are letting lose with the spending they have been holding back on. That has produced the expected push (and overshooting) in consumption. Exactly where we land after that buble of “pent up” consumption need is over – that will depend on raises in income for the consumer class.

    “Conversely, as federal borrowing surged in 2009, in part due to the fiscal stimulus, nonfinancial sector net lending also surged. This is an example of “crowding out”

    You have got to be f’ing kidding us!!! Crowding out when rates are falling to zero? I guess the possibility that nobody had any investment needs in a tanked economy never crossed your mind since it would have crossed out the narrative you are so addicted to.

    • RW says:

      Exactly so: The article began with the wrong priors and ended up where one would expect; GIGO.

    • Frilton Miedman says:

      It’s also worth noting, in his rush to point out that lending has picked up, he forgot to pair the household debt service ratio side by side with household debt to income and the fact that real wages are not improving.

      We’re 70% more in debt relative to income in 1980, but paying the same ratio only because rates are ridiculously low.

      Granted, he incorporated mortgage debt, but that only tells a part of the story, household debt is still 70% more than it was the last time household debt service ratio was this low, in 1980.

      With excess reserves at sickeningly scary highs, never seen in history, if those reserves start being lent, even a little too rapidly, we risk inflation, to wit rates go up, full circle we go back to household debt service ratios being so low only because rates are so low.

      Once this wash-rinse-repeat cycle of credit use to avoid any and all Keynesian acknowledgement is complete, he may have to listen to a few “teeth gnashing Keynesian” say “I told you so”.

      In the meantime, sure, it’s nice to see lending resume, but in the end, you need the revenues & income to pay for it, another repeat of 2001 – 2007 is all we get without improvements in median income & net worth.

      I can’t see how there won’t be a Newtonian equal and opposite reaction to all that pent liquidity, but maybe I’m hanging out with “teeth gnashing” Keynesians too much.

  2. Keith R says:

    DD,

    Thank you for posting your thoughts as they helped me think through some issues. IMHO Mr Kasriel’s analysis does not engage deeply enough into how Fed stimulus has impacted normal economic metrics and their inter-relationships. From my perspective we are walking through economic terra incognita, and I struggle to understand which direction to go.

    • RW says:

      Kasriel is a good economist but he seems to be relying on a model for economy functioning closer to potential and full employment rather than one that is still at the zero boundary, below potential with higher unemployment; e.g., “crowding out” does not exist in the latter.

      The current perverse penchant among governments for austerity rather than fiscal expansion leaves central banks with little choice but to try to support the economy on their own (not very effective in a zero-interest rate environment but the alternative is deflation and collapse). It’s terra incognita in that sense for sure since, during the Great Depression, there was lots of fiscal expansion from government. The only example we have close to what is going on now is the past two decades in Japan.

      But the market feeds on liquidity and it is still getting that so on we go and when it stops nobody knows.

      • RW says:

        NB: At the zero interest rate boundary, below economic potential with higher unemployment, crowding out cannot exist unless the central bank is tightening and doing so rather strongly (something no central banker in the right senses would do under current circumstances).

      • DeDude says:

        You are right. Unfortunately it is quite common for people to think that the rules and correlations remain the same under all economic conditions. People forget the mechanisms and assumptions associated with all these rules of thumb – so they don’t seem to get it when the rules change. Screaming for more investments in a demand constrained economy, or warning about inflationary effects of money printing when the velocity of money is dropping like a rock.

      • Frilton Miedman says:

        RW, absolutely spot on about monetary policy placating fiscal idiocy.

        Fed policy is reactionary to the extreme it’s needed, even Bernanke has tried to appeal to DC on this point repeatedly, and Bernanke is a Friedman/Libertarian school monetarist.

        For him to openly admit monetary policy alone isn’t the solution is a far bigger deal than most realize.

        The new surge in lending is concerning,combined with a lack of growth in jobs, wages and median net worth while household debt is still so high.