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Friday, March 26, 2010

I'd Love To Say This Was Over

But we are still in the middle of a longer secular transition.

Two, really. One is just the demographic transition as the boomers move into their retirement years. That's an invariant.

The second transition is our spending and borrowing habits.

Click on this graph and open it in another tab or window.

Starting from the right top and moving down, the two dashed lines are the purple total household debt outstanding (CMDEBT). Under it you see demand deposits (DEMDEPSL). Demand deposits are funds in transactional accounts like checking and NOW accounts; this number does not include IRA and other retirement funds.

Generally, the banked portion of the population deposits paychecks each month in these accounts, and uses the funds to pay for purchases. Some part of the population uses debit cards to pay for purchases, and some part of the population uses credit cards, but pays the credit cards off each month. So logically, demand deposits should rise as retail spending rises. But if you look at the decade of the 90s versus the last decade, it's clear that debt rose heftily as amounts in demand deposit accounts dropped.

In other words, the transition beginning in the later 90s (after the end of the dot.com bubble) was that consumers borrowed an ever increasing amount of the funds to spend each month.

Entering the recession, that trend abruptly ended.

Now let's look at retail spending against demand deposits:

Again, click on this graph and open it in another tab or window. The orange line is demand deposits converted into millions.

The red line is nominal retail spending. The blue line is the indicator I usually use for retail spending - real retail spending.

The top two lines started changing their relationship in the later 1990s, and then came the 2001 recession (which really began in 2000) and we just kept borrowing.

And then the whole thing just blew up in our faces, and we stopped. It is obvious that we are debtloaded, because if you look at the first graph the red line is the ratio of nonaccrual loans (90 days past due) to total loans. Until that ratio falls quite a bit, debt will be a big drag on the economy. Banks are getting closer to rebuilding their reserves (note the non-borrowed reserves are moving up). But even as banks begin to tip over into a safer zone, companies and consumers will still be on thin ice.

From here on out (for several decades) I expect the consumer side of the economy to conform to a pattern of spending constricted by cash flow as modified by debt payment obligations.

There are definite characteristic of such an economy (debt-loaded and driven by consumer spending).
Increasing government spending can only help insofar as government spending delivers benefits to the lowest tier of the society while not raising government debt loads. Raising overall government debt loads very much more would increase overall taxation or inflict much higher debt servicing costs (which would increase overall taxation), which would shrink the economy.

Over the long term, such an economy relies on saving, debt writedowns or paying down debt, and increase of production for sustainable growth.

As odd as it seems, I think these are the realities that Washington hasn't yet grasped. It's hard for me to look at the demand deposits and retail sales shift and believe that Washington hasn't grasped the reality that so much of the population is obviously living, but they haven't. Perhaps this is why the tea parties are growing.

I have a horrible headache, so if this isn't clear please let me know. It is this backdrop that controls all our future public policy choices.

THANK YOU for posting this! I really, really like your blog!!

Common Cents

ps. Link Exchange??
I am surprised by the $3T jump in demand deposits, where did that come from? Where did that money come from?

Can't say enough about how well thought out your posts are. thx.

I think stock market bulls and/or our government leaders are convinced that the long-term exponential nominal retail spending trend (in red on your chart) was broken in this recession but that it can now resume its previous trend at a lower level. In other words, it is like we simply lost a few years of growth but other than that we are going to be okay.

From what you wrote here, it would seem you are not in that camp. I'm not either. Like you, I think we are teetering on the edge of deflation. Worse, I think any attempts at inflating our way out of this mess will impact the price of oil first. That's not exactly the kind of inflation that would help us.

I also think you are showing us some of the inner workings of our Rube Goldberg economy.

Hussman: Zombies and Rube Goldberg Machines

As we look at the U.S. financial system, and particularly the mortgage market, it strikes me that we've created one massive Rube Goldberg machine which is very complicated, but has the end result of obligating the U.S. public to huge bailouts, possibly without their continuing knowledge. At one end, the Fed purchases $1.5 trillion in Fannie and Freddie debt obligations. Then the Treasury guarantees those obligations. Then Fannie and Freddie begin buying back delinquent mortgages, paying off the lenders in full, and taking the losses at public expense. Next thing you know, a mousetrap snaps and a bubble gets popped.
If the Left could understand cause and effect, it wouldn't be the Left. The Left's pathology is an inability to accept the law of unintended (but often predictable) consequences. (I think Gagdad Bob wrote something to this effect recently.)

This is the exact negation of the carinal virtue of Prudence or Practical Wisdom. It is plunging into your cause without regard for the consequences; it is Recklessness raised to a false virtue.

I wonder if those who consider themselves the best informed aren't most often those who are immersed in the Mainstream Media Narrative, and therefore the most MISinformed.
M_O_M, another cog in the wheel is the "carry trade", at least according to this article. I'm not endorsing everything David Goldman (aka "Spengler") says, but in this case I think he's explained things pretty clearly.

He shows that foreign central banks are no longer the primary purchasers of U.S. Treasuries. Quote:

Remarkably, the most aggressive buyers of US government debt during the past several months have been global banks domiciled in London and the Cayman Islands. They borrow at 20 basis points (a fifth of a percentage point) and buy Treasury securities paying 1% to 3%, depending on maturity.

What I'm failing to understand is what entity is issuing loans at 0.2%--is it the Fed, or foreign central banks?

I also note that, contra his usual cock-sureness, Spengler confesses he has absolutely no idea how long this can go on. Maybe months, maybe decades. Personally, I think it depends entirely on politics, and the U.S. public's willingness to continue taking on government debt.
Oops, forgot the link:

Post-Apocalyptic Zombie Finance by Spengler
What I'm failing to understand is what entity is issuing loans at 0.2%--is it the Fed, or foreign central banks?


Here's how it works. Money is borrowed from private banks at 0.2%. The borrowing is short term. The trade dujour is treasuries. And since treasuries are money good, an enormous amount of leverage is used - a friend at a hedge fund told me 50X is not unusual.

So a hedge fund or bank trading desk that has $50 million in capital can leverage it into billions. Theoretically, there is duration risk, but it's minimal while Bernanke is willing to lend at ~ zero! When Bernanke says he will keep rates low for an extended period, it is a green light for this type of trade.

This is the one of the oldest tricks in the book to stealthily recapitalize a banking system.

So where are the private banks getting it? The Fed, foreign central banks, or deposits?

Banks don't lend money they create credit.

Low interest rates and a suspension of mark to market accounting have allowed banks to mark up their balance sheets. With "healthier" balance sheets, banks are able to extend credit. But it's not just bank credit at work here, a lot of the money comes from overnight repos - money market funds, etc.

FWIW, I have serious doubts that another reflation is possible. In an inflating market, this type of skimming operation can effectively recapitalize a banking system. A deflating market is another matter. We'll see.
As odd as it seems, I think these are the realities that Washington hasn't yet grasped.

Washington hasn't grasped it since the Civil War. They aren't ever going to grasp it.
Neil - borrow short, lend long. Take the difference. That's commercial banking in a nutshell. If you are doing this with investments of equal risk, you are going to make money. If you mismanage the risk, you can lose your shirt. And if you mismanage your rate exposure (so now you're long in poor-paying assets, and short rates are high), you lose your shirt. Banks often write loans with terms designed to minimize their rate risks.

Remember back when the Fed opened the discount window, dropped the discount rate, and begged banks to take the money? Before that, going to the discount window was considered a sign of bad management.

Another thing the Fed did back then was open up the discount window to firms that had historically not been allowed to use it. So certain financial firms that weren't banks were allowed to borrow. That was under the "emergency credit" rubric. Fed Discount window.
Anon - the jump in deposits came from a lot of sources. Some of it was from people getting worried and building cash, which of course implied spending less.

Apparently a lot of it stemmed from defaulting loans. There is nothing like not paying your mortgage for six months to build up your cash in hand.

Generally the worry factor as recessions take hold causes deposits to jump, but then they decline again at the end of the recession.

Certain categories of deposits frequently decline quite rapidly at the beginning of recovery, because people have pent-up demand for goods, and the people who were hit hard take a while to rebound.

But this time seems different, and it seems to be related to our credit situation.
I understand how the leverage is happening, I just wasn't sure where the banks were getting the increase in reserves against which to create credit. So the answer is the Fed discount window? That makes perfect sense.
Angry saver- at times the leverage can be much higher than 50:1.

I unwound my carry trade this week. There's a little punch left in the bowl. I've had my fill.
Which leaves us with an interesting situation, CF.

Because I think a great many people are unwinding. It is particularly notable that oil prices seem to rise with the dollar changes.

It seems to me that we have quite a pattern developing.

What happens when the balloon falls to earth?
Charles - I think Washington hasn't confronted the realities of borrowing.

The Fed pretty much has to stop pumping. Anyone watching treasury yields is thinking rather seriously right now.
Consumer Metrics Institute
Home clearly supports your data..

"The two weakest sectors the Institute monitors have recently been Housing and Retail. The Housing Index continued to bump along with a double-digit year-over-year shrinkage in consumer demand, with the Home Loans Sub-Index having shrunk to the lowest level recorded since September 2008. And by March 21st the Retail Index had returned to levels indicative of a greater than 6% year-over-year decrease in consumer demand. This number is substantially different from the self reported sales figures from the retail industry, which suffer from ’survivor bias’ as a consequence of focusing on ’same store sales in stores open at least a year’. The closing of select stores or entire chains are simply unreported, while the traffic shifted to remaining stores generates a positive spin. The substantially more negative numbers reported by the Consumer Metrics Institute, however, have been matching sales tax collections, which have no survivor bias."

"March 21, 2010 - The 2010 Contraction Traces Unique Pattern:
As expected, the bottoming pattern previously seen in our daily 'Consumer Metrics Institute Contraction Watch' chart (below left) has at least flattened out, and it may have begun to show signs of reversing. Unless the 'demand' side of the consumer economy picks up substantially over the next few weeks the blue line on the graph will drift laterally to the right. If it continues to move in that direction it will be tracing a shape unlike either the mild 2006 (green) or the catastrophic 2008 (red) contractions, indicating instead a relatively shallow but persistent contraction consistent with the oxymoronic 'jobless recovery' that nearly everyone expects. Should the blue line remain in negative territory for the full quarter shown in the chart we will have moved into 'double dip' recession in the 'demand' side of the economy.

Another early measure of the 'double dip' possibility is shown in our 'Consumer Metrics Institute Trailing Two Quarters Growth Index Over Past 60 Days' chart (on the right below). This chart measures the average growth reflected in our 'Weighted Composite Index' over the preceding rolling 183 day period, which corresponds to the 'two consecutive quarters' time span used in classical definitions of a recession. That 183-Day Growth Index slipped into net contraction on March 19th, 2010. Although the 183-Day Growth Index is a very aggressive and preliminary indicator for a recession, it is at least a sign that the much touted 'recovery' is not currently driven by enthusiastic consumers. We have always felt that consumers are not idiots and they understand what they see going on around them; they are unlikely to start another spending spree until the 'jobless' part of the 'jobless recovery' clearly begins to subside."

MOM, Could the buildup in demand deposits also have come from people selling their stocks and bonds and going to cash?

I have been in nearly 80% cash at times since 6/08. It's my understanding that there is still a huge amount of cash on the sidelines. If ever we get some fiscal sanity and pro-business policies in D.C. the market could explode. If we get a large conservative gain in Congress in November, I expect a huge rally. It willl be 2012 before we can expect some real pro-business policies though.
Personally, I'm figuring the market is a 50/50 bet if the Republicans gain in November. Many of their likely actions are probably deflationary in the short term, even if they lead to higher growth rates in the medium term.
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