Deleveraging, Deceleration and the Double Dip
on October 19th, 2010 at 10:24 am
Much optimism flowed from last week’s declaration by the National Bureau of Economic Research that the US recession officially ended in June 2009. How nice of them to let us know.
Markets reacted warmly and the 8 per cent rally in US stocks through September seemed more important than the revelation that the US Fed is worried enough about deflation to be planning another round of quantitative easing – dubbed ‘QE 2′.
I wish I could share the market’s (and the NBER’s) irrational exuberance, but the key indicator that explains where the US economy and its already disastrous employment situation is headed implies that even QE2 won’t set the US on a course to renewed prosperity.
It’s also important to note that the ‘strong’ Q2 US earnings figures seen in July are partly the result of dramatic cost-cutting in US firms – a nice way of saying mass lay-offs. Nonetheless the stronger bottom lines keep producing market exuberance, even if the factors behind those bottom lines will lead to future deflation rather than a boom. As Forbes writer Joshua Brown puts it “there is an effervescence in the air as we head into the Q3 reporting period (starting October 7)”. He thinks the market will once again turn south, and based on that pesky fundamental called the real economy, it should.
So should it on the basis of the key indicator that explains the origins of the apparent stabilisation that led the NBER to declare that the recession was over in June 2009.
For a long time I’ve focused on the contribution that the change in debt makes to aggregate demand, in the relation that “aggregate demand equals the sum of GDP plus the change in debt”. An obvious extension of that was that “change in aggregate demand equals change in GDP plus acceleration in the level of debt”—which would imply that change in unemployment is driven by changes in the rate of growth of debt.
Though I was aware of this implication of my analysis, I held off from testing it because I was concerned that this was pushing the data one step too far.
A physical system with a similar relationship between velocity (the rate of change of one variable) and acceleration (whether the velocity of another variable is increasing or decreasing) would generate a large volume of sufficiently detailed data that the relationship could be empirically tested.
But the economic system, with the large time lags in data collection, survey methods rather than direct measurement, and the dodgy practices statisticians are forced into by politicians and economic bureaucrats who often don’t want raw information to be available? I just thought that the relationship, even though it made sense, wouldn’t be discernible from published statistics. So I held off.
It turns out that I shouldn’t have been so cautious: the data well and truly supports this, on the surface, weird causal relation: the change in employment is strongly affected by the acceleration or deceleration of debt. This can give the paradoxical result that the level of employment can rise, even when the economy is deleveraging, if the rate of deleveraging slows. This phenomenon has driven the apparent stabilisation of the US unemployment rate (though of course the more meaningful U-6 measure has risen to 17 percent, and Shadowstats puts the actual unemployment level at 22.5 percent–well and truly in Depression territory), and it is highly unlikely that it will last.
My uncharacteristic timidity means that I have to doff my cap in the direction of the three economists who first published on this topic: Biggs, Mayer and Pick. They first showed the correlation between what they called “the credit impulse”—the rate of change of the rate of change of debt, divided by GDP—and both GDP and employment (for those who have access to research from Deutsche Securities, they have a simpler explanation of their analysis in Global Macro Issues for December 17 2009: “The myth of the credit-less recovery”).
The chart below shows my confirmation of the relationship with the data on the annual change in unemployment in the USA and the annual rate of acceleration of private debt since 1955. The correlation is -0.67: a staggering correlation of a first and a second order variable over such a period, and across both booms and busts.
The two dotted red lines labelled “S” and “E” show when the NBER thinks this recession started and ended, and they neatly coincide with turning points in the credit impulse—an indicator that the NBER is not even aware of, let alone one that it considers when attempting to date recessions.
Superficially, one might think that since the credit impulse does indicate when unemployment is going to rise or fall, then the current data implies that the recession is indeed over—even if the NBER doesn’t understand the actual causal dynamics at play.
But the chart also shows that there has never been a turndown in credit like this one—the peak rate of deceleration of debt was over 25 percent, versus a mere minus 6 percent in the deep recession of the 1970s. And though the rate of acceleration of debt has the most direct impact on employment, ultimately all three factors—the level of debt (compared to GDP), its rate of change, and whether that rate of change is increasing or decreasing—must be taken into account.
It’s complicated, so an analogy with driving makes it easier to comprehend.
Consider a drive from Los Angeles to some destination East (if you’re an Australian reader, consider a drive West from Sydney), where the drive out represents increasing debt, and the drive back home represents falling debt.
The level of debt compared to GDP is like the distance to be travelled, and today the US has a lot further to travel than it did in the 1950s: 5 times as far, in fact. It’s like the difference between a drive to New York and back, versus a return trip to Utah.
The rate of change of debt (with respect to GDP) is like your speed of travel—the faster you drive, the sooner you’ll get there—but there’s a twist. On the way up, increasing debt makes the journey more pleasant—the additional spending increases aggregate demand—and this experience is what fooled neoclassical economists (who ignore the role of debt) into believing in “the Great Moderation”. But it increases the distance you have to travel when you want to reduce debt, which is what the USA is now doing. So it’s great when you’re driving from LA East (increasing debt), but lousy when you want to head home again (and reduce debt).
With that far to travel back home, you might be tempted to accelerate—which is akin to increasing the rate of change of the rate of change of debt (it’s a measure of the g-forces, so to speak, when they can be generated by either rapid acceleration or rapid deceleration). Acceleration in the debt level when it was rising again felt great on the way out: booms in the Ponzi Economy the US has become were driven by accelerations in the rate of growth of debt. Equally, acceleration in the opposite direction feels dreadful: as the rate of decline of debt increases, aggregate demand collapses and unemployment explodes.
What actually feels better in the reverse direction is deceleration—reducing the rate at which debt is falling—and that’s what’s been happening in the last year.
But here’s the problem: too much deceleration and you actually reverse direction: you start heading East again, rather than returning home. That wouldn’t be a problem if all you’d done was drive to Utah, but instead you’ve hit New York instead: drive any further, and you’re in the Atlantic.
With the level of debt the USA has accumulated, the prospect that any sector of it (apart from the government) can be enticed to go back into accumulating debt once again is remote. So the deceleration in the rate of reduction of debt that is occurring right now will ultimately give way to at best a constant rate of decline of debt, and at worst another acceleration—and the dreaded “double dip”.
These next two quarterly charts emphasise the dilemma: the stabilization in employment has occurred because the rate of deleveraging has slowed, which registers as a positive in the “rate of change of the rate of change”:
But the rate of change of debt is still negative: it’s just risen from a low of -6% to -2%. For the deceleration effect to continue, the US debt car would need to stop its return drive from New York to LA, and head back towards New York once more: the level of debt relative to GDP would need to rise.
This is highly unlikely when all sectors of the American economy bar one (non-financial business) are already carrying more debt than they were in the depths of the Great Depression, when the debt ratio had been driven higher by deflation.
So the deceleration in deleveraging should give way again at some point, and then the NBER may be forced to begin dating the next recession—which is still a continuation of the current Depression.
aangl / steve
Thanks for your references and replies. I clearly have more reading to do on this topic.
ak
“One of the reasons the Chinese system delivers stable growth is that they did not outsource their macroeconomic policy to “free markets””
—
ak, im sorry but i have to disagree on this point. Remember China GDP per capital is very low, so their so called “great economic performance” is a growth number coming off a very low base.
In short, the Chinese economy is simply snapping back like an elastic band which has been held behind for too long. The growth looks great, but the absolute wealth per GDP is a disgrace and reflcts their poor policies of the past.
The reality is innovation and productivity improvements contribute to real growth in output. After decades of being held back by maoist dogma and “culteral revolution”, China is simply copying all of the productivity and innovation improvemtns from The West. Without the West leading the way on these improvements in the 70′s 80′s and 90′s, China would have nothing to copy.
So in fact today the Chinese economy is an INDIRECT BENEFICIARY of the free markets. The rest is just politics.
Thanks bb (145)
So “loans creates deposits” only relates to the abilty of the banks to create new credit, constrained by capital constraints and by funding constraints.
As you say transactions between customers of the one bank doesn’t require raising funds only needs book entries. So the funding question only comes in when it comes time to for the banks to honour commitments to these newly created deposits when payments between banks are being made.
And for this, the funding relates to raising base money from the overnight market or the RBA short term, and amalgamation of this for the long term.
I take it then, if a bank was growing their mortgage book faster than other banks, they’d have greater funding requirements. But if all banks were growing their books in dollar terms fairly equally then the long term funding requirements would be minimised, being supported mostly by overnight and short term funding (most transactions being netted off)?
Following from the above, a consequence of the takeover of St George by Westpac would have been to increase the “within the bank” transactions and reduce the need for funding “between the banks” transactions.
So the banks can support a large volume of transactions on a lower volume of funding but rely on that funding to be readily available, which is where the state of the market and the central bank comes in.
In times of stress, when funding becomes difficult then that may slow new lending until banks can be confident of raising the consequent funding at profitable rates and sufficient amount.
I’m still hazy on the aspects of where Aussie banks are funding mortgages from overseas – what are the interest rate and currency effects?. Does the RBA step in and purchase FX to support this? I know the banks mostly hedge their risks but not sure if it is for exchange risks or interest rate risks or both.
Andre, thank you for the excellent analysis. I would point out, however, that a barrel of oil has an economic utility greater than its energy value and therefore a rise in the price will indeed be sufficient to ensure the rise of alternative sources of liquid-fuelled transport.
Likewise, “stronger than steel” building products will soon become available, we will just have to pay full price.
BB, you’re welcome.
However, if I might add, you are at the very beginning of this journey. If you keep researching you will discover that there is no alternative liquid fuel source or combination of liquid fuel sources that can be ramped up in time as conventional liquid oil declines. Ethonal is a net-energy failure; the cellulose required by cellulosic ethanol (if the process is ever perfected) is too diffuse and would require too many plants to be built to be worth it (so that the cellulose doesn’t have to travel far to get to the plant, otherwise the process won’t be net energy positive); coal-to-liquids can help if we don’t mind sending even more CO2 into the atmosphere and are willing to spend $6.5 billion for just 80,000 barrels per day plants; gas to liquids is another possibility but it too is atrociously expensive when capital is getting scarce and so on.
We are headed for global contraction as oil declines and there is nothing that can stop that now. If we had started mitigation 30 years ago perhaps we would have had a chance. But it is folly to think we can build out the infrastructure for the next energy source while the current one (oil) is declining. Our economy will be in shambles very soon from both the debt deflation that Prof. Keen has foreseen so well as well as declining energy availability.
I recommend reading the U.S. Department of Energy Report PEAKING OF WORLD OIL PRODUCTION: IMPACTS, MITIGATION, & RISK MANAGEMENT and the leaked German military report to get as sense of just how late in the game we are.
BH,
Bofore the exchange rate was floated the Reserve would give a bank $AUD for its nett $USD position [for example] at the official rate. The issue was that this injected and withdrew liquidity into the Australian system.
Today a bank would just take the $USD it borrowed and sell it in the market for $AUD.
Of course there are plenty of people willing to organise all this – for a fee.
The daily turnover in FOREX is in the trillions. The daily turnover in Equities is in the billions. Something of that very broad comparitive scale.
BH
“I’m still hazy on the aspects of where Aussie banks are funding mortgages from overseas – what are the interest rate and currency effects?”
It comes from my point (3). Because Australia has a current account (trade) deficit, we automtically have a capital account surplus.
The capital account is simply the other side of a trade deficit. When an Aussie decides to Buy a Honda from Japan, they sell A$ and buy Yen. The other side of the FX trade has someone selling Yen and Buying A$. So $A (created by the banks) never leave the system – they just end up in foreign hands.
Therefore the A$ eventually goes back into one of the Australian Banks. This is generally viewed as offshore funding. As to whether it directly funds the banks mortgage book is a moot point. The fact is, when someone owns an A$, they have to put it in the Aussie financial system (there are very few bank notes left to put under the pillow).
So the offshore funding issue is really a FX issue. If the Aussie banks start to fail, the result will be lack of demand for the $A – supply of $A is unchnaged because the same number of people want their Honda. The result is an $A collapse.
There is an automatic stabiliser here…If the CBA needs A$10bn to fund itself, then it needs to find almost US$10bn. If the currency falls to 0.25, then the CBA only needs to find US$2.5bn. So a drop in the currency can releive the funding pressure on a bank.
This is what happened during the Asian currency crisis – it was actually a bank fuding crisis which morphed into a currency collapse.
bb #163
In part I agree…
The ‘credit creates deposits’ mechanism, as an internal debt/asset/deposit system is probably close to unlimited in how high it can go (ratcheting down interest rates to keep debtors current).
When the exponential deposits leak ‘off-shore’ to purchase goods & services in an unbalanced trade amount… i.e. a ‘trade deficit’ then we increase ‘foreign currency debt’
The higher the interest rate to restrain the ‘credit creates deposits’ exponential credit/asset/inflation spiral, the more attractive the currency is as a carry trade.
This has a limit for foreign funding at the banking sector, which will be the pledgable net foreign income of the national export sector…
Australian net foreign debt is @ $670 billion
Australian ASX Resource Companies Market Capitalisation at p/e 18 (which is a 5.5% after tax yield) is $570 billion.
A flinch from China and the AUD is trash.
We spent the miracle of ‘credit creates deposits’ to the tune of the entire market cap of the entire ASX mining sector.
To top it off @ $48 billion net credit was created during the past year. Plus $82 Billion for housing and minus $48 billion for business, the government helped out with plus $48 billion. The entire net credit created, was all foreign debt.
This is the way I think of it:
All sorts of folks from all sorts of places hold all sorts of numbers in bank acccounts in all sorts of currency deonominations.
The common link is that those numbers have to be able to pass through the Reserve Banks clearing systems to actually buy stuff in Australia.
When the denomination is not $AUD it has to pass through a step to convert it to $AUD that the Reserve Banks clearing systems will also accept.
A bank cannot just type numbers into peoples accounts willy nilly.
It has to get into an account via a loan, or as a result of a previous loan. [Or from the Reserve putting it there - I mean it runs the system (e'g the $900 handouts that started appearing in banl accounts in the GFC)].
And that loan has to jump the interest rate hurdle.
And the Reserve controls rates.
This one has some interesting data:
Australia’s foreign debt—data and trends
http://www.aph.gov.au/Library/pubs/rp/2008-09/09rp30.pdf
Dear aangel, there is light at the end of every tunnel. Whilst peak oil is being played out, other advances will be made and progress will out-strip regression.
SJ, I think Jesus was murdered because CoffinMan1 could not understand his message. If you can get a copy of the Bible and read it you will find that all the messages are schizophrenic until you hear what Jesus had to say. Many Christians have still not fully contemplated the message of Christ.
Although I do not believe in miracles, I consider myself to be a disciple of not only Christ, but of Ghandi and the Dalai Lama as well.
This did not come naturally to me. My soul was saved 9 years ago by a species or a god that I do not know but that thought I was worth saving and told me that I must make the effort to do likewise for all other humans.
It is a frustrating exercise but I try. I think Jesus would be telling everybody to take a chill pill so as not to make matters worse.
“I’m still hazy on the aspects of where Aussie banks are funding mortgages from overseas – what are the interest rate and currency effects?.”
BH,
Up till 2007 Australia was 2nd only to the US in RMBS {Residential Mortgage Backed Securities) thankfully very little of that was sub-prime.
However the GFC had a major effect in Australia, as it had on the rest of the world, and securitisation has dropped considerably since then.
An interesting address by Dr Guy Debelle, Assistant Governor (Financial Markets) RBA on securitisation here.
btbtb,
lol “I think Jesus would be telling everybody to take a chill pill” I think you might have had a few too many of those pills man!!
BullturnedBearturnedBull @ 166:
“There is light at the end of every tunnel. Whilst peak oil is being played out, other advances will be made and progress will out-strip regression.”
That is purely a statement of faith. As aangel has shown it
is highly unlikely that we will replace rapidly declining oil production with any form of renewable energy.
Look at the attached graph. People don’t appreciate what a tiny percent wind and solar energy represent.
There is absolutely no reason why Olduvai Theory won’t come to pass: http://dieoff.org/page125.htm
Warners v Elders Finance is off course an old precedent in Australian law dealing with the legaility of the “mere book entry” including in the light of the notion of capitol adequacy:
http://www.austlii.edu.au/cgi-bin/sinodisp/au/cases/cth/FCA/1993/117.html
bb, jason, peter_w, burrah,
Thanks for the responses and the links. It seems that I’ve been hazy with the word “funding” thinking initially that funding a mortgage would be to obtain the funds to finance it for the term of the mortgage whereas perhaps it is more that the funds are only required in order to make good any withdrawals of deposit (created by the mortgage) which is obviously a short term thing. Seems reasonable?
Understanding the dynamics of this stuff is not simple.
Regarding the overseas “funding” that banks seem to have such need of. Perhaps it refers more not to availability of funds but of price of funds. That is, it is a profitability question – the banks are in “need” of maintaining margins. Perhaps, the banks are sourcing cheap fund from OS because getting a good margin locally has issues..
Anecdotally I’ve heard retirees OS are looking to Oz to get some return on their money – something to live off. Australia having appeared to weather the GFC storm is looking relatively safe with decent yields to these investors. Add the rising currency – we might yet have an Aussie Bubble.
I’ve come to the conclusion, that the problem of how bank borrowing from OS affects the local system ends up in the RBA’s lap. It’ll play around with forex swaps, etc to maintain its main target – rates.
Burrah, was interesting looking at the effect of the GFC’s effect on securitisation and the RBA’s balance sheet. To my untrained eyes, for the year to June 2008 it looked like “Other Securities” was driving the RBA’s balance sheet growth until it wasn’t. In June 2008 “Other Securities” comprised 52.8% of the RBA balance sheet, by September 2010 that has become 31.6%.
BB, as cyrusp points out, that we will be able to maintain this sort of civilization as we contend with the various converging natural resource crises hitting us is a statement of faith. Although it has good evidence for it (the last several hundred years it has been true), the evidence was created during the ascent of the fossil fuel bubble we currently are in. A world of declining fossil fuels will be very different indeed.
I encourage you to set aside your faith for a moment and actually prove for yourself that civilizational contraction will not occur as oil declines. I believe you will find that it is impossible to do. Read the leaked Germain military report, as well. You will quickly see that your faith is misplaced.
The only open question is how much we contract before we reach a “stable” level of population and economic activity. With renewable energy sources currently making up less than 1% of the world’s primary energy supply, my guess is that we will contract very far indeed.
I was one of the opening speakers at the conference and I invite you to watch the short synopsis I gave on the first day. It provides the whole picture in just 14 minutes. This appears to be the first time you are examining this question so I expect that your immediate reaction will be to think I’m daft. I assure you that the decline of oil production has far-reaching impacts that almost no one is aware of. Combined with the deflation we are entering, our world will seem to change almost over night.
http://www.postpeakliving.com/aspo-2010-talk
Steve, if you’re still reading these comments, I would love it if you were to watch the video as well and provide any comments you see fit.
-André
Algae to oil.
Hi Andre,
I’ve watched the video, and the one addition I’d suggest is putting the inverse sigmoid model and Hubbert’s Peak as its derivative into the presentation near the beginning. The reason for this is that most people accept that the oil on the planet is finite (on a human time scale), so that the argument that initially it was easy to get the oil, and that over time it gets harder, drops right out of the basic proposition.
Once people accept that, they’ve accepted the basic shape of the Hubbert Peak, which you can illustrate simply by showing that the derivative of the inverse sigmoid gives you the current rate of extraction. Then the issue becomes how much can we change this shape–both in a positive sense (extending it) or a negative one (the propositions about oil producers hanging on to their oil and the exportable surplus running out in say 2040).
Without this fundamental starting point, I think it would be possible for people to “tune out” in the “technology/the market” will solve it way.
I think it would also be useful to illustrate how unique oil is as an energy density product–to counter the belief that we can find a substitute; and illustrate the scale of industrialisation needed to shift from fossil fuel transportation now to renewable–to counter the belief that we can do all this tomorrow.
On an unrelated issue(!), Australian readers may have seen the criticisms of the Australian Research Council’s funding process that I made in an article published in The Age and the Sydney Morning Herald in the last week:
http://www.smh.com.au/national/education/show-us-the-money-20101024-16z9c.html
For more on why Australia’s research funding system is flawed, check out Geoff Davies’ excellent swipe at the system from two years ago in The Australian:
http://www.theaustralian.com.au/higher-education/opinion-analysis/system-based-on-caprice/story-e6frgclo-1111115710688
And a professor of astronomy who has done very well out of the ARC has referred me to a paper of his in which he too points out that the system rewards conventional thought rather than innovation:
http://www.control.com.au/bi2008/299conscience.pdf
If I get the OK from Bryan, I’ll put a short blog entry up on this topic, linking to these three papers.
A US double dip is certain. Not likely for Australia.
Thanks, Steve. I think your comments are spot on. I have a longer video on my site for people to watch that goes through the whole oil story, including the Hubbert curve. In this case I was speaking to a knowledgeable audience so I could cut some corners. I will be redoing that video, however, because I’ve needed a shorter piece for a while now and will make sure your points make it in.
I’ve been asked to coauthor a paper for a European financial journal with an economist at Moscow University and Mikael Höök, who has done some of the best work out there on giant oil field depletion rates and global coal reserves. He’s at the Uppsala Global Energy Systems Group in Sweden. As an aside, it’s interesting to note that that Beijing University has partnered with the GESG so rest assured that the Chinese are well-versed in fossil fuel depletion since they are working with the world’s pre-eminent group on the topic.
The paper is tentatively titled “Risks to the Global Energy System in the Early 21st Century.” I greatly respect your insight and work and assign your Roving Cavaliers of Credit piece as homework to one of my classes.
Because we are talking to money people, I would very much appreciate your comments on a draft version of the paper so that our language speaks in a way they can hear. My commitment is that we get the money people to wake up to our converging crises and this paper will be a small but solid step forward with that. The draft should be ready early next year, possibly sooner. If you are open to that, please do let me know.
BBB, oil from algae is simply the latest in a long string of “solutions” that aren’t solutions and, in fact, often are not even net-energy positive. Read any of the pieces by Robert Rapier and you will see that algal oil has formidable challenges that, like fusion, are unlikely to be overcome at a price our civilization can afford.
P.S. it’s a pity there is no function to subscribe to posts with this blogging software.
Hi Steve,
All this ongoing talk of covered bonds is making me nervous. Its like we’re playing the game “what mistakes did US/Europe/Ireland make and lets copy that”. Do we really want to risk ending up like the US or more likely, Ireland?
Everyone has blamed the US banks for screwing up the western world, but I think it has more to do with education – on debt and on housing. You need a roof over your head to live… you don’t need to live in the trendy areas or have a bigger house than your friends – especially when that extra (above necessity housing) means you have to borrow more than you can ever reasonably afford.
Is there any “no to covered bonds” rally happening anytime soon? Please start one – I mean better rally now, than riot later, right?
Agreed TheOC,
But I’m not in a position to do so with my time constraints. I’m about to put out an appeal for assistance from blog members on a range of fronts–including formalising the Center for Economic Stability that we formed early last year. Perhaps such a rally could be a first activity, if others can come forward to organise it.