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
1 920 818 0236
I have a lot of problems with you, dear mister Kasriel. Well, actually one:
ReplyDelete"I cannot contain my optimism about the economy’s prospects in the New Year."
versus, a couple of months ago: http://www.financialsense.com/contributors/paul-kasriel/even-no-fed-taper-slower-growth
"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."
Commercial bank credit growth (the main component of depository institution credit) is almost negative:
http://research.stlouisfed.org/fred2/graph/fredgraph.png?&id=TOTBKCR&scale=Left&range=Max&cosd=1973-01-03&coed=2013-12-04&line_color=%230000ff&link_values=false&line_style=Solid&mark_type=NONE&mw=4&lw=1&ost=-99999&oet=99999&mma=0&fml=a&fq=Weekly%2C+Ending+Wednesday&fam=avg&fgst=lin&transformation=pc1&vintage_date=2013-12-19&revision_date=2013-12-19
Is it not true that the Shadow Banking System has done the lion's share of credit creation in the recent decades? And that the traditional 'reserve velocity' is not particularly relevant at this time - given the $2 Trillion of excess reserves in the system?
ReplyDeleteAlso, it seems the shadow banking system has been constrained in its credit creation by a lack of high quality collateral , as the Fed has been hogging most of it. Therefore, is it possible that the Fed tapering would actually accelerate credit creation by the shadow banking system as more high quality collateral becomes available to the private sector?
that's nice idea for properties investment.Residential Real Estate Funds is fine.
ReplyDeletethat's brilliant blog for Properties investment.Residential Real Estate Investments is so good.
ReplyDelete