In last week’s “Decision Making at the Federal Reserve” at the International House of New York Janet Yellen said that the US economy had made tremendous progress in recovering from the damage caused by the financial crisis, that labour markets were healing and that the economy was on a solid course. She also said the economy was not a bubble economy, and that if you were to look for evidence of financial instability brewing you would not find it in key areas: over valued asset prices, high leverage and rapid credit growth. She and the FRB did not see those imbalances and despite weak growth would not describe what we currently see in the US as a bubble economy.
Perhaps the question was the wrong one. The bubble, indeed most bubbles, are financial in nature and relate to both the flow of financing and the current stock of financing. We are always in a bubble to some extent given that one of the key facets of the monetary system is the discounting of the present value of future flows through the allocation of assets, principally of money relative to all other assets. Today’s differential between what the economy can produce over time and the value and supply of assets that represent the future expenditure flows from our economy, are I believe, in excess of the present value of those flows. Part of this is due to monetary stimulus designed to drive growth forward in the face of demographic change, increasing income inequality (which weakens the expenditure base of the economy) and important transitions in key emerging economies that have numerous structural relationships.
We are in a bubble and while the economic issue today is one of a deflating frame (i.e. not one with inflationary characteristic usually associated with economic overheating), the differential between the financial frame and the economic has arguably never been so wide. Perhaps the Federal Reserve should have defined what they believed to be a bubble or rather the moderator should have been a bit cleverer!
Some may say that excess financial leverage of households has moved back to more sensible levels: the following chart shows that consumer debt levels have moved back to early 2004 levels but that these levels were associated with much higher longer term real GDp growth rates. In this context debt has not really fully adjusted.
And, looking at shorter term real growth trends we see that real GDP growth has peaked at much lower levels relative not just to total debt to the rate of increase in consumer debt. One would be forgiven for thinking that the last 5 years included a recession in the data, but it has not:
And household debt has increased of late, and while mortgage debt growth has been relatively subdued….
……………..consumer credit metrics have been anything but:
We can also compare household debt metrics to income growth: again, income growth has slowed (without even accounting for skews in its distribution) while the relationship between asset values and income values have skewed upwards, primarily because of unconventional monetary policy: low interest rates and QE but also increasing income inequality and lower rates of capital expenditures.
In Japan which has experienced much more pronounced demographic change falling unemployment rates have not been accompanied by rising wages. Just because we see headline unemployment rates falling in the US does not necessarily mean that the economic frame is a solid one, indeed is the relationship between an expanding asset bubble and a deflating labour/capital/total factor productivity frame a solid one?
So we have rising asset values and declining income and GDP growth:
Similarly the wider non financial sector debt (gov’t, consumer, Non financial corporates) debt has actually increased in the US relative to GDP. If this is not a divergence, a key structural metric of a bubble, then what is?
And as we see below, household assets to capital expenditures are at historical extremes:
And the ratio of the change in non financial corporate debt to capital expenditure (outside of recession) is the highest it has been since the 1980s, albeit with much lower real GDP growth rates:
The financial sector is one area where leverage has fallen considerably, but again the relationship with real growth rates leaves cause for concern:
And if we look at nominal growth rates of loans and leases in bank credit (FRB H8) relative to GDP we find a still fundamental level of excess over rolling 10 year periods:
A clear decline as mortgages defaulted during and following the crisis but a recovery in the growth rate since to levels synonymous with prior cyclical peaks:
All in all we still have significant financial excess in the US, a disturbing fact in the light of the FRB’s portrayal of financial/economic system risks.