FOREVER BLOWING BUBBLES

We’ve had an intense fascination with blowing bubbles since the day we’re born. Whether it’s soap bubbles, balloons, bubble gum, we’re forever blowing them, the more the better, the bigger the better. We watch in awe and anticipation as the bubble gets bigger and bigger, and we snap back in excitement (and a little surprise) as the bubble bursts, often in a messy and dramatic fashion. Did we not expect it to blow up? Then we blow another one. and another.

It’s quite the similar story with adults in the financial world: we create, often through breakthrough financial engineering advances, investment opportunities that look too good to pass up, we fuel the bubble with a toxic mix of greed, cheap credit, intense lobbying, and minimal regulation, we market the opportunity as a low risk/high return affair (as if this concept actually ever existed in real life), and we feed it to the people who can least afford it, sometimes forcefully, sometimes fraudulently. And finally, when the bubble bursts, we borrow the government’s bailout mop to clean up the mess left behind. History is riddled with financial boom-bust-bailout episodes, and one does only need to look in the recent past for some of the more striking examples of leveraging and excess gone wild. It has even been shown in a rather comprehensive and thorough way by Reinhart and Rogoff in their excellent seminal treatise on the history of financial crises that this boom-bust cycle has been getting shorter and shorter, with more devastating consequences and spilovers on the global economy (you can download the entire excellent dataset of the book for free here).

So you wake up every morning and you wonder “What is the next financial bubble, how big is it, and who’s blowing it?”. Or maybe you don’t, but you should, since we’ve already experienced in very stark detail (and still do) how someone else’s big messy pile can quickly turn into your own sour bill to pay. And like with every other question I have, I turned to Google search to get started on an answer. I typed “next financial bubble” in the search box and got the following random candidates for the US economy, in no particular order: derivatives, student loans, credit card debt, the stock market (and more recently social media stocks), and healthcare. There are many more bubbles outside the US market, like commodities, China, emerging markets, and other lurking risks, but we can examine those in a different post.

The the $1.2 quadrillion (one thousand trillions) derivatives market has been dubbed “one of the biggest risks to the world’s financial health”. It’s complex, it’s unregulated, and it ought to be of concern that its notional value is 20 times the size of the world economy (note though that we’re talking here about notionalvalues, not net values). U.S. commercial banks currently hold a notional value of $244 trillion in derivatives, with Net Current Credit Exposure of commercial banks to derivatives of $353 billion (due to bilateral netting), and that’s the number we’ll use for the US market. See the latest OCC report for further details. College tuition costs are soaring and forcing the young to bear obscenely high levels of student loan debt, while a ballooning $1 trillion student loan bubble shares a strikingly scary resemblance to the toxic subprime mortgages of six years earlier (and are just as likely to be repaid). Credit card debt is as american as apple pie, and rising healthcare costs prompted ObamaCare, while stock market bubbles are a recurring and familiar scene. While the U.S. Higher Education, credit cards, and healthcare bubbles aren’t an asset bubble like stock or real estate bubbles, it is a bubble-like phenomenon with very similar risks and implications as asset bubbles.

I couldn’t quite seperate media hype from real risk, so to test the claim that a particular phenomenon is a bubble or not, and to compare the claims side-by-side, I resorted to a simple visualization technique called (what else?) the bubble chart, whereby I plot the bubble phenomena on a three-dimensional graph according to 1. overall growth since 2001 (in multiplier form), 2. latest yearly growth rate vs average yearly growth rate (also in multiplier form), and 3. with the size of the chart bubble indicating it’s relative size to US GDP in real life. These dimensions basically illustrate the total amount of growth in the past 10 years (vertical), the most recent rate of growth relative to the 10-year average growth rate (horizontal), and the size of the “problem” relative to GDP (size and color of bubble). The crude and preliminary results look something like this:

Three basic observations: the fastest growing recent trend can be observed in college debt, the biggest increase in the past 10 years has been in the derivatives market, and the biggest exposure to the overall size of the economy can be found in the stock market, albeit at a much slowing pace (due mostly to the great correction of 2008).

The current price to earnings ratio of the overall U.S stock market stands near its long-term historical average of 15, so it seems that overall valuation is where it should be. I’ll go on a limb and say that credit card debt seems to be under control, owing to a recent 3 year episode of consumer credit deleveraging following the shock of 2008. The derivatives market looks like a runaway train on the chart above, but it relatively small in net terms, and considering that the derivatives market is in its infancy pretty much, and hence starting from a low base, such great rates of growth are expected. Which leaves us with skyrocketing healthcare and education costs, among other things, to get alarmed about.

The cost of healthcare, like college education, has exploded in recent years, far outpacing wage growth and the overall rate of inflation:

Healthcare spending as a share of the US economy reached an all-time high of 18.2 percent in 2011, an incredible threefold increase since 1960. The sad fact is that Americans spend twice as much on healthcare compared to other developed countries, but get lower quality care and less efficiency. Like any other industry, the healthcare industry is tied to the health of the overall economy and when their services become even more unaffordable for vast portions of the population, such as in the next recession, the industry will experience some form of a collapse. The popping of the healthcare bubble will cause all levels of the U.S. healthcare industry to downsize in the form of layoffs, salary cuts, hospital and medical office closures. As with housing, healthcare will always be needed, but the US healthcare industry’s current levels of largesse and parasitic profits cannot be sustained.

On student loans and the alarming, crisis-like levels it reached, I point you to this succint piece in the Pulse, and this cartoon:

Bubbles this big simply have to be closely monitored and kept in check. The government should seek sharpening of monetary policy and macro-prudential tools to deal with these, due to their implications for the economy and the strength and stability of the financial system, as well as the overall well-being of the society.

-Samer

PUBLIC PRIVATE DEBT BURDEN: A STOCKTAKING SINCE THE LEHMAN FAILURE

The global financial crisis showed the distinction between private and public debt is far less important than previously thought: private debt can quickly become public debt and high public debt can quickly hinder private borrowing. Recent experience in Europe shows that refinancing problems, even for the sovereign, can arise abruptly. More importantly, they can arise either from large public debt (Greece), large private debt (Ireland), or a combination of the two (Portugal). In February 2011, the G20 announced that they would monitor country imbalances on the following indicators: public debt and fiscal deficit; private debt and private savings rate; and the external imbalance. In this post, we take stock of the main changes in public and private debt levels after the crisis and explore their implications for financial stability.

METHODOLOGY

We examine changes in the total (public and private) debt of a number of countries during 2005-10 based on quarterly flow of funds level data from Haver Analytics. Total debt is calculated by summing up the debt of nonfinancial corporations, financial institutions, general government and households including non-profit institutions serving households (NPISHs). Debt is calculated as the sum of (i) securities other than shares (excluding financial derivatives).; (ii) loans, and (iii) accounts payable of each sector. The underlying data for these variables come from national flow of funds. Finally, we divide the debt stocks by GDP to get a measure of the total debt burden of the economy (given that GDP reflects the capacity of the whole economy to generate income and repay the debt).

FINDINGS

Outstanding debt levels in advanced countries—public and private—are generally higher than they were before Lehman, despite deleveraging in some sectors. This suggests higher refinancing risk for both public and private borrowers in the years ahead.

In particular:

  • The public sector has been the primary driver of debt accumulation in advanced countries after Lehman’s demise due to continued fiscal deficits and sluggish growth, sometimes more than offsetting the positive developments in other sectors. Gross general government debt is now higher across the board for all countries, but especially for Japan and the US. This is also the case on a net debt basis.
  • Outstanding debt of the financial sector is also higher in most cases, except for Germany, Ireland and the United States. However, due to ongoing efforts to boost bank capital, the net asset position of the financial sector has improved in most cases.
  • The household sector has been deleveraging in most advanced countries, except in GIP, as consumers shy away from contracting new debt and increase savings. At the same time, due to increased valuation of household assets, the asset position of households is now in much better shape, except for Greece. In the US, a significant part of the household deleveraging can be attributed to write-offs on consumer loans and mortgages.
  • Outstanding debt of the non-financial corporate sector is somewhat higher than before, especially in Ireland and Portugal. On a net basis, the financial position of the non-financial corporate sector has improved in most cases, except for Ireland and Portugal.

More broadly:

  • Total Debt is still growing. In most advanced countries, the economy as a whole, putting all sectors together, is still accumulating debt.
  • Risk transfer. Although private debt has been declining gradually since Lehman, this has been more than offset by the increase in public debt.
  • Initial conditions matter. We can show (see below) that countries with higher private debt before the crisis experienced larger increases in public debt in the post-crisis period.

  • Refinancing risk. Given the larger total debt stock, refinancing risks (for both private and public debt issuers) are now much higher and likely to remain elevated for some time.
  • Debt workouts. In highly indebted countries where domestic savings are low (as reflected in current account deficits) and growth prospects are weak, debt workouts may become necessary.
  • Sovereign risk. A lesson from the crisis seems to be that authorities need to monitor the private stock of debt, in addition to the public sector debt.

With the public sector becoming the main debt accumulation engine in the post-crisis period, there is a need by policymakers (including public debt managers) to expand the monitoring scope to include private as well as public debt. To the extent that new government debt could end up crowding out corporate debt at specific maturities and vice versa, policy makers and private-sector risk managers need to pay more attention to refinancing risk in the years ahead. Gross debt and net debt levels are worth monitoring in parallel, as the former can give a picture of potential liquidity problems, while the latter can give show solvency problems.

-Samer

Serkan Arslanalp from the IMF contributed to this post.

US HOUSEHOLDS NET WORTH – SOME GOOD NEWS

Economic realities and short-term prospects are bad in the US. You hear it everywhere, from the media to your next door neighbor. Growth is flat, unemployment is high, and the housing market has crashed with presumably still some downward space to go. But beyond the media hype, how bad are things? Fundamentally? and how does it compare with previous recessions? I wanted to shed some light on this matter using a single, uncomplicated economic measure with a long enough time-series to cover at least the last 50 years. The simple yet powerful concept of net worth came to mind.

Net worth is simply what’s left on someone’s balance sheet after you deduct all your liabilities from your assets. What you have minus what you owe. It’s a core measure of solvency, used mostly in financial sector economics (banks capital), but also in any kind of balance sheet analysis involving assets and liabilities. I wanted to analyze the combined net worth of US households over the last 50 years, and see where we stand. Luckily, the readily-available and infinitely useful flow of funds datafrom the Federal Reserve provide a nice historical quarterly time-series of the US households’ balance sheet positions. Below is a quick visualization I made using that data.

One line traces the evolution of combined households net worth in USD billions, and the other shows a share of net worth over total assets, the higher the number the better for both indicators.

The viz shows a steady increase in net worth from the early 50′s to 2007, except for a hiccup related to the dot.com bust of the first few years of the 21st century. Then came 2008 and everything came crashing with armageddon-like ferocity.

The evolution of the share of net worth over assets, which can be considered as a measure of “soundness” of net worth, has similarly gone through the dot.com and 2008 turbulence, but has on the other hand been on a slow but steady erosion since the early 50′s.

So far so good, except that, before crunching the numbers, I was expecting to see a particular trend post-2008, particularly one of declining net worth and declining share of net worth to assets among US households, to go with the gloomy stream of economic news and market sentiment of the past few years. Instead, the numbers show a rather strong rebound in both indicators, starting from early 2009. Low and behold, things are not so desperate after all if you were to trust the fundamental information derived from the flow of funds data. How could that be? One simple explanation, also provided by the flow of funds sectoral balance sheet data of the US economy, is that Americans have taken extra care post-2008 to reduce their credit card debt (liabilities) and increase their savings deposits (assets), hence improving their net worth. While aggregate consumption ( and hence growth) has been the main victim of this balance sheet cleanup, things are looking better fundamentally for american households.

Caveats. Along with the level of net worth, one has to also look at the distribution: We already know from census data that the rich are getting richer and skewing the averages. Equally important is a look at earning power and disposable income: unlike net worth (a solvency concept), earning power is an income statement concept, or a “liquidity” concept. It is indeed more palpable than the net worth concept. So granted, households net worth is only one part of the economic picture, but it’s a fundamental one with long-term implications.

It is hard to convince someone who has lost their job or saw the value of the house they live in slashed in half that things are looking brighter. The alternative is trusting the media. I’d rather trust the hard numbers.

-Samer