The pull between spending and saving

In a speech on Wednesday, Atlanta Fed President Dennis Lockhart talked about how the economic outlook is being shaped by the process of deleveraging (reducing debt and increasing saving) that is occurring in the economy.

By way of background, President Lockhart emphasized the important role that some amount of debt plays in economic growth: while difficult to measure precisely, research suggests that debt levels that get high enough are associated with extended periods of subpar economic growth.

"Debt is not in and of itself a bad thing. Debt supports economic growth by allowing households, businesses, and governments to smooth their spending and investment over time. Borrowing and lending can help facilitate the allocation of capital to productive uses in the economy. But high debt levels can also result in lower economic growth, a point that Stephen Cecchetti, of the Bank for International Settlements, made in a paper presented at the Kansas City Fed's symposium in Jackson Hole, Wyo., last week."

Relative to the 1990s, the last decade witnessed a surge in borrowing by the nonfinancial sector (comprising households, nonfinancial businesses and governments). Indeed, as President Lockhart noted:

"Relative to the size of the U.S. economy measured in terms of GDP, the total domestic debt of nonfinancial sectors of the economy reached 248 percent in 2009, increasing by almost 75 percentage points over the previous decade alone."

While no longer growing, the overall debt position of the nonfinancial sector has barely declined since peaking in 2009.

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How did we get to this point? Much of the increase in total debt during the 2000s was in the form of real estate debt, and most of that was by households and unincorporated businesses (mostly sole proprietorships and partnerships). During the 1990s the mortgage debt of households was relatively stable at around 45 percent of GDP, but it increased to a peak of 76 percent of GDP in 2009. Over the same period, mortgage debt for unincorporated businesses increased from around 12 percent of GDP to almost 20 percent.

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Because real estate is relatively expensive, it is not surprising that mortgage debt heavily influences the overall debt burden of individuals. Rapidly rising home values from the late 1990s to 2006 supported the notion that housing was a good asset to purchase…until it wasn't. According to the S&P Case-Shiller national home price index, home values have declined by more than 30 percent from their peak in 2006, after having increased by more than 150 percent compared with the previous decade.

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From their peak in 2009, debt levels for households and unincorporated businesses have declined relative to GDP notably by a combined 15 percentage points. Reduced mortgage debt accounted for three quarters of that decline. As President Lockhart notes, repairing the balance sheet of the household sector, just as it does for businesses, can occur through some combination of debt reduction and increased savings.

"Household deleveraging has occurred mostly through a combination of increased savings, debt repayment, and also debt forgiveness. At the same time, there has generally been less access to credit for households as a result of stricter underwriting standards. The inability to qualify for home equity loans and other forms of credit has slowed the pace at which new debt is taken on by households replacing paid-down debt. The effect is to reduce their debt burden over time."

In contrast to households and unincorporated businesses, the amount of debt owed by the nonfinancial corporate sector has not declined very much since 2009. Nonfinancial corporations increased borrowing during the second half of the 2000s. But most of the debt growth was from increased issuance of corporate bonds. Since its historical peak in 2009, the total debt of the nonfinancial corporate sector has remained at around 50 percent of GDP, as continued bond issuance has largely offset declines in other types of corporate borrowing.

If individuals are aggressively reducing their debt burden, and corporations haven't increased their overall borrowing, why hasn't the overall debt burden of the nonfinancial sector of the economy declined since 2009? The primary reason is that the amount of federal government debt has increased sharply in recent years—from 35 percent of GDP in 2007 to about 65 percent of GDP in early 2011.

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As President Lockhart observes:

"While the private sector—households and businesses—has made notable progress in lowering its debt burden, discussions of how to reduce public debt have only just begun. The government still needs to introduce major policy changes to put public debt on a sustainable path. Demographic trends, which I referenced earlier, will make public debt reduction even more challenging."

How long will the deleveraging process take to play out? I'm pretty confident that nobody really knows precisely, but President Lockhart suggests that we may be closer to the beginning of the process than the end:

"Rebalancing simply takes time. A 2010 report by McKinsey surveyed 32 international periods of deleveraging following financial crises and found that, on average, the duration of these episodes was about six and a half years. U.S. debt to GDP peaked in the first quarter of 2009. So, by that standard we are much closer to the beginning than the end of our deleveraging process."

Lockhart also makes the point that this necessary structural adjustment has consequences for the medium-term outlook:

"When economies are deleveraging they cannot grow as rapidly as they might otherwise. It is obvious as consumers reduce spending they divert more of their incomes to paying off debt. This shift in consumer behavior increases the amount of capital available for financing investment. But higher rates of business investment are not likely to fully offset weakness in consumer spending for some time, as businesses continue to grapple with uncertainties about the future."

From a monetary policy perspective, slower growth as a result of deleveraging raises important challenges:

"To my mind, it's becoming increasingly clear the challenge we policymakers face is balancing appropriate policy responses for the near to medium term with what's needed for the longer term. In other words, we must continue to help the economy achieve a healthy enough cyclical recovery, especially with unemployment high and consumer spending lackluster. At the same time, we must recognize the longer-term need for directionally opposite structural adjustments, including deleveraging."

How does President Lockhart size up the role of monetary policy in this context?

"Given the weak data we've seen recently and considering the rising concern about chronic slow growth or worse, I don't think any policy option can be ruled out at the moment. However, it is important that monetary policy not be seen as a panacea. The kinds of structural adjustments I've been discussing today take time, and I am acutely aware that pushing beyond what monetary policy can plausibly deliver runs the risk of creating new distortions and imbalances.

"We may find, as economic circumstances evolve, that policy adjustments are required. In more adverse scenarios, further policy accommodation might be called for. But as of today, I am comfortable with the current stance of policy, especially considering the tensions policy must navigate between the short and long term and between recovery and the need for longer-term structural adjustments."

By John Robertson, vice president and senior economist in the Atlanta Fed's research department

 

Just how out of line are house prices?

In Wednesday's post, I referenced commentary from several bloggers regarding the sizeable decline in housing prices reported by Zillow earlier this week. As I discussed yesterday, the rat-through-the-snake process of working down existing and prospective distressed properties is likely far from over, and how that process plays out will no doubt have an impact on how much prices will ultimately adjust.

Recently, Barry Ritholtz's The Big Picture blog featured an update of a New York Times chart that suggests there will be a significant adjustment going forward:

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Prior to the crisis, I was persistently advised that the better way to think about the "right" home price is to focus on price-rent ratios, because rents reflect the fundamental flow of implicit or explicit income generated by a housing asset. In retrospect that advice looks pretty good, so I am inclined to think in those terms today. A simple back-of-the envelope calculation for this ratio—essentially comparing the path of the S&P/Case-Shiller composite price index for 20 metropolitan regions to the time path of the rent of primary residences in the consumer price index—tells a somewhat different story than the New York Times chart used in the aforementioned Ritholtz blog post:

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According to this calculation, current prices have nearly returned to levels relative to rents that prevailed in the decade prior to the housing boom that began in the late 1990s.

Of course, the price-rent ratio is not the most sophisticated of calculations. David Leonhardt shows the results from other such calculations that suggest prices relative to rents are still elevated, at least relative to the average that prevailed in the 1990s. But the adjustment that would be required to bring current levels back into line with the precrisis average is still much lower than suggested by the Ritholtz graph.

How much farther prices fall is, I think, critical in the determination of how the economy will fare in the immediate future. Again, from President Lockhart:

"The housing sector also has indirect impacts on the economy. In particular, the direction of home prices is important for the economy because changes in home prices affect the health of both household and bank balance sheets. …

"The indirect influence of the housing sector on consumer activity and bank lending would almost certainly aggravate housing's impact on growth."

Here's hoping my chart is more predictive of housing prices than the alternative.

Update: The Calculated Risk blog does a thorough job and concludes that we don't have "to choose between real prices and price-to-rent graphs to ask 'how far out of line are house prices?' I think they are both showing that prices are not far above the historical lows."

Update: The Big Picture's Barry Ritholtz points me to his earlier argument against reliance on price-rent ratios.

By Dave Altig
senior vice president and research director at the Atlanta Fed

Is housing hurting the recovery?

Though the week is only half over, I'm going to nominate Stan Humphries and Zillow as bearers of the week's most distressing economic news:

"Home values fell three percent in the first quarter of this year, marking a pace of decline not seen since 2008 when the housing recession was at its worst. Home values fell one percent between February and March and 8.2 percent from March 2010."

Calculated Risk provides a handy table of how prices have affected equity values in homes by locale, as the Zillow Real Estate Research blog predicts the price-decline end is not so near:

"Previously, we anticipated a bottom in home values by the end of 2011. But with values falling by about 1 percent per month so far, it's unlikely that will happen. We now believe a bottom will come in 2012, at the earliest."

At The Curious Capitalist, on the other hand, Stephen Gandel says he's not so sure:

"To be sure, housing prices have fallen this year. But the Zillow numbers out today make the housing market look worse than it is. The problem is with how Zillow tracks home prices. Unlike other measures of the housing market, Zillow's numbers are not based on actual sales, but on estimates of what its model thinks your house, along with every other house in America is worth. Zillow's model is similar to how an appraiser figures out what your house is worth. It looks at past sales of houses that are similar to yours and then guesses what your house is worth. But by the time those sales are fed into Zillow's system they are months old. … If the housing market is turning, Zillow is going to miss it."

Is the housing market turning, particularly with respect to prices? Tough to say. If you want your glass half full, these words from the New York Fed's Liberty Street Economics might be the tonic for your tastes:

"This post gives our summary of the 2011:Q1 Quarterly Report on Household Debt and Credit, released today by the New York Fed. The report shows signs of healing in household balance sheets in the United States and the region, as measured by consumer debt levels, delinquency rates, foreclosure starts, and bankruptcies…

"Delinquency rates are generally down…

"New foreclosures fell nationally and in the region. About 368,000 individuals in the United States had a foreclosure notation added to their credit report between December 31 and March 31, a 17.7 percent decrease from the 2010:Q4 level. New foreclosure rates fell from 0.19 percent to 0.15 percent for all individuals nationwide…"

What may be the most important aspect of the report is highlighted by the Financial Times's Robin Harding: "…fewer new mortgages going bad, and some bad mortgages getting better." In fact, for the first time since the crisis began, the percentage of mortgages transitioning from 30 to 90 days delinquent to current exceeds the percentage transitioning to seriously delinquent (90-plus days).

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There is, of course, plenty of material for the housing-price bears. For example, the flow of seriously delinquent mortgages is quite elevated.

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According to estimates from CoreLogic, the supply of "distressed" homes is greater than 15 months at the current pace of sales:

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Kevin Drum thinks this all adds up to problems for the recovery (hat tip Free Exchange):

"Most analysts now expect that the housing market won't bottom out until sometime next year. Until that happens, it's unlikely that that the sluggish economic recovery we're seeing right now will improve much."

The view here at the Atlanta Fed—and the answer to the question posed in the title of this post—was provided earlier today by our president, Dennis Lockhart, in a speech given to the Atlanta Council for Quality Growth:

"…can we have high-quality growth while the residential real estate and commercial real estate sectors continue to be so weak? Not completely, in my opinion. The recovery will progress, but it will not be robust until we work through the economy's serious imbalances, including those in the real estate sector.

"As I look ahead, I think the most reasonable assumption is that improvement of the real estate sector will lag an otherwise improving economy. But I am encouraged by the fact that the economy is increasingly on firmer footing."

I will let you decide whether that glass is half-empty or half-full.

By Dave Altig
senior vice president and research director at the Atlanta Fed

A disturbing trend: No growth in total business establishments in U.S.

The last Atlanta Fed poll of small businesses in the Southeast suggested an uptick in confidence late last year. A similar upturn has been noted in the National Federation of Independent Business's survey of its members conducted in February of this year and released in March. This upturn is good news for the U.S. economic outlook, as small firms are one group that has lagged the economic recovery.

It's also good news, given the continuation of unimpressive readings from last week's release of the Quarterly Census of Employment and Wages (QCEW) for the second quarter of 2010. As we have noted previously and highlighted in this recent Wall Street Journal blog post,

"The recession caused a sharp decline in new business start-ups, intensifying job market losses and potentially putting future economic growth at risk."

The QCEW data also showed that the number of business establishments with payrolls in the United States has remained stuck at around 9 million since late 2007. By comparison, in the early 1990s there were about 6.5 million establishments, a number that rose to close to 8 million in 2000 before peaking at 9 million 2007.

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The net creation of business establishments—that is, physical locations for conducting business such as manufacturing plants, retail stores and business offices—has in the past been a key ingredient in job growth in the United States. This growth is driven partly by demand from newly created businesses and by mature firms expanding their footprint by opening additional locations. The demand for physical space is also clearly important to the commercial real estate industry, which has been burdened by elevated vacancy rates in many markets and generally low demand for new space.

Another trend from the QCEW data is striking—the number of employees per establishment is much lower than it used to be. The average size of U.S. establishments was relatively stable during the 1990s, at around 16.5 employees per physical location. The 2001 recession was associated with a decline in the average size to about 16 workers per establishment, and the average size continued to track lower during the last decade, moving down to about 15 employees per establishment in 2007. The latest reading for the second quarter of 2010 was 14.3 workers per establishment, up from 14 workers in the first quarter.

Several possible explanations exist for these declines in average establishment size. First, there is a cyclical response to weak demand as firms cut their payrolls. Second, productivity gains over time allow a plant, store, or office to support the demand for its goods or services with fewer workers. Third, there is a secular trend away from industries that have a large average establishment size, such as manufacturing.

If one digs into the data, only one major sector has experienced a rise in average employment per location over time—health care. This growth is likely a result of increased demand for health care services, and those services are primarily embodied in the staff at doctors' offices and hospitals. Manufacturing, on the other hand, has witnessed dramatic declines in average plant size. During the 1990s, average plant size was relatively stable at around 43 workers. The average size then declined to about 38 workers following the 2001 recession and remained around that level through 2007 before declining again and reaching an average size of 33 workers per plant in the second quarter of 2010. This trend appears to primarily reflect a combination of secular shifts away from labor-intensive types of manufacturing where productivity gains have already played out—some apparel manufacturers, for instance—and sharp cyclical downturns.

Of course, something will have to give if there is employment growth—primarily more and/or larger establishments. Consider the following thought experiment: if the average size of establishments returns to the prerecession level of 15 workers per location, and private-sector jobs are added around a pace of 2.4 million a year pace (or 200,000 jobs a month), then we would see establishment growth return to the 1992–2007 average of about 160,000 per year. Clearly, we are currently far below that trend.

By John Robertson
Vice president and senior economist in the Atlanta Fed's research department