Richard Koo Answers The Most Critical Question About The Western Economies: Is The Deleveraging Over?

In his latest research note, Nomura Chief Economist Richard Koo – who pioneered the concept of “balance-sheet recession” – says he feels the need to respond to those who are saying that the age of private-sector deleveraging in the U.S. is over.

According to Koo, that assertion stems from an incorrect read of the Federal Reserve’s latest Flow of Funds report, released in early December.

The report showed that for the first time since 2007, the financial surplus of the U.S. household sector turned negative. In other words, the value of financial liabilities – or debt – was larger than that of financial assets in the household sector, meaning the net savings of households turned negative.

The graph below shows this shift. The white bars are assets – notice how they have exceeded the red bars (liabilities) since 2007 as households paid down debt in the wake of the collapse of the credit bubble. The blue line shows the difference between the two (assets minus liabilities).

Household sector net savings

Photo: Nomura

The shift to negative net savings in the household sector is supposed to be bullish for the U.S. economy. The implication is that at the end of 2012, households finally started borrowing again – spending again – as opposed to paying off past debts.

Koo, however, suggests that observers are missing the details, which paint a much bleaker picture.

In fact, according to Koo, the way in which the household sector shifted to net negative savings at the end of 2012 has only been observed twice before in recent memory. The first time was following the collapse of the internet bubble in 2000, and the second time was following the collapse of Lehman Brothers in 2008.

Koo writes:

Financial deficit due to drawdown of financial assets

We then have to ask why the broader household sector ran a financial deficit in Q3. The answer can also be found in Figure 1: the fact that the latest white bar is below zero means households drew down financial assets in the quarter.

And that is hardly a good sign. It has happened only three times since 2000, including the present occasion.

The first instance (barely visible in the graph) was in 2000 Q4, when the Internet bubble collapsed. The second was in 2008 Q4, when the failure of Lehman Brothers sparked a global financial crisis. People faced cash flow problems in both periods and probably were forced to draw down existing savings to make necessary payments.

Consumption driven by asset drawdowns not sustainable

During the bubble period towards the middle of Figure 1, much attention was paid to the fact that the US household savings rate had turned negative. While the sector did run a financial deficit during this period, the deficit was attributable to the fact that the increase in financial liabilities (ie growth in borrowing) was greater than the increase in financial assets (ie growth in savings). There was no drawdown of financial assets.

Hence we need to pay attention to the fact that the latest figure shows only the third drawdown of financial assets since 2000 and that this drawdown is responsible for the financial deficit in the broader household sector. The reason: if household consumption is being financed by the drawdown of financial assets, it is not likely to be sustainable.

This pattern of drawing down financial assets while reducing financial liabilities has been frequently observed in Greece during the last two years and is definitely not a positive development, in my view. 

Meanwhile, Koo notes that the corporate sector in the United States remains a net saver, per the latest Flow of Funds report:

Corporate sector balances

Photo: Nomura

So, what is the outlook for corporate sector releveraging, then?

Koo writes that it’s unlikely to return for several more years:

Even in the aftermath of the Internet bubble collapse, during which the necessary adjustments were far milder, it took 12 quarters—three full years—for corporate sector behaviour to return to pre-bubble norms.

Given that the shock of the housing bubble collapse was several times greater, I suspect that at least several more years will be needed before US companies stop increasing savings and resume borrowing money to expand operations.

And with both the corporate and household sectors refusing to borrow, Koo writes that “fiscal stimulus is currently the only thing preventing the US economy from falling into a deflationary spiral, since both households and businesses are increasing savings in spite of zero interest rates.”

Bottom line: Koo thinks the releveraging argument is “premature,” to say the least.

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